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Should You Repay Your Past? Or Save for Your Future?

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In the wake of May's bond market rally from heaven, administered rates have seen additional downward pressure into June. GIC rates have extended their decline, while Canadian mortgage rates are downright juicy.

In the background we have the Bank of Canada going through a bit of a flip-flop on policy as this week's policy meeting heard more about risks facing growth from abroad, allowing Mr. Carney and crew to leave rates unchanged (no surprise) and tone down the previous guidance of higher rates either later this year or in 2013 .

That said, Bank officials are still adamant about the need for Canadians to pare back debt and will not relinquish their view towards an eventual tightening policy unless things in the world (and at home) become very dire.

Given this environment, it's no surprise that Canadians are uncertain as to whether they should be paying down debt instead of building investment nest eggs. This was indeed the dilemma we faced during RRSP season as individuals opted not to contribute and focused on debt repayment as well. To be fair, the concern over global markets was equally to blame for the reduced attention to RRSPs, but that is a transient factor. The debt choice is more integral to the household and deserves some careful thinking.

First of all I will always defer to a person's psychology relating to debt. If someone is completely averse to having leverage on the balance sheet, they should always lean towards reducing their debt load to a more comfortable level, providing they have all the facts about the pros and cons of doing so. For those who are not as anxious about debt, the decision as to how to allocate surplus (household income minus expenditures) towards debt and investments needs to address the following: current and expected interest rates, expected return on investments and an assessment of future income stability (is one's job relatively safe or not?).

Usually a review of these items will provide the appropriate answer regarding debt-investment split; however, if someone needs a more analytical approach I would recommend the following. Most governments, in their fiscal budgeting process, will look at debt servicing costs as a percentage of income.

Indeed, whenever you borrow money your bank will examine various ratios that look at the amount of revenue spent on paying interest (and capital) on debt relative to household income. For individuals with stable income, the goal may be to see a reduction in debt servicing versus income, which effectively means paying down debt so that the interest payments decline over time.

In cases where income is rising, such as the situation of a person coming out of school and expecting steady increases in salary/bonuses, the strategy may be to maintain debt servicing ratios at a comfortable level, which will naturally imply an increased amount of the surplus each month or year going to investments. This of course assumes no change in interest rates so the same consideration for the future course of rates has to be taken into consideration as I mentioned above.

At the end of the day, Canadians need to do two things -- keep debt at a level that is manageable, even in the face of rising rates, and build a retirement nest egg for the future. To do one at the sole expense of the other invites some very unwelcome results down the road.