Many people flee debt like the plague. Yet there are good debts and bad ones! It is imperative to distinguish them well.
Winston Churchill said, “There is no harm in changing your mind. Provided it is in an effective way.”
Let us start understanding it with imperfect credit. For example, if your prospective client has a credit card balance at a 20% interest rate and comes to you to contribute to their RRSPs, you can advise them, kindly, to repay his debts first. Indeed, no risk-free investment could offset this loan’s high rate by a return of 20%.
Besides, if the client has no more consumer debt and only must repay a residential loan, a student loan, or any other type of debt whose interest is low and deductible, there is usually no urgency. We need to have a clear and coherent vision of our client’s financial goals and ask themselves where their money (after-tax) offers them the best return. We are talking here about simple tax optimization.
For instance, take the case of Pauline, a 35-year-old single parent with two dependent children. She has taken out a mortgage at a rate of 3% annually. Except for her contributions to a group RRSP, she has no other habit of saving. In recent years, she has focused only on the repayment of her mortgage.
Despite all her financial obligations, Pauline still generates a hundred dollars of surplus every week. She wonders if accelerating her mortgage payments would be the best strategy for her. You advise Pauline to bet on savings rather than repaying her accelerated debt. Why? The answer: the maximization of its net worth, which is to say, what remains after the debts have been paid.
To compare apples to apples, the first investment tool that should come to your mind is necessarily the TFSA. As it makes it possible to grow the sums tax-free, it is possible to exclude the notion of taxation from the comparative calculation and thus to compare two equivalent cash outflows from Pauline’s pockets.
For the same financial effort, which is $100 in savings per week, she would get an additional 66.6% gain in her TFSA compared to a prepayment of her mortgage, which is 2% of the annual return difference, assuming a 5% return in the TFSA.
If Pauline invests instead in term deposits with a 1% yield, it would be more advantageous to repay her mortgage. As an advisor, you need to check each of your clients’ dollars’ performance and make sure they put it in the most profitable place. Your client will have five options: TFSA, RRSP, RESP, non-registered investments, or repayment of debts.
We took the TFSA example to simplify the analysis, but marginal effective tax rates (METRs) must always be considered. A competent financial planner must analyze each situation to make a good decision.
As the RESP and its benefits are already discussed, I occasionally meet young professionals with little or no savings, few debts, and children but have not yet opened an RESP. On the other hand, they are enormously proud to mention that at age 35, they have almost finished repaying their mortgage. To understand the mistake they make, let us go back to Pauline’s example. She has a $100,000 mortgage balance with a remaining 10-year amortization, $963 per month payments, and a 3% borrowing cost.
After a meeting with his financial planner (Pl. Fin.) And a good discussion about the debt, both put together an action plan. The first step is to reduce mortgage repayments. To do this, refinancing with a new amortization of 25 years is proposed. Payments are now $473 per month. Pauline now has a monthly surplus of $460 per month.
The debts are dreadful, and you must evaluate the circumstances it may cause. The conditions should be appropriately assessed to avoid any unforeseen circumstances. If you stay ahead and make sure you are also adequately prepared, you will make it through.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud platform where their QuickBooks™️ file, critical financial documents, and back-office tools are hosted in an efficient SSO environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.