What’s your debt actually costing you?

Canadians have a problem: debt. There’s too much of it. And we’re not paying it off.

In fact, according to a recent survey, 71% of Canadians carry some form of debt.

Excluding mortgages, the average Canadian holds almost $27,000 in consumer debt (credit cards, lines of credit, installment loans, car loans, etc.). Most worrisome of all: Statistics Canada says that as of last December, Canadian household debt rose to 164.6% of disposable income. Meaning the average Canadian owes $1.65 for every $1 he earns in income—approximately the same level recorded in the U.S. immediately prior to the housing bust.

Understanding the true cost of debt

Shocking as these statistics may be, what’s even worse is the cost of carrying that debt.

From a financial perspective, it’s substantial. The average Canadian pays just under $1,400 in interest every year on his or her line of credit. That may not sound like much, but keep in mind interest rates are currently at historic lows. For every 1% the prime rate rises, annual payments rise by $350. So it wouldn’t take much for interest costs to become prohibitively expensive.

Perhaps more significant is the opportunity cost of debt—or maybe it should be called missed opportunity cost: The money used to pay off debt could have, instead, been invested.

Eliminating debt is a very good idea, but make no mistake: the money you use to repay the loan robs you of compounding power. Over the long term, the cost of this compounding power may be substantial—and the younger you are, the higher the cost will be.

Imagine you’re 46, and you contribute $200 a month toward debt repayment. The next year, you begin contributing $200 monthly into your retirement account. Assuming an 8% return rate, you’ll have $103,731 by the time you’re 65.

But let’s say you didn’t have to pay off the debt. You could have started investing one year earlier, at age 45. If you had, you’d have $114,532 put away by age 65. So, while the cost of your debt was $1,200, the opportunity cost was $10,801.

To invest or not to invest . . .

Should you try to eliminate all your debt before investing? Or should you pay down debt while continuing to save and invest? It’s a good question, with three possible answers:

Mathematically, the right answer is to do what will make you the biggest return. So, if the interest rate on your debt is higher than the rate of return you could expect from an investment, pay the debt first and invest later. If the rate of return on your investment is higher, invest first and pay off debt later.

The emotional right answer is to acknowledge debt is an emotional trigger—people hate having debt, and many find it difficult to feel completely comfortable while they carry it. If you’re like that, paying off debt completely (even if it’s low-interest debt) might make the most sense.

Perhaps the most realistic answer is to do both: making paying off high-interest debt (i.e., credit cards) a top priority. But once that’s dealt with, pay off low-interest debt and invest at the same time.

Does debt ever make sense?

All that said, not all debt is created equal. In fact, there can be times when taking on debt makes a lot of sense—particularly when that debt allows you to invest in a way you wouldn’t be able to otherwise. Here are some examples:

Education

Education is the ultimate investment in yourself. Not only is an advanced degree or certification an exceptionally long-lived asset (it lasts your entire life, and it rarely goes down in value), it can often have a direct and permanent impact on your earning power.

RRSPs

Do you have unused RRSP contribution room? Borrowing to make up for those contributions can sometimes be a good idea—particularly if you use the tax refund your contribution generates to pay off the loan.

Non-registered accounts

Borrowing to build up a non-registered account can be an effective use of debt. However, the risk of such a strategy depends largely on what you invest in—securities such as government bonds or blue-chip equities offer a drastically different risk profile than precious metals or small technology start-ups, for example.

Rental real estate

Another potentially good use of debt, particularly if rental income can cover the mortgage and taxes. In most cases, interest costs associated with borrowing can be written off.

Keep in mind investing and personal finance isn’t just about math—emotions, psychology and behaviour play a significant role in the management of your money.