What Should You Focus on: Getting Out of Debt or Saving for the Future?
When it comes to student loans, many people want to get rid of them as quickly as they can so that they can get on with the rest of their life. While they may not regret using student loans to finance their education, repaying them for years to come can be frustrating, especially when they can see so many other opportunities before them. Maybe they want to buy their first home, start saving for retirement, or start a business. When someone wants to pay down their student loan aggressively, but also looking forward to the future, the best approach is a balanced one – getting out of debt but also setting money aside for later.
If you’re in this situation, don’t give up in hopeless frustration that you can’t have it all. Maybe you can’t right now, but there are ways to achieve a good balance between the money you need right now and saving for what you’ll need later. To help illustrate how you can have a bit of both right now, consider Darren’s situation (we have changed his name to protect his privacy).
Case Study - Saving While Getting Out of Debt
Darren used student loans to finance his education. Upon graduation, he was fortunate to land a great paying job. With the payments he’s making on his student loan, he still has at least 7 years to go before it’s all paid off. He could afford to repay the whole student loan in just under 4 years if he doubles his payments each month. However, that means he’d have to put off saving for retirement for nearly 4 years. Starting retirement savings early means that he can take advantage of compound interest, but more importantly, he can earn an immediate return of 50% with his employer sponsored RRSP matching program. Darren’s other concern is that if he doesn’t choose ahead of time what to do with his money, he’ll just blow it and have nothing to show for it later. What should he do?
Smarter Ways to Do Things
Traditionally, and for good reason, the best advice is to always pay down debt because the interest rate to borrow money is higher than what you can earn in a savings account. However, there’s more to it than meets the eye, and logical numbers aside, we need to outsmart our bad money habits at times.
In Darren’s case, there are advantages to taking a balanced approach, rather than paying all the debt off first and then starting to save. Not only will his employer contribute to his RRSP, the other thing to consider is how would he manage a financial emergency over the next 4 years if all of his extra money is used to pay off his loan?
At some point, the unexpected will happen, so planning for the worst and hoping for the best is always better than scrambling to catch up when the unexpected does finally happen. After all the hard work it takes to pay down debt, no one wants to be forced to take out a loan or use a credit card to cover an emergency expense. Having some cash readily available is the one true trick for getting out of debt.
It boils down to making well-planned choices with the money that’s available. What would Darren’s payments be if he paid his student loan off over 5 years instead of about 4? This would get him debt free 2 years sooner than if he continued with the payments he was making now. But, is that all he’d gain?
If doubling the monthly payment pays the student loan off in about 4 years, only topping it up by another half as much would extend the repayment time to a little over 5 years. This is longer than if he doubled his payment, but it’s still less than the 7 years he has left now. By only topping up by half as much, there’s money left over to start an RRSP. That’s the huge benefit of a balanced approach.
Advantages of Employer Matching RRSP Contributions
RRSPs reduce how much income tax you pay. The best way to contribute to an RRSP is to have the money come right off your pay cheque before you even see it. What you don’t see, you don’t spend, and when you pay yourself first, you know you won’t end up short on cash. Looking at Darren’s situation with the company’s RRSP matching program, they add 50% to each RRSP contribution he makes. Nowhere else can he guarantee himself a return of 50%! The investment increases by half before it’s even deposited in the bank.
To gain an even bigger advantage, Darren could ask his employer to reduce the amount of tax they withhold when they deduct the RRSP amount “at source,” which means before he gets his pay cheque. By doing that, he would end up with a little more of each pay cheque in his bank account, rather than having to wait for the refund when he files his tax return the following year.
A Balanced Approach is Often the Best Way to Get Out of Debt and Get Ahead
The benefit to this balanced approach is that Darren gets out of debt with his student loan, because it’s repaid in a reasonable amount of time, and he can start saving for retirement right away. For Darren, this is a win-win because he knows how much harder it will be to save later on when he owns a home and has a family. Student loan interest is also tax deductible so together with the income tax reduction from the RRSP contributions, there will be additional money with which to start an emergency savings fund.
A balanced approach to getting out of debt is a great way to manage life’s challenges, establish good money habits, build financial security through long term savings, and deal with your debt.