When to prioritize debt repayment over saving

Lindsay uses the priority pyramid to find out how much money she has to put towards debt repayment or investments

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Money Fit - Lindsay V3In our April 2016 issue of MoneySense, we introduced you to Lindsay Tithecott, a 29-year-old who is trying to pay down debt, build up savings and buy a larger condo. Throughout the year we’ll be giving her a financial challenge every two weeks to help her get her finances in tip top shape. Make sure to follow along! In her last challenge, we asked Lindsay to rethink her budget-busting fitness classes. This week’s challenge involves more budget basics. 

Challenge No. 2

Lindsay’s budget factors in savings as if they were an expense. This can make budgeting very confusing. So for her second challenge, we asked Lindsay to redo her budget, starting with annual disposable income and not including any savings at all.

To do this, we asked her to take pay stubs from both her full-time job and her part-time job and do the following:

1. Calculate what she earns gross annually from both jobs, then deduct income taxes, EI, CPP, Disability insurance payments, etc. from that amount to get her total net income.

2. Subtract the $2,880 RRSP contribution that her employer matches dollar for dollar at work from her net income calculated above to determine how much is left.

Lindsay’s experience

I’m so glad I did this challenge and the timing was great for me. I was able to refer to my 2015 tax information since I just filed my taxes. I found completing the calculations for net income, expenses and money left over for investing difficult because I have two jobs; the first has all of the normal taxes, CPP, OAS  and RRSP contributions deducted while the second is from my part time job teaching and for that job, taxes are not taken off the gross amount.

Usually I try not to think about how much tax I am paying to the government, mainly because dwelling on the amount of tax I pay each year makes me sad. This method of avoidance has worked in the past, but there has always been this grey area that this challenge has has brought to light. Interestingly, it turns out that I have more money than I thought. While this is partially due to a pay increase at both jobs and project-related overtime, most of the extra income came from just running the budget numbers correctly. I even got creative and added a priority pyramid infographic to show the numbers at a glance (see below).

The numbers were clear. My net pay from both jobs is $54,483. The amount I have available yearly for saving or paying down debt is $8,353. My RRSP match is $2,880 and I subtracted this from my net amount. What I have left over annually in my budget that can be used to pay down debt, rather than add to savings is $5,473.

What I learned was that I am not making the lower row of the pyramid–debt repayment—a priority. I’m skipping up to savings and ignoring my debt. I think I have to backtrack in my financial plan to do debt repayment first, and then move up to savings.

One thing to clarify is that I did not include any annual bonus. My bonus is tied to my employers’ profit. In my career I have seen bonuses range anywhere from nothing (during the recession) to thousands of dollars, and everything in between. I prefer to keep my bonus just that—a bonus! Balancing my budget with money that may or may not get paid to me would be #moneyunfit!

What the expert says

“The best thing Lindsay can do with the $5,473 she has available annually is to use it all to pay down her line of credit debt,” says certified financial planner Heather Franklin. She explains how the interest rate on the personal line of credit (PLC) debt is a couple of percentage points higher than her mortgage and car loan so it needs to be brought down to zero. “A large PLC is going to haunt her until it’s eliminated,” says Franklin. “At $5,000 a year she’d have this debt eliminated in two years, which is doable for her. Franklin’s fear is that if Lindsay pays only the PLC interest annually, it will languish for years. “She’s not getting great returns in her investments so paying down the debt is still the best savings strategy available to her.”

As well, Franklin would like Lindsay to add any bonus she gets to her savings account and use it for emergency savings. But if Lindsay absolutely needs more, she can cash in the $2,238 in the EPOCH US LARGE CAP mutual fund in her TFSA. “That fund has a very high MER and whoever sold it to her is getting a nice trailer fee from it,” says Franklin. “It’s a fund that’s performing way below its benchmark for years. She’s losing money by holding on to this fund.”

The key for Lindsay is to make debt repayment a priority but also “to absolutely not add any more debt to her balance sheet,” says Franklin. “From now on, she needs to pledge to stay out of personal debt. Franklin also recommends that Lindsay shelve any new big expenses such as her furnace until she’s paid down her debt or made the decision to move to a bigger condo or stay put. “Almost all new expenses that will add to her debt will have to wait—for now,” says Franklin.


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