Part 5: Constructing a Savings and/or Debt Paydown Strategy
This is the fifth post in a series of six that walks through a theoretical exercise of me financially coaching the Average Canadian Household (as defined by Statistics Canada data) to see how we could improve their financial situation.
In the first post, we did a deep dive into the Average Canadian Household’s finances, looking at their income, expenses, and net worth.
In the second post, we did a deep dive into the Average Canadian Household’s essential expenses.
In the third post, we did a deep dive into the Average Canadian Household’s discretionary expenses.
In the forth post, we looked at aligning earnings with your values.
In this post, we will talk about how the average Canadian could go about constructing a savings and/or debt paydown strategy. If you have high-interest consumer debt (let’s put aside mortgage debt for now since we will talk about it later in the post), you should look to pay that off before saving. Whether you have debt or not, a good first step is to establish an emergency fund.
- An emergency fund can be used to cover expected and/or unexpected expenses if for some reason your income sources are temporarily halted (e.g. laid off, injured and unable to work, etc.). It is generally recommended that you keep 3 to 6 months of expenses saved in this fund. I would look toward the upper end of that range (or even more than 6 months of expenses) if you have a job where income is significantly variable (e.g. self-employed, entrepreneur, etc.)
- I recommend to my clients that an emergency fund is kept in cash in a high interest savings account or money market fund
- It’s best to keep this cash cushion separate from your day-to-day chequing / operating account – the idea is to create a “barrier” to access (only to be used when in dire need). I recommend that my clients place their emergency fund in an online savings account that is not with their primary financial institution. This usually means that you can still access the funds in 1 to 2 business days if you need them (but it’s not as easy as just transferring from one account to another at your primary bank)
- An emergency fund is particularly important if you don’t have low-interest credit (e.g. a home equity line of credit, “HELOC”) at your disposal. If you do, you can choose to use that as your backup plan if you prefer to keep the majority of your portfolio invested. Although I have low-interest credit available, I still prefer to keep some cash on the side to cover unexpected expenses if they were to come up. The last thing I want to do is to be forced to sell investments to cover day-to-day expenses (and potentially trigger capital gains)
- Ideally your emergency fund is in a non-registered account or a tax-free savings account. I don’t recommend using a Registered Savings Plan (RSP) since you will be subject to tax when you withdraw the money and will lose your RSP contribution room forever
- As you are funding your emergency fund, it is a good idea to look into whether your employer offers an employee savings fund. It is quite common for employers to match employee contributions to a savings plan up to a certain percentage of their income (e.g. 5%). An employee savings plan can also be used as an emergency fund if need be (as long as it is a non-registered account or a tax-free savings account). I know I said above that it is probably best to pay off debt before saving, however, this can be the one exception given an employee match can often have a benefit that exceeds the carrying cost of debt (e.g. a 1-for-1 employer match is an instant 100% return on your money). Often times, if you miss out on your employee match, you lose it forever (if you aren’t signed up one month, it won’t carry forward to future months)
- Next is debt paydown. There are two main strategies – which one you choose is up to you:
- The debt snowball – make the minimum payments on all of your debts each month. Use any money left over to pay down the debt with the smallest balance. This is good for people who are motivated by momentum. The idea here is that once you extinguish a couple of smaller debts, it will motivate you to keep paying off debt aggressively
- The debt avalanche – make the minimum payments on all of your debts each month. Use any money left over to pay down the debt with the highest interest rate. This is more suited for mathematical optimizers who want to make sure that they are paying the least amount of interest as possible
- After you have set up your emergency fund and paid down your debt, the next step is to look at contributing to a tax-advantaged account, e.g. a Registered Savings Plan (RSP), or a Tax-Free Savings Account (TFSA). Which account to use ultimately depends on your personal tax situation and when you will likely draw down the money
- Given the complexity of RSP’s and TFSA’s, I’ve written a separate post specifically on these two tax-advantaged vehicles. Read more here
- Once your tax-advantaged accounts are funded, the next step is to invest in a non-registered / taxable account
Pay Yourself First and Automation
- Pay Yourself First – whether you are paying down debt or saving, it is best to “Pay Yourself First” (i.e. pay down your debt, or contribute to your savings account BEFORE you spend on discretionary items). This concept is so important that I wrote a separate post on “Pay Yourself First”
- Automation – I am a huge fan of automation. Nowadays, most companies allow you to automate your bill payments (e.g. utilities, cell phone, internet, etc.), debt payments (credit cards, line of credit, mortgage, loans, etc.), and savings (automatic contribution to savings accounts, etc.). Automating saves you time monthly on “life admin,” in addition to making it easier to “Pay Yourself First”
Pay down mortgage, or save/invest?
- Those of you who have mortgage(s) will have to make a decision to either allocate your extra cash to paying down the mortgage or saving. There is no right or wrong, so I suggest that you do what feels best for yourself and based on your risk/return preferences
- Pay down your mortgage
- Pay off your mortgage faster
- Peace of mind from having less debt
- Pay less interest
- If the expected rate of return (after tax) on investments is higher than your mortgage interest rate, this is not the financially optimal option
- Potential to earn more from investing (after tax) vs. your mortgage interest rate
- There is no guarantee that your investments will outperform your mortgage interest rate on an after-tax basis
- Takes longer to pay down your mortgage
- May be less comfortable having more debt
- Pay more interest
- Pay down your mortgage
In the next post, I will wrap up this six-part series on Coaching the Average Canadian Household. We will tie it all together by taking a look at how the Average Canadian Household could improve their financial situation by tracking their finances like a business, aligning their essential expenses, discretionary expenses, and earnings with their values, and constructing a debt paydown and/or savings plan.
If you are interested in my Financial Coaching Program, get more information on the program here and sign up for your free consultation.