Should I save or pay down debt?A fair comparison requires proper consideration of the risks of each option that are often overlooked.

This is one of most common questions we are asked when financial planning with clients. Usually it arises when there is surplus cash from income that could be used either to accelerate paying a mortgage or a line of credit versus investing in savings for retirement.

Let’s meet Alice and Bob who have a 5 year fixed rate mortgage costing 3.0%1 and see that Canadian equities returned 13% last year. Rather than reduce the mortgage they are thinking it would make more sense to use surplus cash to invest. To see why this might be a mistake we have to consider a number of factors: the borrowing period and the true expected return from investing, adjusted for the volatility in returns, fees and taxes.

Before we take these steps some readers may appreciate another perspective on debt. Most people are familiar with buying a GIC. Now imagine that instead you have sold a GIC to someone else: you will receive a lump sum of money and be obliged to make interest payments until the GIC matures. Thus selling a GIC (or a bond) is equivalent to taking on debt. It follows that reducing debt is equivalent to buying a GIC. The insight here is that reducing debt is a risk free investment (it is hard to default on a debt repayment already made) whilst investing in the expectation of higher returns is risky.

To be consistent we must compare both the debt repayment and investment options over the same period, which we will choose to be 5 years. To keep things simple we will just consider 5 annual payments at the start of each year, rather than monthly payments.

We now turn our attention to the expected return if we choose to invest rather than reduce debt. Jane & Joe observed that Canadian equities returned 13% last year but their existing retirement savings are not solely invested in stocks but a more cautious mix of 60% stocks and 40% bonds. Since the objectives for the additional funds are the same, so should be the asset mix. PWL routinely estimates expected returns for portfolios with different asset allocations. These estimations take into account historic returns, adjusted for current prices on the basis that higher current asset prices infer lower future returns and vice versa. The expected return for a portfolio with 60% equities and 40% bonds is currently estimated at 5.42%.

We know investment returns can vary from one year to the next so we should account for this uncertainty. For example, consider a five year period where returns each year are 7%, -2%, 12%, -6% and 14%. The average annual return is 5%. However $100 invested at the start would be worth $126, an annualised return of only 4.7%. The reason the annualised return is less than the average return is due to the variability in the returns from one year to the next – we call this volatility drag. We adjustour expected portfolio return for volatility drag reducing the expected return from 5.42% to 5.13%2.

Finally there is the impact of investment fees and taxes. Typically investments might range from 1.3% with a low cost manager such as PWL to 2.4% for a balanced mutual fund. The after fee return is thus 3.8% to 2.7%, respectively.

Debt repayment is made with after tax dollars so any fair comparison should also account for the impact of taxes. Let’s assume Alice and Bob could either repay $12,000 of debt or save the same amount every year for 5 years. If all the returns are capital gains and Alice and Bob are taxed at a 43% marginal tax rate then the results are summarised in the table below. In this example we used an after fee investment return of 3.8%.

Options Cumulative Gain, Pre-tax, Over 5 Years Cumulative Gain, After Tax, Over 5 Years
Reduce Debt $5,621 $5,621
Invest $7,197 $4,102

Source: PWL Capital

Should Alice and Bob be able to save in their RRSP (and assuming no change in their tax status over the 5 years) then the impact of saving pre-tax income in the RRSP would offset the tax on withdrawal, so the proper comparison would be between the pre-tax investment return and the debt savings. In our example Alice and Bob would be better paying down debt unless they have RRSP contribution room. If we had used the higher investment fees associated with retail mutual funds then paying down debt would always be the preferred option.

Although we have made several assumptions along the way, the steps to make a proper comparison between the two options are the same:

  • Compare both options over the same period
  • Use realistic investment return assumptions and adjust for volatility drag
  • Adjust for fees and taxes.

Applying these simple rules can help mitigate our natural tendency to underestimate risks and overestimate returns.


If Alice & Bob have a variable mortgage then the variable mortgage rate does not account for the risk of rising rates during the five years. Thus, even in this case, it would be prudent to use the fixed rate mortgage interest rate as the hurdle rate.
To a good approximation the volatility drag = (portfolio standard deviation)2/2. Our estimate for the portfolio standard deviation is 7.67%.