Many tax filers recognize that paying down debt or investing are smarter ways to spend their tax refund than splurging on a new big-screen TV or a quick weekend getaway.
But with household debt levels near record levels and interest rates starting to climb, the choice between saving or reducing the amount owed has become an increasingly important decision.
Clients with refunds need to consider their whole financial picture when weighing the choice, says Andy Nasr, director and lead investment strategist at Scotia Wealth Management.
“This isn’t just about investing, it’s about really developing a plan to preserve and accumulate wealth and that’s going to vary from person to person,” he says.
“It is going to depend on your objectives and your risk tolerance.”
If your client has high-interest debt such as a balance on a credit card, using a tax refund to reduce or eliminate that debt should be the priority.
There’s nothing that will give clients a guaranteed rate of return like paying off the balance of a credit card that is charging 20% interest, says CIBC’s Jamie Golombek.
“I wouldn’t do any RRSPs, I wouldn’t do any TFSAs, I would primarily direct that money to paying down that debt,” says Golombek, managing director of tax and estate planning.
The decision is trickier when it comes to debt with less onerous interest rates. Mortgages, home equity lines of credit or car loans may carry much lower interest charges.
The Bank of Canada has increased its key interest rate target three times since last summer, moves that have prompted the big banks to raise their prime rates. The prime rate at Canada’s big banks now stands at 3.45% compared with 2.7% at this time last year.
And while the timeline is uncertain, economists are predicting rates will go higher this year, further pushing up the cost of variable-rate mortgages and other lending linked to prime rates.
Nasr says you have to compare the interest rate you’re paying on your debt with the after-tax rate of return you think you might be able to see if you invest instead and consider what your financial picture would look like if things don’t turn out as you hope and your returns fall short or you end up losing money.
“I wouldn’t consider investing unless I thought my expected return on something, whether it is the cash flow from it or the total return, would be enough to service those debt obligations while I have them,” he says.
Nasr adds it is important to remember that unless you’re investing in something like a GIC, the market can be volatile and there is no guarantee that the principal is secure.
“If you invest in stocks, you should expect some level of volatility which can affect the capital that you’re putting to work,” he says.
Golombek says if you are able to tolerate some risk and have a long enough time horizon before retirement you may be able to realize a significant benefit by skipping extra payments on low-interest debt and instead making contributions to an RRSP or TFSA account.
“It doesn’t necessarily make sense to pay down debt,” he says.
You don’t want to be mortgage-free, but have nothing saved for retirement, he adds.
“Every person is different, but I’m not sure it makes sense to take extra money and pay down low-interest debt when you have a long enough time horizon where you can get a higher rate of return.”