A Step In Managing “Then” Money

Should you pay down personal debt or save for the future?  Both are “then” spaces, so in a way equivalent. There is an easy answer.

It depends.

Advisors can analyze this.  The problem has traditionally been that they do not and instead rely on intuition.

It depends on several things:

  1. What is your tax rate?  The lower the tax rate, the more it tends to make sense, arithmetically, to pay down debt.
  2. What can you earn on a similar investment? Paying down mortgage debt is riskless.  The risk was in buying the house.  Credit card debt is a no-brainer.  Continuing to hold debt contains risk because rates or other terms could change adversely.  In the real world, there is no riskless investment that pays more than the financial institution charges on your mortgage.  To assume a rate higher assumes that you are investing both money and more risk.  You should always earn more if you invest more.
  3. Can you deduct the interest you pay?  If yes, then the rate you must beat is lower and thus it may make sense to hold both a retirement plan and a mortgage.  There are sometimes ways to make mortgage interest deductible.  Explore those too.

The intuitive answer to the invest in the retirement plan first option, relies on the tax deduction.  “Would you prefer $5,000 working for you or $3,000 working for you and $2,000 working for the government?”  Easy, but wrong answer unless you explore the outcomes.

The right answer is found by assuming the same out-of-pocket money over the life of the mortgage. Would I be better to pay down debt and then invest huge in the retirement plan after the mortgage is paid off, or would a little in each work better?  Maybe in the middle.  It is a bit tedious to be sure you are using the same after tax cash each year, but necessary.  The only time you can address the better/worse question is at the end of the mortgage.  Interim results don’t matter.  Analyze each and discover which has the larger retirement plan balance on the day the mortgage is first paid off.

That is the hyper-rational approach and it is not necessarily the only good one.  There other aspects that matter too.  Hamid Amiri of SH Financial in Toronto put me onto this article.  It deals well with softer issues.

The reason you use the last day only for comparison is that you cannot know what the interim results mean.  I have often wondered what happens 15 years or so into the program of doing both when I have $200,000 in a retirement account and still owe $140,000 on the mortgage.  Would I be happy or sad if interest rates doubled?

The client supplies all the money to the plan.  Financially, it is a two player game.  What extra the client earns, the lender/retirement-plan combination issuer loses.  If the lender did better by you holding both plans, they would recommend both.  If they did better by you paying down the mortgage, they would recommend that.

Which does your lender promote?

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. Contact: don@moneyfyi.com 

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