August 2010

This article is provided by Brian Marling of Neighbourhood DLC – Canada’s #1 Mortgage Team  905.372.7222

The answer to the question of whether to use any excess cash for investments or debt repayment seems to go back & forth on a regular basis. However, the scale seems to be tipping in one direction since the financial crises hit in the fall of ’08.

Hopefully if we learned anything from the past couple of years it is this – there is no such thing as a sure thing when it comes to investments.  So, what to do? Invest or repay debt? Perhaps this excerpt from a recent Toronto Star Article will help shed some light for you…

Canadians are learning to save more, invest more conservatively and de-risk their retirement account. So, despite what your personal conclusion might have been last time you thought about the smack-down between RRSPs vs. mortgages, the economic equation has recently tilted in favor of paying down debts vs. building up assets, but only for those of you with low tolerance for any investment risk.

As you probably noticed, despite recent moves by Mark Carney and the Bank of Canada to nudge the numbers upward, the interest rate being earned from GICs, term deposits and government bonds remains pathetically low.

For those risk-averse savers who abhor the volatility of the stock market, money is earning 3 per cent – if they are willing to lock in for a few years—and less than 1 per cent on demand deposits and savings accounts. Hey, did you ever hear of the rule of 72? Guess how long it takes money to double if your retirement’s nest egg is earning 1 per cent per year? Yes. You guessed it. 72 years.

Do the math. If you are paying 6 per cent, 5 per cent or even 4 per cent on your mortgage – which is on the liability side of your personal balance sheet – but your financial assets are (only) earning 1%, 2% or 3%, then you are effectively destroying wealth. It’s the debt equivalent of constantly buying high and then selling low in the stock market. Once you think about for just a few seconds, you realize it’s dumb.

Here is how to think about the tradeoff between paying down your mortgage versus saving in your RRSP or TFSA. If your mortgage is costing you 5 per cent, then every dollar you don’t invest but instead use the money to pay-down debt will earn the said 5 per cent. If the debt clock is ticking at 10 per cent or 15 per cent like many credit cards, the argument for raiding your retirement accounts to eliminate the debt is even stronger.

Of course, if your investments – RRSPs and the like – are invested aggressively under the hope and expectation that they will earn more than mortgage rate you are paying or current bond yields, then you can justify not paying down your mortgage. After all, borrowing at 5 per cent makes sense if you expect to earn much more.

However, you have to be able to look yourself in the mirror and say: “Yes, I think my assets will earn more than my liabilities are costing me.” Remember, even the most delusionary deflationary pundit doesn’t forecast a 5 per cent gain on your Government bond, or GIC or cash that is only earning 3 per cent per year interest.

Don’t take my word for this. A recent article by two economists at the University of California at Berkeley made the same point, albeit with reference to a U.S. audience. They examined more than 15,000 household financial records and determined that over a quarter of those households should completely abandon equity market participation or stock ownership because of the high interest rates they are paying on their large portfolio of debts.

To quote their words in a scholarly journal called the Review of Financial Studies, “Households with high interest debt have a reduced benefit to equity participation and in many cases should not own any stocks…repayment of outstanding debt almost always yields a higher rate of return than many of the safe (investment) assets.”

This might be quite obvious to some – pay down your credit card debts, duh! – but the fact 25 per cent of their sample isn’t doing it right is downright shocking. Yet I suspect the percentages of sub-optimal behaviors might even be higher in Canada.

Many Canadians might be better-off forgoing the immediate tax deduction from the RRSP contrinution – which will eventually have to be paid back – and instead pay down their high interest debt. An even stronger case can be made against TFSA contribution, again, if your debts are ticking at high rates but you assets are growing (or even shrinking) at low rates.

Ok. Here’s the bottom line. It’s time to look at both sides of your personal balance sheet at the same time. Add up all your debts and compare the interest cost of all your liabilities against the interest you will be earning on your retirement investments, based on your current asset allocation mix between stocks and bonds.

If the former is greater than the latter, it’s time to pay down some debt and forgo the investment plan contribution. Oddly enough, not contributing to your RRSP or TFSA might make you wealthier in the long run. …

In light of the above article, and combined with current low mortgage rates, there has never been a better time to consolidate your debt and finally get on track for the future!

Here at Neighbourhood not only do we provide Award Winning Service and the best selection of mortgage products in the country, but we also provide our Free Financial Fitness Seminars and have also added Personal Financial Coaching for those who truly desire a change but would like some assistance along the way. If you don’t change something then don’t expect different results.  As always you can call us anytime to discuss how we may be able to help you.

Here at Neighbourhood, & the home of the Brian Marling Mortgage Team, we are concerned for the total well-being of our clients. That’s why we are taking the years of experience from our award winning office and offering a series of  FREE Seminars to our clients, their friends & families, and to the public at large. The seminars, entitled ‘Financial Fitness’, will be offered free of charge and will cover all the secrets of successful personal financial freedom. If interested please call our office at 905.372.7222 to reserve your spot as seating will be limited. The next Financial Fitness Seminar will be Sept 28/10.