What Would You Do With An Extra Dollar?
One very important question in personal financial planning is “What would you do with an extra dollar?”. Whether it’s a bonus from work, or a $20 bill inside a birthday card, extra money will come to us from time to time. When this happens, you basically have two choices: save it or spend it. On one hand you can hide it under your bed or invest it, while on the other hand you can spend it on something useful or on something frivolous.
It should be obvious that a financially savvy person would prefer to save their extra money rather than spend it on something wasteful, but there are many schools of thought on where your extra dollar should go. Some believe you should aggressively attack debt before you even begin to think about investing, while others say that high-interest debt is your first priority and then you can pay down other debt at the same time as investing.
I’ve put a lot of thought into this, and although I wouldn’t say I have a lot of excess cash, I do have an opinion on where mine goes. I like to look at saving money as the same as earning money. Therefore, if I pay down some debt that costs me 10% annually, then that’s the same as investing in something that earns me 10% annually. With that in mind, where my extra dollar goes depends on the magnitude of the return on investment or cost of borrowing, whichever the case may be.
Last week I chimed in on RRSPs and TFSAs. A lot of people overlook the real impact investing in RRSPs has. Here’s a quick example: Take your marginal tax bracket as a percent and multiply by 1. If you’re in the 29.95% tax bracket, then your tax refund should be roughly equal to 29.95% of what you contribute to your RRSP. That’s the immediate rate of return you receive, in the form of a tax refund, from contributing to your RRSP. Sure, you might not get your refund for a few months, but if you contribute $5,000 to an RRSP, and you’re in the 29.95% tax bracket above, then your refund, ignoring everything else, should be around $1,497.50. That refund can be used to pay down debt, invest in a TFSA, or spent on anything else your heart desires.
The order of importance for where I put my extra dollar is as follows:
- High-interest debt (20% or more)
- High-interest debt (10-20%)
- Regular debt (5-10%)
- Low-interest/tax preferred debt
- Other investments
I should mention that many financial planners say that low income earners get more bang for their buck by maxing out their TFSA first, because they don’t get as much benefit from their RRSP contributions as higher income earners. So one caveat would be to contribute to your RRSP only to the point where it would bring your income down to the lowest possible tax bracket, and then you should contribute to your TFSA.
You might have noticed that I put high-interest debt above RRSPs even though I touted RRSP contributions as having large and immediate returns. High-interest debt is poisonous, the higher it is the longer it will take you to get rid of. If you have any high-interest debt, you should put every last dollar you can afford to into getting rid of it. Once that debt is gone, I believe the next place you should put your extra money is into an RRSP. My reasons are twofold: (1) The refund, and (2) It will still be there if you absolutely need it.
This is only my opinion, but I believe that the order of the first three items on the list above is important, but the rest of the items can easily occur in any order, or simultaneously. As you pay off debt, the money that used to be going toward making the regular payments will now become “extra money” and can be applied to your other debt or invested in other places.
Right after I graduated from university, I concentrated on making RRSP contributions and only made the minimum payments on my debt. I even increased my debt by borrowing money to max the maximum contribution. The refund was applied to debt, and that lump sum payment went entirely to principle. Within three years of graduating, I had enough funds in my RRSP to use as a down payment on my first property using the Home Buyers Plan to withdraw my RRSP funds without having to pay tax on them. If I had stuck to the old plan of paying down all my debt first, then there’s no way that I’d have bought a property by now.