Understanding the Real Cost of Debt
We constantly hear the same thing over and over again – Canadians are struggling financially. They’re spending too much, saving too little and are in way over their heads in debt. We’re often encouraged to work with a Financial Advisor or Financial Planner who can help navigate all these twists and turns and provide us with the knowledge and understanding that we need. However, the challenge comes in when far too many of these professionals focus on products and sales, as opposed to providing real solutions to these problems.
Often, the most value that your Planner provides you would be in the way of advice and education, as opposed to simply products and services. And among the most valuable pieces of advice are often tied to taxes – that is, the reduction of taxes – and how they impact the overall financial picture.
When having conversations with clients, it’s important to provide other perspectives and also change the way they normally talk about and view certain topics. In the conversation of ‘should I invest or pay down debt’, for example, most people aren’t looking at the full picture.
When looking from a high level, making a decision may be ‘easy’. For example, if you’re getting 5% on your investment and paying 4% on your debt, it may seem that investing is the right way to go. However, most people don’t take into considering the ‘tax’ implications of the scenario – this often leads to the ‘wrong’ decision being made, without all the facts.
Understanding Pre-Tax Cost of Debt
Calculating the pre-tax cost of debt can make a huge difference in the outcomes in financial planning. Not only that, it helps you to understand the math behind the numbers and making more informed decisions as to what to do with your (excess) capital.
To put it in perspective, if you have a debt that is charging you 4%, you need to understand that the COST to you in total is not actually 4%, but higher. This is because when you get paid, taxes are deducted, so when the capital is being invested or being used to pay down debt, it is after tax. In other words, paying $100 on your credit card is actually costing you more than that $100. How much the cost of the debt of course depends on your tax bracket - and the higher the tax bracket, the more the impact.
If we were to assume a 40% tax bracket, a 4% debt would actually be costing you approximately 6.7%. That’s a fairly big difference, especially if this debt is being paid over multiple years.
The Formula
The formula to calculate the pre-tax cost of debt is as follows:
{Pre-Tax Cost of Debt} = {Cost of Debt} \ (1 - {Tax Rate})
This is how we get to the 6.7% —> 4 / (1 – 0.40) = 6.66667%
The real cost of debt goes beyond just the interest rates. By factoring in tax implications, businesses and individuals can make more informed financial decisions. In our example, a 4% cost of debt translates to a higher pre-tax cost of 6.7% with a 40% tax rate, highlighting the importance of understanding the full picture. In a scenario where the tax bracket was 50%, the pre-tax cost would be 8%, further highlighting the impact.
Understanding this formula also makes it easier to make decisions on how to use your capital. The age old question of ‘should I invest, or pay down my debt’ becomes less complicated and easier to navigate. This especially can have a big impact for those who have chunks of money sitting in a savings account at the bank (paying next to nothing in most cases). Money that’s earning you almost nothing can be reallocated to pay down a debt that’s costing you a much higher amount.
For high income earners, the difference between the pre-tax and after-tax cost of the debt becomes more pronounced (as highlighted above), which is why in many cases, allocating excess capital to paying down the debt can make more sense.
All in all, understanding the pre-tax cost of debt can help make more informed and better decisions when it comes to:
- Debt management
- Investment decisions
- Cash flow management
With interest rates going up over the last couple of years, and it having a significant impact on most Canadians, it is important to understand the big picture and how the true cost effects your bottom line. By being able to do some quick math, it can help you make more informed decisions and reach your financial goals sooner.
To get a more thorough understanding of how taxes may impact your personal or business financial picture (and how to potentially lower them), get in touch with us!