Next week we will continue our series on Setting a Course to Be Debt Free, but today we will address a very common question: should I pay down my debt, or should I contribute to an RRSP? The answer depends on your circumstances. Here are the four questions you need to answer:
- What interest rate are you paying on your debt?
- What return will you earn on your RRSP investments?
- What is your marginal tax rate?
- Are you a disciplined saver?
The first two questions are easy to analyze. If you are paying 24% interest on your department store credit card, and your RRSP contribution will be invested in a savings account type investment earning 2% interest, so you obviously save a lot of money by paying down your debt first.
Here’s another way to look at it: “Investing” $1,000 by paying down your 24% interest credit card will “earn” you $240 this year. That same $1,000 invested in your RRSP will earn you $20 in interest. If you have high interest debts, you are almost always better off paying down your debts first.
Of course the advantage of investing in an RRSP is not just what you earn in your RRSP; you also get a tax refund for contributing to your RRSP, which is where question #3 enters the equation. If you are in the 30% tax bracket, your $1,000 RRSP contribution will generate a $300 tax refund for you. Here’s the math:
Choice #1: Use $1,000 to pay down high interest (24%) debt. Return = $240 in interest savings in first year.
Choice #2: Contribute $1,000 to your RRSP. If you are in the 30% tax bracket, you get a $300 refund, plus at 2% your RRSP will earn $20, so at the end of one year you are up by $320. However, you still have your credit card debt, so you pay $240 in interest, so that leaves you $80 ahead.
If you just look at the first year, contributing to your RRSP appears to be the best choice. But what about the second year? If you still owe $1,000 on your credit card, in the second year you pay $240 in interest, but you don’t get any further tax deductions on your RRSP. Your RRSP may still earn 2% on the $1,020 that’s invested, or just over $20, but that leaves you $220 behind in the second year, which when combined with the $80 you were ahead in the first year still leaves you worse off by $140.
It gets worse every year thereafter, if you still have credit card debt.
As this example illustrates, in most cases, if you have high interest rate debt, and if you earn a low return in your RRSP, you are better off paying down debt.
Point #4 above asks if you are a disciplined saver. If you are, contributing to an RRSP may make sense. In the above example if you contributed to your RRSP and then took your $300 tax refund and paid down your high interest credit card, you would reduce the balance owing, which reduces the interest you will pay in the future. If you are very disciplined and will have your credit card paid off over the next few months, it may be possible to do both: contribute to your RRSP and pay down your debt.
Unfortunately, most Canadians that get a tax refund don’t use it to pay down debt; they spend it. If that’s what you are likely to do with your tax refund, don’t bother contributing to an RRSP. Use your money to pay down your debt, and become debt free faster.