Considerations
Before we dig into how to best get rid of your high-interest debt, we need to consider the pros, cons, and repercussions of both options.
The debt itself
When it comes to paying off your debt, you need to be smart about which debt you pay off first. The best way to approach this: start with the highest-rate debt first. For many, this means credit card debt.
So, why credit card debt above, say, a student loan? There are two main reasons. The first is that paying off the higher-interest debt will give you a better return. Think about it, what would you rather have hanging over you? Debt with 19.99% (or more) interest? Or debt with 6% interest? While trying to tackle a small, low-interest loan first might be appealing because you can pay it off faster, from a financial perspective, taking on the highest-interest debt first is the smartest decision because it will save you more money on the interest you’re paying.
The second reason to tackle credit card debt first is because it’s revolving your credit score, which is a sensitive thing for most of us. If you pay off your credit card first, should disaster strike, you’ll have the room on it to use it again. If you had paid off your student loan first and left yourself with a maxed-out credit card, you could find yourself in even more trouble than you started with.
Potential repercussions of using savings and investments
Having to take money from your savings or investments isn’t the most ideal situation, but you should also be aware that there’s often more to it than just losing these funds and investments. Depending on the type of account or investment, there are some bigger repercussions as well, which include getting taxed, paying fees, and losing contribution room.
While this sounds daunting, don’t be deterred just yet. As our experts will explain in the next section, this isn’t necessarily as bad as it sounds.
Say you have $1000 in debt at 19.99% interest and, at the same time, $1000 in savings that is earning 5% interest per year. In one year, your debt will become $1,199.90, and you’ll be paying $199.90 in interest. Simultaneously, your savings will become $1050.00, meaning you earned $50. If you’d use your savings to pay off your debt all at once, it’s true that you’d be losing your hard-earned savings and the interest acquired, but you’d also be saving yourself $149.90 on the interest you would be paying on your debt.
Even if you do end up having to pay a fee to withdraw that $1,000 from savings or investments, the fee is likely very minimal or, commonly in the case of a GIC, you’ll lose the interest earned to date. However, assuming that is the case, you will still come out ahead if you choose to pay off the debt first.
Deciding what to use to pay off your debt
If you’ve decided it’s in your best interest to dig into your savings and investments to pay off debt, the next step is figuring out which accounts or investments to use first. There’s a definite thought process that needs to go into this to ensure that you come out on top. So, I asked three of Canada’s finance experts to weigh in with their opinions on the matter. Here are their respective takes.
Your savings
One of the first places you may look to pay off your debt is your emergency fund. However, we’ve been taught that emergency funds are for, well, emergencies: things like losing a job or long-term sickness. Which leads to the question: is struggling under the weight of high-interest debt actually an emergency? Robb Engen of Boomer & Echo says yes.
“In my mind, paying 19% interest or more on a credit card or store credit card qualifies as a major financial event. You should treat that debt like a hair-on-fire emergency and get it paid off as quickly as possible. Why continue paying minimum monthly payments on your high-interest debt when you have $1,000 or more sitting in a savings account earning 2% interest?”
However, Robb also points out the importance of starting that emergency fund up again as soon as you are able.
“Once it’s paid off, take the extra cash flow you were putting towards your credit card and put it into savings to build up your emergency fund again.”
Pros of using savings to pay off debt
- The money is there and available without having to dip into investments
- You won’t have to pay any fees to access the money (this will depend on your savings account)
- If your emergency fund is earning interest, it’s at a much lower rate than the debt interest
Cons of using savings to pay off debt
- Your emergency funds likely took years to build up and probably will again
- If you are hit with another emergency (e.g.: loss of job or illness) with your fund depleted, you may end up right back in debt
Pull from investments.
What about pulling from investments? After all, it seems somewhat backward to be losing your money to pay off fees when you need it to pay off debt. However, personal finance expert Barry Choi points out that the approach of using your investments doesn’t have to be a negative one. In fact, it can even help you get ahead.
“Let’s say the investment you’re thinking about selling is a GIC. Even if you need to pay a penalty, it’s still worth selling your GIC as that’s likely making you less than 5% interest. You could take that money and pay down your debt and see a better return instantly. It would also be worth selling any other investments you have such as stocks or ETFs even if you have to pay capital gains.”
Of course, it’s important to keep in mind what type of investment you are pulling from. As Barry points out above, GICs have low interest rates so it’s worth pulling from those even if it comes with a fee. However, this isn’t true for all investments. Some will require much more consideration before you dip into them.
Pros of using investments to pay off debt
- The earning interest rates for many investments are smaller than the rate of interest on your debt
- Investments do not equal a guaranteed return. Paying off your debt is a guaranteed return.
Cons of using investments to pay off debt
- You may be hit with fees including early withdrawal fees and capital gains
- If you look at it from a long-term perspective, there is a chance that your investments could perform very well and you may lose out on the opportunity to collect
RRSPs should be your last resort
So, what about using an RRSP to pay off your high-interest debt? After all, this is an investment that most Canadians have and contribute to regularly. However, Kyle Prevost of Million Dollar Journey says to leave RRSPs alone unless you have no other options.
“If you have alternatives to selling investments from your RRSP and withdrawing the cash in order to pay off debt, you should almost always go in that direction. This is especially true if you earn a substantial income, and are in the highest Canadian tax bracket. In that situation, you’re likely to pay a tax rate of 53% on everything that you withdraw, not to mention that your RRSP contribution room is gone forever.”
Pros of using RRSPs to pay off debt
- Clear your debt quickly as you likely will have enough to cover it in your RRSP
Cons of using RRSPs to pay off debt
- You will be taxed at an extremely high rate to withdraw from RRSPs early
- You will lose the contribution room if you withdraw from your RRSPs
- By withdrawing from your RRSPs, you are jeopardizing your retirement/old age fund
So, taking these potential repercussions into consideration, is there a time when you should leave your high-interest debt as is and keep all of your savings and investments in place? In Kyle’s professional opinion, no. “Honestly, once that debt goes over 20%, it’s really, really hard to recommend not paying it down.”
How balance transfer credit cards work
A balance transfer credit card is a low cost, low interest credit card that gives you, the cardholder, a better chance at being able to pay off your credit card debt faster. Once you’re approved for a balance transfer credit card, you’ll transfer your existing credit card debt over to the new card (there is a transfer fee). Most balance transfer credit cards have a low interest promotional period lasting from 6–10 months, but then significantly increase the interest on the transferred credit card balance after that period is over.
Here are some balance transfer cards to check out:
What next?
Clearly, paying off high-interest debts should be your priority, however, as our experts pointed out, you should have a strategy to do this. Dipping into savings and investments may not sound like an ideal way to go, but when faced with high-interest debt, it’s a smart course of action so long as you make the appropriate considerations. As advised above, it’s best to turn first to your emergency savings or smaller, low-return investments like your GICs, before pulling from bigger investments with more conditions such as RRSPs.
