When it comes to financial planning for financial freedom, every Canadian faces the dilemma of whether to pay off their debts first or prioritize growing their wealth through investments. But like the classic “who came first – the chicken or the egg?” riddle, there is no straightforward answer to this. It depends on many factors, including your individual circumstances, your financial goals, the types of debt or opportunities you have, and your mental strength. So, how does one choose which path to take? After all, your choice will affect the pace of your journey to financial freedom. But there is one more important thing to take care of before you focus on either of these paths.

Where Financial Planning Begins

Whether to pay off debts or invest, you first need to have enough money in hand. Many individuals make the rookie mistake of allocating a significant portion of their salary towards debt repayment without building an emergency fund to manage daily expenses in the event of an economic downturn, a medical emergency, or unemployment. Remember, your emergency fund should cover at least 6 months of living expenses. Once these needs are taken care of, you can then consider investing or repaying debt.

So, the first step to financial planning is honestly reviewing and understanding your current financial situation, and mapping a budget to use your money optimally. How much do you spend on utilities and rent? Is there a way to cut down on food costs? How much can you afford to spend on entertainment or leisure? All these questions can be clearly answered when you design a budget and account for every dollar that you earn.

Any money left after paying these expenses is now free to invest or clear debts. But which one comes first?

When To Prioritize Debt Repayment

Student loans, mortgages, credit card debt, car loans – we all have them, right? And while we might have taken them one at a time, we often have to pay them off simultaneously in installments, causing much stress and a huge hole in our savings. So then, paying off your debt first makes more sense, doesn’t it?

Especially in two scenarios:

  • High Interest Rates: If you have taken on debt with high interest rates, such as credit card balances with 18-25% interest, paying them off as soon as possible is sensible. You can save hundreds of dollars in interest payments. In fact, it wouldn’t be wrong to think of it as a “guaranteed return” of 18-25% — much more than you could earn through traditional investments.
  • Managing Credit Score: An unpaid debt leaves a blemish on your credit score and reduces your chances of getting another loan or insurance. Paying off your debts in time improves your credit score, opening up several avenues for better financial opportunities – including better job prospects.

When To Prioritize Investing

If paying off debt has its perks, so does investing. Here’s how prioritizing investing can also be a good idea:

  • Compounding Returns: Paying off debts takes time, but so does creating wealth. Investing allows you to leverage compounding to accumulate wealth. The returns on your investments in the form of dividends, interest, or capital gains also act as a supplementary source of income for you. The earlier you begin investing, the longer your money gets to grow, sometimes even surpassing the interest rates on certain debts in the long run.
  • Beat Inflation: In an inflationary economy, building wealth becomes essential as the purchasing power of your money erodes over time. The things you can buy with $1 today will cost maybe $3 in a few years, and to be able to afford such changes in the value of money, you need to build a sizable corpus through smart investing.
  • Achieve Financial Goals: In addition to emergencies and necessities, you also need to meet personal goals, such as buying a house or planning for a comfortable retirement. Investing in various instruments, such as mutual funds, exchange-traded funds (ETFs), and bonds, gives your money time to grow and helps you achieve these long-term goals.

Investing, though prone to volatility and even short-term losses, has historically compounded your savings and increased your wealth in the long term. Hence, starting on your investing journey early certainly has its advantages.

With both debt repayment and investing having their own merits and risks, how do you actually decide on which one suits your needs the best?

Which Is Financially Beneficial: Debt Repayment or Investing?

In finance, when in doubt, turn to the numbers. By comparing the interest earned on investments with interest paid on debts, and their respective tax implications, you can come to an informed decision about what you need to do.

Interest Paid vs. Interest Earned

As mentioned earlier, high-interest debts, such as credit card debts, charge 18-25% interest. Personal loans can go even higher, up to 35%! Alternatively, the average return on equity investments is 12%. In this case, paying off the debt can save more money than investing.

At the same time, mortgages come at an interest rate of 4-6%, which is lower than the 8-12% you could earn from your investments. Here, prioritizing investing would be wiser.

Doing these calculations needs research and analysis, something that a professional accountant can better help you with.

Determine Tax Benefits on Loan and Investments

Some tax-deductible debts can actually prove beneficial for you. In investing, a Tax-Free Savings Account (TFSA) offers tax-free long-term returns. In fact, the returns earned on a TFSA are also tax-free. Thus, if you happen to have a particularly good run with your investment decisions, you can use the sizeable returns earned in your TFSA to pay off your debts. So, if the loan interest rate is not crippling your budget, prioritize investing in a TFSA and use your own money earned from investments.

Balancing Debt Repayment and Investing

While which one to prioritize depends on your financial status and goals, the truth is that managing both debt repayment and investing is equally important. What can be different is the ratio or weightage you need to apply to them to lower your financial burdens. Also, consulting a wealth manager or accountant to help you better simplify your debts through consolidation or effectively plan for your retirement or a home through strategic investing is a good option. Many people follow the 70-30 formula to strike a balance between investing and debt repayment: 70% of your extra income goes toward paying off high-interest debt, and 30% toward investing in a tax-efficient portfolio or savings accounts. However, you can design your own formula that you can review and adjust as you achieve your financial goals.

Psychological Thinking

Having discussed how to zero in on what works best for you, there is one point that holds great weight in this debate. And that is your own peace of mind.

No matter what the numbers say, if having a debt looming large over you gives you sleepless nights and affects your mental health, prioritizing paying it off over investing is always the right decision. After all, your mind and health are the most precious assets. Safeguarding them should always be the priority.

Contact Black and Gill LLP in West Toronto to Help You Manage Your Personal Finances

A professional accountant can help you manage finances, get better debt and investment deals, and plan all of this in a tax-efficient manner. At Black and Gill LLP, our accountants and tax advisors offer services including tax and financial planning. To learn more about how Black and Gill LLP can provide you with the best accounting and taxation services, contact us online or call us at 416-477-7681.