The True Cost of Debt

Feb 1st, 2012

Pick up any article about personal finance and you’ll see the same story: Canadians are spending too much, saving too little and carrying too much debt. In other words, they need help.

That’s where advisors come in. However, all too often advisors focus on product and accounts such as RRSPs and TFSAs as a means of solving problems for clients.

Yet some of the most valuable advice I give has nothing to do with those products. It’s that taxes impact every financial allocation decision.

Changing perceptions

People refer to income, both employment and investment, in pretax terms. They say, “I make $75,000,” not, “I make $57,978 after tax ($75,000 after tax in Ontario).”

Makes sense. How many clients actually calculate after-tax income? Besides, $75,000 sounds better because it’s a higher number, and we all like knowing we make more—even if we keep less.

On the other hand, we look at expenses based on their nominal value, as in, “I paid $50 for that.”

If the expenses happen to be deductible or qualify for a tax credit, the average person usually knows it will actually cost them less than $50.

Now, let’s flip this on its head. What would you have to earn to pay that $50? The Ontario resident earning $75,000 has an average tax rate of 22.70% and would have to earn $64.68.

That’s kind of a depressing discovery, isn’t it? The point is, considering before—and after-tax amounts can help us allocate our money differently.

The true cost of debt

Interest rates are currently near all-time lows, which is great news for anyone with debt. But what is this debt really costing people?

The chart “Pretax carrying cost” (below) shows the pretax carrying cost of various interest rates across various average tax rates. We can see a few things from this chart:

  • People with lower average tax rates have pretax carrying costs similar to the after-tax rate (as to be expected)

  • The inverse is true for higher income earners. The pretax carrying cost of an 18% credit card is actually 25.71%. In dollar terms, in order to pay $18 of interest on a $100 balance, this person would have to earn $25.71, a full 43% more. Even a 3% rate turns into 4.29%.

To higher-income earners, this revelation can be rather shocking.

The subsequent reaction is typically, “Oh well, what can I do? I have to pay tax.” While this is true, it provides us with a new frame of mind for allocating funds.

In order to make those decisions, however, we have to consider the marginal tax rate. Why? The cost of debt using marginal rates can be seen in the chart “Cost of debt with marginal rates.” Looks a lot uglier, doesn’t it?

The folly of emergency funds

Most clients feel the need to have a cash cushion.This may be a few thousand dollars, or up to six months’ income. Typically this emergency fund sits in regular or high-interest savings accounts and earns up to 2%.

Meanwhile, clients carrying mortgages are paying at least 3% interest.On the surface, this looks like a 1%loss per year. But again, this compares before—and after-tax interest rates, which we’ve seen is like comparing apples to oranges.

Let’s say a client in a 40% marginal tax bracket has $10,000 sitting in an emergency fund and a mortgage at the same time. Based on the above rates, let’s see what happens when we consider the after-tax implications:

  • After-tax rate of return from deposit: 1.2%

  • Interest paid on debt: 3%

  • Total Loss: 1.8%

Most clients would say that 1.8% is a small price to pay for peace of mind. But let’s look at it on a pretax basis:

  • Pretax interest earned: 2%

  • Pretax interest cost: 5%

  • Total pretax loss: 3%

Now the client must consider, “If there were a new high-interest savings account paying me 5% instead of 2%, would I move my money?” Who wouldn’t? So the choice is clear: your clients should pay down debt instead of holding a pile of cash for an emergency that may never come.

But what if an emergency should occur? This is where proper planning comes in.

I encourage all clients who use their emergency funds to pay down their mortgages to take out a home equity line of credit to use in case of emergency. Sure, that means paying interest when an emergency happens. But in the meantime, you save interest. For more disciplined clients, more advanced mortgage solutions, like all-in-one line of credit mortgages, can make this even easier to implement.

True, the mortgage is a cost, not a return. But return increases your disposable income, and so does not paying interest.

Compound these savings over time and you’ll see how fast clients can reduce their debts.That simple $10,000 deposit could save as much as $10,699.07 in interest over the course of 25 years. That’s equivalent to 3% a year, or the same thing as earning 5% a year pretax in a 40% tax bracket.

Pretax carrying cost


Cost of debt with marginal rates