Meet Daniel, a 35-year-old marketing professional living in Vancouver. Like many Canadians, Daniel has been feeling the weight of his financial obligations, from his mortgage payments to managing credit card debt.
But recently, things are beginning to take a positive turn. Daniel has started a side gig offering digital marketing consulting, and it’s paying off, bringing in an extra $800 each month.
With this new source of income, Daniel finds himself at a crossroads. Should he use this money to pay down his debts or put it into an investment vehicle to build long-term wealth?
The mortgage on his home is $350,000 with an interest rate of 4.5%, while his credit card debt, although manageable, carries a steep 19.99% interest rate.
He has read countless articles debating whether paying down his debt or investing for future gains is the smarter move, but he’s still unsure.
On the one hand, investing that $800 could yield good returns, especially if he chooses low-cost index funds that have historically averaged annual returns of about 7-8%. On the other hand, paying down the credit card debt would guarantee savings on interest and cut down his monthly obligations.
Should he put the extra cash into paying off his debt to minimize his monthly obligations or dip his toes into the investment world to grow his wealth over time?
Should I Consider Investing My Extra Cash?
Well, a good rule of thumb is to invest if you can earn a higher return on investments than the interest rate on your debts. So say you have a mortgage with a 5% interest rate and an index fund offering a 10% annual return, in this case, investing your extra cash could help you come out ahead.
However, if you have credit card debt at 20%, it’s typically smarter to focus on paying off that debt, as no stable investment can outpace that interest rate. But it’s not always that simple.
Investments can be unpredictable and can fluctuate in value. An index fund might rise by 10% one year but fall by 10% the next. While there are low-risk investments with guaranteed returns, like CDs or government bonds, these often yield less than the rates charged by high-interest debts.
So it’s important to weigh key factors before deciding:
1. Long-Term Wealth Building
If you are looking to build long-term wealth, investing might be a good choice. Investing can build long-term wealth through compounding. By investing in stocks, bonds, or mutual funds, you allow your money to grow over time.
Starting early amplifies the benefits of compounding, which can significantly grow your wealth over the years. However, if you’re uncomfortable with the ups and downs of investments, you may want to focus on debt repayment instead. A higher risk tolerance generally makes investing more favourable.
2. Inflation Protection
Investing can help protect your money from inflation. If the returns on your investments exceed the inflation rate, your purchasing power remains intact. Historically, investments like commodities and inflation-indexed bonds help counter inflation by maintaining value and generating returns during economic fluctuations.
Should I Pay Off My Debts With My Extra Cash?
Debt is the money that you’ve borrowed and are now paying interest on. If left unpaid, your debts will grow continuously, with interest charges adding to your balance. There are several good arguments for choosing to pay down debt rather than investing.
1. Interest Costs
High-interest debt, like credit card balances, can be especially costly. In Canada, the average credit card interest rate sits between 19.99% and 25.99%, a rate most investments simply can’t match.
Choosing to pay down this debt can result in major interest savings, providing a quicker path to financial freedom. In a rising interest rate environment, this strategy becomes even more essential.
Higher interest rates mean that a larger portion of each payment goes toward interest rather than the actual loan amount, making the debt harder and more expensive to pay off. Reducing this debt can save money over time and bring peace of mind, especially when interest rates are on the rise.
2. Reduced Financial Stress
Beyond saving money, paying off debt can also reduce financial stress. Carrying significant debt can weigh on you mentally, often leading to anxiety or worry.
If the burden of debt is keeping you up at night, then focusing on repayment could be the right choice. Being debt-free or even reducing the balance can bring a sense of relief and help you feel more in control of your financial future.
3. Improved Credit Score
Improving your credit score is another benefit of paying off debt. A high credit score is essential for securing favourable interest rates if you plan to borrow in the future, whether for a mortgage, car loan, or other major purchase.
Your credit score also affects other areas of life, like insurance premiums, rental applications, and even employment opportunities in some cases.
By paying down debt, you can improve your credit utilization ratio (the portion of available credit you’re currently using), which plays a large role in determining your score. Lowering this ratio can help increase your score and position you for better financial opportunities ahead.
Should I Pay Off My Debts or Invest: Which is better?
Each option offers unique benefits, and the “right” choice depends on your financial goals, debt interest rates, and personal comfort level.
Paying off debt—especially high-interest debt—can be financially and emotionally rewarding. If your debt has a high interest rate, paying it off should be a priority. Few investments can reliably beat these rates, so paying off high-interest debt can save you significant money over time.
Also, if you plan to borrow for a big purchase soon (like a home or car), paying down debt can help boost your credit score. If you’re experiencing stress or anxiety over owing money, paying it off might bring peace of mind. Being debt-free, or at least significantly reducing debt, can offer a sense of relief and financial freedom.
However, if your debt has a low interest rate, such as a mortgage or certain student loans, investing could offer better returns. Investments in low-cost index funds, for example, have historically averaged 7-8% returns annually, which may outpace the interest you’re paying.
If you’re financially stable and can manage your debt, investing may provide significant long-term growth, especially in tax-advantaged accounts like a Tax-Free Savings Account (TFSA) in Canada. Contributing to accounts like a TFSA can yield tax-free gains, making investing very attractive.
If you have room in such accounts and manageable debt, investing can be a smart way to build wealth with the benefit of tax-free growth.
RECOMMENDED READINGS:
- Should I Refinance My Mortgage Now That Rates Are Falling? (2024)
- What is The Best Way to Invest Money in Canada for 2024?
- 10 Safe Investments with High Returns in Canada (2024)
- 8 Best Investments in Canada for 2024
- When Are Taxes Due in Canada? The 2024 Canada Tax Deadline
Final Thoughts
Many people find that a balanced approach works best for them, one that involves both paying down debt and investing.
For instance, if you have extra cash, you might allocate a portion to high-interest debt while also contributing to investments. This way, you’re both improving your net worth and building your future wealth.
Ultimately, the decision comes down to your unique situation. If debt feels overwhelming or has high interest, tackling it first might offer peace of mind and immediate financial benefits. If your debt is manageable and low-interest, investing could provide long-term growth potential.
So carefully considering your financial goals, debt levels, and personal comfort, and taking a balanced approach, where you invest and pay down debt strategically, can often be the best of both worlds on the path to financial freedom.
