One of the most common questions we hear in financial planning is a deceptively simple one: “Should I use my extra cash to pay down debt, or should I invest it?” Like many questions in financial planning, the answer is: it depends.

There is no universal rule that says you should always pay off debt before investing—or always invest while carrying debt. The better approach is to look at the cost of the debt, the expected return on your investments, your tax situation, your time horizon, and your personal comfort level with debt and investment risk. Think of it less as choosing between “good” and “bad” and more as deciding where your next dollar can do the most good.

Start With the Expensive Debt
If you have high-interest debt, particularly credit card debt, the decision is usually much easier. Credit card interest rates can be extremely high. Trying to earn an investment return that consistently beats a double-digit borrowing cost is a difficult—and unnecessary—game to play.

For example, if you're paying 20% interest on a credit card balance, paying that debt down can help you avoid future interest costs at a rate equivalent to the borrowing rate—unlike investment returns, those saving aren’t dependent on market performance. That's a pretty tough investment to beat, especially once you account for investment risk and taxes. For this reason, high-interest consumer debt should generally be prioritized before investing additional discretionary cash. There can be exceptions depending on the circumstances, but as a general rule, expensive debt deserves immediate attention.

Lower-Interest Debt Is a Different Story
Things become more interesting when the borrowing cost is relatively low. Consider a student loan, mortgage, or car loan. If the interest rate is modest, it may not make sense to aggressively pay down the debt at the expense of every other financial goal.

Student loans are a good example because the tax treatment can matter. In some circumstances, the interest paid on qualifying student loans may generate a tax credit – which reduces the effective cost of borrowing and changes the calculation. The key word is “effective.” A loan with a stated interest rate of 6% doesn't necessarily have the same economic cost as another type of debt at 6% if one has a tax benefit associated with the interest.

A car loan, though, may present itself differently. Let's say you have a car loan at 5%, and you have some extra money available each month - you could put that money toward the loan and effectively earn a risk-free 5% return by avoiding future interest. Or, you could invest the money.

If you're investing in a Tax-Free Savings Account (TFSA), for example, investment growth and withdrawals are generally tax-free. If your investments are expected to earn more than the financing cost over the long term, there may be a strong argument for investing rather than accelerating the car loan.

For example:
•    Car loan interest rate: 5% 
•    Long-term expected investment return: 7% 
•    Investment account: TFSA

On paper, investing looks attractive because the expected investment return exceeds the cost of the debt—and the TFSA allows the investment growth to occur without tax. But, there is an important catch—the 7% investment return is an expectation, not a guarantee. The 5% loan cost is very real.

Markets don't move in a straight line. You could invest $10,000 and see it fall to $8,000 shortly afterward, while the car loan continues charging interest as scheduled. That's where risk tolerance and time horizon enter the conversation.

The Math Isn't the Whole Story
Financial decisions aren't made in a spreadsheet alone. Two people could have identical incomes, debt, investment options, and interest rates—and still reasonably make different decisions. Why? Because peace of mind has value.

Some people sleep better knowing they owe as little as possible. For them, paying down a loan may be worth choosing a slightly lower expected financial return. Others are comfortable carrying low-cost debt and prefer to put their money toward long-term investments and be more focused on building wealth over several decades. Neither approach is necessarily wrong. The goal is to build a financial strategy that is both mathematically sensible and emotionally sustainable.

Don't Forget the Middle Ground
It's also worth remembering that this doesn't have to be an either/or decision. Instead of putting every extra dollar toward debt or investing every dollar, you could do both.

You might:
•    Continue making your regular debt payments.
•    Contribute enough to capture an available employer retirement-plan match.
•    Build an emergency fund.
•    Invest additional savings in a TFSA or other appropriate account.
•    Make extra debt payments with whatever remains.

This approach can provide a nice balance between reducing debt and building long-term wealth. For many families, that balance is more realistic than pursuing one goal to the exclusion of everything else.

The Bigger Picture Matters
Before deciding where your next dollar should go, it's worth looking at the bigger financial picture:
•    Do you have an emergency fund?
•    Are you contributing enough to take advantage of an employer matching program?
•    Do you have high-interest debt?
•    What type of debt do you have, and is there any tax benefit associated with the interest?
•    What is your investment time horizon?
•    How comfortable are you with market fluctuations?
•    What are you ultimately trying to accomplish with your money?

A young family saving for retirement may reasonably make a different decision than someone five years from retirement. Someone with a large emergency fund may have more flexibility than someone living close to their monthly cash-flow limit.

So, Should You Pay Down Debt or Invest?
A useful starting point is: 
•    High-interest debt? Often warrants priority consideration but should be assessed in light of your overall financial circumstances.
•    Low-interest debt? Start comparing the effective cost of the debt with the expected, after-tax investment return—and consider the risks involved.
•    Tax-advantaged investing? Accounts such as TFSAs can make investing particularly attractive because investment growth can be tax-free.

But don't let the spreadsheet make the decision for you. The best strategy is the one that fits your entire financial picture, including your goals, taxes, cash flow, risk tolerance, investment horizon, and personal relationship with debt.

At the end of the day, financial planning is less about finding one perfect answer and more about making a series of good decisions that work together. And because everyone's circumstances are different, debt repayment versus investing is a decision worth discussing with your financial planner who can help you look at the whole picture—not just one interest rate or one investment return.
 

_{*The comments contained herein are a general discussion of certain issues intended as general information only and should not be relied upon as tax or legal advice. Please obtain independent professional advice, in the context of your particular circumstances. This article was written by Rick Irwin, for the benefit of Rick Irwin, Mutual Fund Representative with Trinity Wealth Partners, a registered trade name with Investia Financial Services Inc., and does not necessarily reflect the opinion of Investia Financial Services Inc. The information contained in this article comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any securities. Mutual Funds are offered through Investia Financial Services Inc. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.}