This is our first case conference supplemental episode. We’ve built a couple of cases with numbers to illustrate what we discussed in our main episode about debt, saving, and investing. These are based on some common dilemmas that we encounter or questions that people ask us. The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor. 

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Case 1: Recent Graduate with Lots of Debt, Delayed Gratification, & No Investments or Savings

Case 2: Incorporated Physician with Bothersome Personal Debt

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Transcript

1. Introduction
2. Case 1: Debt, Delayed Gratification, No Savings or Investments
3. Case 2: Incorporated Physician with Bothersome Personal Debt

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Introduction

[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor. 

[00:00:17] BF: So this is our first case conference supplemental episode. We’ve built a couple of cases with numbers to illustrate what we discussed in our main episode about debt saving and investing. These cases are based on common dilemmas and questions that we get from people all the time. The idea is that you’ll consider how these situations apply to you, but I want to emphasize that it’s not specific advice. We’re not giving advice here. But, hopefully, you can relate to some aspects of the cases and use them to help think through your own situation, whether on your own or with your advisor. So with that, let’s jump right into the cases.

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Case 1: Recent Graduate with Lots of Debt, Delayed Gratification, & No Investments or Savings

[00:00:50] MS: Great. So the first case that I’ve got is a recent graduate with lots of debt, lots of delayed gratification, and no investing or savings. So this is pretty common. It’s a graduate in Ontario. They have $200,000 of debt on their personal line of credit at six and a half percent interest. The maximum limit on their line of credit is $350,000. So there’s still some room there. They managed to pay the interest during their residency years to keep it from growing further, and they’re now starting their practice. 

But they’re paralyzed with uncertainty that they’ve got all these things going through their heads about what to do next. They expect to make about $300,000 a year when they’re working full-time, but it will likely take them a year to build up to that point with some startup costs along the way. They also feel behind. It seems like their friends all own a house or a condo and have started investing. Some are building pensions through work. They’ve heard that starting it early and investing with compounding returns is important, but they’ve got nothing invested in their RSP or their TFSA, and they feel completely overwhelmed and/or don’t know where to start with that. 

So this is a very typical scenario, and part of why I wanted just to talk about this one is because it stresses people out, and it’s very common. So one of the things that I picked up from your RR episode with Chris Hadfield is that the best cure for fear is competence and a plan. So let’s build that competence and just go through a bit of a plan in this case. So how would you get started with that, Ben?

[00:02:13] BF: Yes. So I think the first step is going to be building that financial security and feeling of security that we talked about in the main episode on this topic. So they do have $150,000 of room on the line of credit to absorb cash flow crunches, which, again, well, not risk-free as we detailed in the episode. Due to the nature of the loan, it’s still going to be a pretty good source of liquidity and a pretty reliable source of liquidity. But still, they feel uncomfortable in their situation. So given how they feel and their cash flow uncertainty early on in their career, I think it’s going to be really important to control spending and at least for now continue living like an average-income Canadian, rather than the high-income one that they actually are. 

If we think back to the earlier episodes on goal setting and motivation, I do think that it’s going to be sensible in their situation to reward themselves to some extent by spending on something that they want but maybe not a yacht or a supercar, which are expensive both upfront and also come with high ongoing costs, not to mention probably not improving their lives as much as they think that they will. 

[00:03:14] MS: Yes. So maybe a trip with friends or some more restaurant meals or better funding their hobby, whatever that is, as opposed to something with expensive insurance taxes and lots of servicing costs aligned with their values, like we talked about in the first few episodes. What may seem ridiculous to one person seems awesome to another. So that’s really kind of a personal choice. 

But I will say that one thing that I’ve noticed is the maintenance costs for things always surprise people. That’s not much of an issue when you’re financially stable, but it really surprises you. Then when you don’t have the money, it’s not a good feeling. 

[00:03:46] BF: Yes. We see this in financial planning all the time. When we’re doing long-term financial projections, and someone comes and says, “I want to buy this thing,” and it doesn’t seem like it’s that expensive to buy it. But when you model the future costs, like this happens with buying a larger home is a pretty common one. When you model the ongoing costs of owning and maintaining that home, all of a sudden it’s really, really expensive in the long run. I think it’s the same for anything that comes with ongoing expenses related to it. 

[00:04:12] MS: Yes. I think if you frame that with how longer it’s going to take you to reach financial independence versus not or what other things you could do with the money, then you can make a really good informed decision about it. 

[00:04:21] BF: Yes. That’s one of my favorite ways to frame decisions like that is how many years of not being financially independent is this decision going to cost you. As opposed to dollars or whatever, it’s like, okay, you have to retire four years later to buy this thing. Then people are like, “Wow. Okay, maybe not.” 

So back to our case, as their income builds up or has occasional jumps, they can use their earnings above their lifestyle needs, which, again, they’re going to keep at a relatively low level to pay down the line of credit. To reiterate on the line of credit, paying down that line of credit is going to be approximately but not exactly equivalent to saving, and it’s going to generate room on the line of credit for those low-income months. So they’ll be able to bridge their cash flow needs with the room there and then also use it for tax installments when they start to come due. 

[00:05:05] MS: Yes. I think it’s important for us to put some more numbers too because it seems like something that will never happen and that you have to go like this forever. But that may not be the case, so let’s go back to the case. It’s now November. Their first few months of practice have flown by, and now they’re bringing in between 15,000 and 20,000 dollars in net revenue each month. They took a good vacation with a friend. Otherwise, they’ve kept their spending around $4,000 a month, despite the pay bump. This has allowed them to knock their line of credit down to about $125,000. So they’re starting making some progress on it already. 

With their training salary for the first six months of the year and then their newfound income, they figured that their taxable income for this year is going to be about $180,000. That’ll mean about $50,000 owing in April. But they plan to have even more room by them because they’re going to be paying down some of their line of credit to cover that, as you’d mentioned as an option. 

But this is good because they can see some progress starting to make them feel a little better, and that psychology is going to be really important, I think, to sticking with the plan. But they are wondering whether they should contribute to their RRSP or their TFSA or start investing now that they’re feeling a little bit better with what’s going on. 

[00:06:08] BF: Yes. So that’s a really important point there. On the RRSP, when you contribute, you’re able to deduct the full amount of the contribution room from your taxable income. So everyone gets a limited amount of RRSP room through their lifetime and that deduction – so you make a contribution. When you make a contribution, you are able to deduct the amount that you’ve contributed from your taxable income. That deduction is going to be more valuable to you the higher your tax bracket is because it’s reducing your taxable income. So if you’re getting yourself down out of a higher tax bracket, that is worth more to you in deferred taxes than if you’re in a lower tax bracket. 

So this year, based on where their income is, they’re still in the middle of the 48% tax bracket, which is that’s a high tax bracket. But it’s not the highest tax bracket. We know based on how we expect their income to progress that their future tax rate is going to be higher. So next calendar year starting in January, we’re pretty sure, almost certain that they’re going to be well into that 54% highest tax bracket. So that means based on their situation, waiting to use the RRSP deduction is going to be more valuable than using it immediately. 

If they do really want to get started with investing because they’re in more of a position to do so now, I think putting some money into the TFSA is going to be a good option, as long as their financial foundation is strong, and they feel that they can meet their other near-term goals without touching the money they’re putting away into a long-term investment. I do think that learning aside, which is another important reason they would do this, but just on the economics of it, they would have to be fairly aggressively invested to beat the six and a half percent a year savings that they would have gotten by paying down more of their debt instead. So I think that their ability and willingness to take risk with their investments is going to be another consideration there. 

But to reiterate on learning, just getting money invested, I think, is valuable beyond the economics of doing so. 

[00:07:54] MS: Yes. It helps you to overcome some of that inertia about opening your first self-directed discounted brokerage or whatever you’re going to use to invest with and learning just the basics about how to buy and sell something. It’s less intimidating because of those dollars are small. That could save a lot down the road if that’s the route that you take, and develop competence and confidence that reroutes you from more expensive mistakes or other options too. So the TFSA is at least tax-free. It’s fun with after-tax dollars, so the closest competitor to debt that we have to investing. 

So back to the case here, it’s now April. Our early practice professional is consistently making around $25,000 a month after overhead. It’s pretty good. They’re spending a little more in lifestyle now, about $5,500 a month up from about $4,000 a month. But they’ve continued to hammer down their debt, knowing that the taxes are coming up. After paying their remaining $50,000 tax bill, their line of credit is sitting around $100,000. So it’s come down substantially. They’re feeling comfortable with their shrinking debt and their stabilized cash flow. But they do feel uncomfortable about not investing yet. They’re starting to feel that pressure a bit more. 

[00:09:00] BF: Yes, Mark. You’ve looked at this, and you have a good simple calculator to compare paying down debt versus the RRSP versus the TFSA. That’s part of an article that you wrote about debt repayment in early physician practice. There may be a compromise when someone has their stable platform and debt at a level where they can do a bit of both tax advantage investing and debt repayment. 

[00:09:19] MS: Yes. For that last $100,000, now that they’re in the highest tax bracket, I put the numbers into my little calculator. An RRSP would give you a big tax refund that you could apply then against more debt repayment. Or you could invest it. So that’s the decision that you’ve got to make. If we use that $300,000 of income and lifestyle spending together, they would have about $9,000 a month to allocate to that decision. So they need to pick what pot they’re going to put it in. 

They could, with that, have their debt eliminated in 12 months. So I’m saying that because the reason why I actually made that calculator was to show people graduating that there’s actually a light at the end of the tunnel because it’s hard to see that. Now, if they’ve redirected $31,000 to their RRSP, and then they got a refund of $16,500 in the top Ontario tax bracket, they could put that against their debt. The result of that net would be that they’d have an extra month to eliminate their debt. So it wouldn’t be 12 months. It’d be 13 months. 

But at the same time, they’d also have 31,000 to 35,000 dollars in their RRSP, depending on how early they contributed in the year and, of course, some investment returns. So that would make them feel good with more money in their account statement, and build their investing competence and confidence. But they would, eventually, have to pay the money on that, pay the taxes on that RRSP down the road. But that’s, hopefully, going to be in a lower tax bracket well the way long down the road. Although in the interim, they could be accessed up to $35,000 tax-free using the home buyers plan, and then repay it slowly after that to continue in kicking that tax can down the road. 

So what I did was a pretty simple simplistic calculator. My main objective there is to show that, one, there is going to be a light at the end of the tunnel. Two, if you are going to start investing and you’re in a high tax bracket, the RRSP can help you do a little bit of both in a nice way. If you’re not on a high tax bracket, TFSA is the other way to do it.

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Case 2: Incorporated Physician with Bothersome Personal Debt

So let’s move over to our mid-career mortgage dilemma. This is a super common question that comes up, and I’ve actually struggled with this one a lot. So I was really excited when you guys took this one on. So we’ll fast forward 15 years. This is an incorporated physician. They’ve got still some bothersome personal debt, though. So they’re mid-career. They’ve maxed out their TFSAs and their RRSP each year. They’ve also been able to save some money down in their corporation about, a million dollars. But they still have a $500,000 adjustable rate personal mortgage left on their house. 

That didn’t really bother them when interest rates were in the ditch. But interest rates are now rising five percent or higher potentially, and they’re wondering whether it makes sense to pay themselves more from their corporation so that they can pay that debt down faster or whether to leave it in there and just keep investing it. So how would you approach that dilemma?

[00:11:59] BF: Yes. So this is a tough one, but the decision that we’re making is whether to – I’m just trying to kind of reiterate what we’re trying to do here. So we’re deciding whether to retain money tax-deferred in the corporation where it can be invested or pay personal tax, taking money out of the corporation, and then use that personal after-tax money to pay down personal debt. 

So I do want to make sure it’s clear to everybody listening that this is not an easy problem to solve numerically, let alone with consideration for the softer side of the financial decisions. So nobody should feel bad about grappling with this one. The optimal result in a model is going to rely on a ton of assumptions. So I kind of alluded to this in the main episode that we did in this topic that even if we can show mathematically what is optimal, that optimal solution is going to be based on a ton of assumptions. 

We’ve got things like your current versus future tax rate, and that’s going to change based not only on your income but also based on changes to tax rates over time. Even if we correctly predicted what your income is going to be now and in the future, that doesn’t necessarily mean that tax rates are going to stay the same now and in the future. So there’s a lot of uncertainty just around that which can change the math pretty meaningfully. 

Then the debt interest rate compared to your expected after-tax investment returns is another one, including the characteristics of those returns, which is that mix between capital gains and dividends and income and even when the capital gains are realized. So these are all things that we have to make assumptions about in a model. If we change any of the assumptions, the optimal answer could also change. So just important to understand that even though there is a way to quantify the answer to the question, it still has a ton of uncertainty around the answer. 

So with that, when we have run this through a financial planning model, the numbers are pretty close between taking the money out personally to pay off the mortgage versus leaving it invested with the mortgage intact, unless you start to get into extremes like really, really high interest rates on the mortgage. As much as I would love to have the perfect numerically optimal solution, we’re dealing with so much uncertainty here that my primary decision point, unless we’re in an extreme scenario of really high interest rates or something. 

My primary decision point here is going to be how badly the debt is bothering the client. If it’s keeping them or their spouse up at night, then I would be more inclined to have them pay it off faster, even if that was theoretically or mathematically slightly sub-optimal. But based on how different debts take different emotional tolls on people, that may push me to encourage them to, for example, take money out from the corporation to pay off their personal line of credit if that was really irking them but maybe less so for a mortgage if they didn’t find that to be as bothersome. 

Now, math would also factor in a little bit there since mortgage rates are typically going to be a little bit lower. We’re going to talk a lot more about corporations later in the series. So this is a bit of a premature introduction to some important concepts that are relevant to the case. One of the challenges with using corporate dollars to pay down personal debt, as I mentioned with a tax rate uncertainty, is that you have to pay personal tax to get the corporate funds out. 

Now, there are a few ways to sort of make that more efficient, and we’re going to do an entire episode on this later and for reasons that we’ll explain later in that episode. Some of the taxes that a corporation pays are refundable in certain circumstances, and some result in something called a capital dividend account. So these get created because you’ve already paid a bunch of taxes in your corporation, and it’s for a reason called tax integration. But again, that’s just beyond the scope of this, so we’ll come back to that in a future episode. 

If you have refundable taxes in the corporation or an unused capital dividend balance, moving money out of the corporation to repay personal debt can be much more tax-efficient personally than taking, for example, a fully taxable salary bonus. Now, you’re not really paying less tax overall, but you’re capitalizing on the fact that your corporation has already paid a bunch of tax which reduced your personal tax liability. 

Anyway, you can find out about these balances by talking to your accountant. You can ask them if you have any RDTOH or CDA balance. Beyond that, so beyond those instances where there are ways to get money out slightly more tax-efficiently at the personal level because the corporations already paid a bunch of tax, beyond that, there are a couple big variables in this. Invest in the corp versus pay down the personal debt decision. The corporation allows you to defer personal tax on the investment income that you earn through your business. So you either pay personal tax now, or you can accumulate wealth in the corporation by saving and investing. Then pay personal tax later to pay off that personal debt. 

If you know or at least expect that your future tax rate is going to be higher than your current tax rate, then taking some extra money out now can be better to smooth your income, lower your taxes later, and pay down some of that debt. Now, that can be the case in early career if you haven’t had your lifestyle costs increase a whole bunch or if you haven’t had a bunch of really expensive kids yet. But think that you will before the loan is paid off. Then on the other side of that example, if you’re likely to have lower costs of living soon and take money out in a lower tax bracket, then usually best leaving money in the corp for now and taking it out when you’re in a lower tax bracket. So there’s a lot of dancing around tax brackets here. 

[00:17:01] MS: Yes. I think the point I would take from that analysis, besides the fact there are so many variables there, but there are ways that if you do have money sitting in your corporation that could be moved out efficiently, that value of that money sitting in your corporation that could be moved out efficiently, you may want to actually move that out because it does a road over time. We’ll talk about that later. 

But also, if you are bothered by your mortgage, this could be a way to efficiently move it out that wouldn’t impact your corporation investing so much because of the refunds, et cetera with the RDTOH or the capital dividend account as the two big examples. So the key there is to know that and ask that question of your accountant if you’re thinking about moving the money out. 

[00:17:42] BF: Yes. It is a really important point to consider, and there are a lot of cases where people are not taking advantage of the ability to get money out of the corporation more tax efficiently, which, again, we have a whole episode on this later on in the series. 

The other big variable, and we covered this in the main episode, but in this case, the other big variables can be the loan interest that you’d save compared to the investment return that you’d otherwise get in the corporation, the expected investment return. Now, again, as we talked about in the main episode, that’s not going to be an apples-to-apples comparison because repaying debt is closer to risk-free, and investing gives you this expectation but not the guarantee of a positive return. 

Now, when interest rates were in the two to four percent range, paying down debt was not so attractive compared to the long-term expected return on an aggressive investment portfolio even after tax in a corporation. But it could be compared to an ultraconservative portfolio, like a bond portfolio inside the corporation, or just leaving cash inside the corporation. So if someone had a big pile of cash in their corporation for whatever reason, the alternative of taking that out to pay off debt would be more interesting when rates were lower. 

Now, rates are higher. They’re kind of five or seven percent, depending on the type of debt that we’re talking about. That’s pretty compelling as a safe return at the personal level. Now, the other side of that, though, is that taxes are a sure thing. So I don’t know if I would want somebody to take a massive dollar amount out of their corporation, pushing their tax rate up to save a little bit of interest. But I would consider taking some money out to top up a current tax bracket or maybe even a tax bracket, but it’s only a slight bump in total tax rates. 

When we’ve modeled this, which, again, is not a simple undertaking and is pretty noisy in terms of the outputs, we found that the difference between paying off the mortgage immediately by drawing from the corporation fully taxable and paying it off over like a 25-year mortgage amortization while investing in the corporation is pretty small. Now, if you think about it, the difference in expected outcomes in the cases is pretty much driven by the difference in after-tax returns at the personal level from corporate investments, which is – that’s not a super easy number to calculate. 

But your effective personal level return from earning investments inside the corporation, we’ve got to compare that to your personal interest rate on the debt, and it’s the difference between those two numbers. It’s going to drive the difference in outcomes. We found the difference only gets really meaningful. Even then, it’s still not huge. We’re not talking about a 2X difference or anything like that. But it only gets really meaningful when interest rates are really high. Like in our model, we found at 10% interest is where it started to diverge a little bit. Other than that, the math was super close. 

So my main takeaway in all that is the main driver on that decision is going to be how much the debt is bothering the client psychologically or maybe even on a cash flow side. How much it’s bothering them. But with all the other variables and nuances involved in those calculations, it’s definitely something that I would talk about with an accountant and a financial planner. But it is important to consider the factors mentioned because the default answer for most questions is, oh, I’ll just leave everything inside the corporation because that feels more tax-efficient. But I think that there are actually some pretty important personal financial planning variables and psychological variables to consider. 

[00:20:50] MS: Yes. Wow. That’s a great and very thorough explanation, which is why this is a common problem that comes up that people don’t have a good answer to. But it’s a really important one. I’m sure hearing the thought of 10% mortgage rates made people feel fairly uncomfortable. But people also feel uncomfortable because they don’t want to be making some major misstep and feel like they’re missing out on something by not taking advantage of it. 

So I think the good news here is that you probably can’t go wrong in a major way either way. The bottom line is, unless it’s a really high interest rate, is what would you do that helps you to sleep at night. The math is not that important to this decision-making really. Paying a lot of credit may be even more compelling, just because of not only the higher interest rate but also the way it psychologically affects you more so than a mortgage does. 

So I think this is a great example of a complex financial issue that you discuss with a professional but that you can only really make actually a good decision about it by considering and bringing your own personal perspective and preferences to the table, which is why we’re having all of these discussions here in this podcast series. Because even if you use a financial advisor, your perspective is what’s going to drive the optimal decision-making, more so than the math a lot of the time. 

[00:22:02] BF: Yes. I even think that just having this information and having the knowledge that there are more than just the financial factors to consider. If they’re going to use financial advice, I think that it puts them in a much better position, both to identify a competent advisor but also to use their knowledge and expertise to better their own financial situation. I think if someone who’s completely financially illiterate and doesn’t want to know anything goes to seek financial advice, I think that they’re at risk of making bad decisions for them individually. Also, it’ll be harder to find a competent advisor. I do think that this knowledge is important, whether people are using it to make their own decisions or to seek professional help. 

[00:22:44] MS: Great. Well, that’ll wrap up our first little case conference around our episodes. We’ll probably do these intermittently, depending on the episode and the content, just to supplement what we’re doing with some extra discussion. 

[00:22:55] BF: All right. So we hope to see you for the next procedure where we’re going to take the money scope deep inside the basics of investing. 

Related Resources

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The material in our first few episodes is strongly related to the first three modules of The Loonie Doctor Core Financial Curriculum. Here are a few articles closely related to this one.

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Medical training comes with a high upfront basic cost. The debt load can be overwhelming and scary. It falls outside of the realm of most people’s experience. However, many doctors have trod this path and it turned out okay. I will give some suggestions of how you can make it easier to be okay. Not just okay now, but to make yourself a financial super-power for the rest of your career.

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When you start making more money, the future has arrived. You have felt the growing burden of your debt and now it is time to the turn the tables and crush it. That requires you to pay attention and make a debt repayment plan. The basic variables are your income, spending, debt repayment, and investing. This post looks at some Canadian data and applies that along with some tips to boost your success. There is also an embedded calculator to plug your own numbers into.

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Most people face competing priorities for their income. One of the most common dilemmas is whether to more aggressively pay off debt vs invest more. Debt interest and missed time in the market can both result in compounding losses over time. You need to make a deliberate plan and then execute it.

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When faced with the competing priorities of paying debt vs investing, many will choose a compromise and do a bit of both. Once your debt is at a safe level, starting your investing journey can help you take advantage of a longer time horizon. You can also build good investing habits right from the start. Learn why the TFSA [or FHSA] is excellent for this. Also, consider when an RESP or RRSP may be even better.

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You need to make a concrete plan to eventually eliminate your debt.That may mean consolidating some of it. For Canadian student debt, that decision should factor in opportunities for loan forgiveness, interest relief, and tax credits. There may also be fine print for some loans like financing and mortgages. Besides the math, you must also consider your psychology to make a plan that you can execute.