What’s the best investment? Your debt

If someone guaranteed a 30 per cent risk-free, tax-free, no-fee, return on your investment, compounded monthly over one year, you might call the cops.

It may sound too good to be true but that's exactly the reward and risk for people who pay down their balances owing on most credit cards sponsored by retail chains, like The Bay, which charges customers nearly thirty per cent.

In this age of low returns and high risk, a dollar spent on just about any debt beats a dollar spent on any investment.

The biggest payoff comes from paying down high interest debt but even when you stack it against a typical 10 per cent consumer loan from a bank or even a secured home equity line of credit at 4 per cent it still makes sense. Safe investments with comparable risk such as Government of Canada bonds, Guaranteed Investment Certificates (GICs) and high interest savings accounts rarely pay out more than 2 per cent.

Keep your money at home

The same logic applies to paying down your mortgage - with a more direct advantage. In addition to reducing the amortization period and future interest payments, every dollar spent on a mortgage automatically becomes equity in your home. That equity normally appreciates over the long-term with the price of your home and — as a bonus — the amount of appreciation isn't taxed if the house is your principal residence (much like any capital gains accumulated in a tax free savings account).

Better than an RRSP

It may sound like blasphemy but even the much beloved registered retirement savings plan (RRSP) can be bested by debt payments. One of the most attractive qualities in an RRSP is the ability to deduct contributions from taxable income, which is like an automatic return equal to your tax rate. However, those contributions plus appreciation are fully taxed when withdrawn in retirement. The plan holder is normally in a lower tax bracket by then, but the amount of tax can severely diminish the original tax savings.

The argument for paying down debt before making an RRSP contribution can get a little more complicated depending on the individual, but choosing debt over contributing to an RRSP is not a missed opportunity. Allowable contribution space can be carried forward indefinitely for future years.

Choosing debt over an RRSP contribution makes more sense for young people who tend to have the lowest incomes and highest debt levels. The tax rebate from an RRSP contribution is only as big as the contributor's tax bracket. Young people who hold off on a contribution could reap a bigger benefit later in life when they are in their higher income years and debt is compounding at a lower rate.

The truth about debt

Despite a strong argument for making debt a priority, survey after survey shows Canadians allowing growing debt to take a backseat to savings.

A recent survey by TD Bank found 44 per cent of respondents plan to take debt into retirement, which doesn't make any sense. One thing debt and savings have in common is their ability to compound, but in opposite directions. That means debt will eat into savings, and as borrowing rates rise, eventually swallow a retiree's nest-egg.

So why aren't the big banks that conduct these surveys do a better job of educating people on the advantages of paying down debt before investing? It might have something to do with the fact that every major Canadian bank has a lending branch and an investment branch — and two profit streams that feed off of each other are better than none.