Financial Fundamentals (Pt. 3.5) Good debt and building net worth
Once you’ve got your budget and cash flow set up, and any major debt issues under control, you’ve got the foundation of your financial house in order and can start building on it - increasing your net worth.
Net worth is essentially all of your assets (anything you own of value) less all of your liabilities (what you owe). If you’re cash flow neutral (you spend exactly what you earn and save nothing) your assets won’t increase and even though you won’t go into debt, trying to imagine a life without working seems pretty far off as well. By building your assets you are able to prepare for emergencies, a period of unemployment, retirement, or even early financial independence.
Now that you are “bad debt” free, you’ll find that you have more money at the end of the month to put to use. With less income going towards debt servicing, you can start to put some items on the asset side of your balance sheet. Items that build up our net worth include our home, vacation or investment properties, investment accounts, collectibles, and even some types of insurance policies. By continuing to keep debt levels low, and saving for our goals (both short and long term) you can ramp up your net worth.
You’ll notice I specified being bad debt free - if net worth is just your assets less your liabilities, wouldn’t you want to be completely debt free? Maybe, maybe not. When looking at the items on your productive debt list, these will generally have a fairly low interest rate, which introduce a new factor into whether or not to pay back the loan all at once - Opportunity Cost. Opportunity cost essentially states that once you’ve committed a dollar to something, you can’t use it somewhere else - so if you use a dollar to pay back debt with a low interest rate, you can’t invest it and earn a return and the “cost” to you is the lost earnings on that dollar.
For example, let’s look at if you have $10,000 free at the end of a year and are trying to decide between a lump sum pre-payment to your mortgage, or investing the money. For this example, we will assume you have a $300,000 mortgage without CMHC insurance, paying $1,402.86 monthly, with a 2.89% interest rate and a 25 year amortization, and are earning $75,000 in Alberta.
By putting the $10,000 into your mortgage you can potentially shave 14 months off your mortgage, and save just over $10,000 in interest payments (your ‘earnings’ over this period). That’s pretty great right?
If you put that same $10,000 into a non-registered account conservatively invested at 4% (assuming all capital gains on disposition), your $10,000 will have grown to just under $26,660 by the end of the 25 years, and once you’ve
paid tax on the gain you would have earned $14,120.
If you have the room to put the $10,000 into an RRSP account, you would see a tax savings of $3,050. If you chose to further invest that, after 25 years it will have grown to just under $34,800, for growth (while tax sheltered) of $24,800. Of course, you will be taxed on RRSP withdrawals, this may or may not be the best strategy for you - if you anticipate being in the top tax brackets in retirement the tax on withdrawal can eat up to 48% of your growth, but if you are below the 30.5% tax bracket in retirement you will net after tax $24,185 for earnings of $14,185.
If rather than your RRSP you invested in your TFSA instead you would see growth of $16,660 which would not be taxed on withdrawal.
As you can see, if the interest payable is sufficiently low, it is reasonable to assume you can earn a higher return with your free cash than what you save by paying down your debt. This is the same principle as borrowing money to invest (in that case, the tax deductibility of your interest expense makes investment even more attractive). By continuing to grow your investment portfolio while paying down your mortgage (or accelerating the growth of your investment portfolio by borrowing to invest) you can grow your net worth faster than you would by paying down your low cost debt alone.
So why doesn’t everyone do this? In a word, comfort. Many folks I talk to acknowledge that they are sacrificing some return in favour of paying down their mortgage because they are more comfortable knowing they own their home outright. Once it’s paid off, no matter what happens to their personal situation they have a roof over their heads - and there is value in that. Borrowing money to invest is something that should only be done by those comfortable with the risks associated with it, as the assumption that you can earn more investing than you pay in interest may be true over the long term, but it certainly isn’t true every day.
If you borrow $30,000 to invest and the market drops by 20% the next day, the loan and interest you need to pay back doesn’t decrease. Would you be able to repay it in that scenario? And would a scenario
like this cause you to either pull out of the market entirely from fear, or double down on a risky investment to “make up ground”? If yes, the downside to this could very well outweigh the benefits. What is best for you and your family will depend on a lot of factors, and is something you should discuss with a Financial Advisor.
Next time, we will be discussing goal setting - it’s great to build up your wealth, but rather than building for the sake of having it, having defined goals can help you stick to your plan, and find the most efficient ways to get there.
Elyce Harris is a CFA Charterholder working with Cornerstone Investment Counsel, a registered ICPM in Alberta, Canada. She is also a licensed insurance broker in Alberta, Ontario, and PEI. While every effort is made to ensure the accuracy of statements, errors may occur. If a specific stat or carrier policy is cited, a source will be provided, however this is not done for generalizations. Please note that in all scenarios investment returns are not guaranteed, values change frequently and you could lose money. Any performance data represents past performance and does not predict future performance.