Pay Down That Debt With Your Tax Refund

Now that we are all done school, we are now at the point where we need to think about paying down our debt. With on the order of six figures of student loan debt, it’s hard to feel like we’re making any progress towards paying it down. Although we have not been forced into an amortization plan yet by the bank, we have been paying the interest and some principal every month. This will ensure that the principal is at least going down a little. If we only paid the interest every month, the principal would never decrease (although it would decrease in real dollars due to inflation).

We could pay more in principal every month to our loan, and this is not a bad idea. Every dollar paid to the principal is sort of like a dollar contributed into a fixed-income investment which pays interest at the same interest rate as the loan. So paying down principal is like a fixed-income investment. Instead of increasing the principal we pay down every month, we have chosen to maximize our RRSPs first and foremost, which is something I discussed in a previous article. Under the assumption that over the long term our RRSP will achieve a rate of return roughly similar to the loan interest rate, this is a great idea because the return of the RRSP will match the return of the loan (again, treat the loan as a fixed-income investment) but we will also get a bonus: a tax rebate will be generated from the RRSP deductions (because income contributed into an RRSP is tax-deferred).

Since we have made our RRSPs our #1 priority (for the reason mentioned above and described here), we maximized our RRSP contribution room last year and will again maximize our RRSP contribution room this year, at the expense of less principal applied to the loan monthly. In April 2006, we plan to receive a hefty tax refund generated from our RRSP contributions. Since we have already maximized our RRSPs, we do not need to use contribute the tax refund into our RRSPs. Instead we are planning on applying the entire amount against the student loan. This is only possible because we already have an automated savings plan for vacations and other short-term goals, and therefore we do not need the tax refund for any other purpose.

It turns out my parents also used this technique for many years while paying down their mortgage on their home and on a second rental home, allowing them to pay it down faster and become debt-free sooner.

10 thoughts on “Pay Down That Debt With Your Tax Refund”

  1. >> Every dollar paid to the principal is equivalent to a dollar contributed into a fixed-income investment which pays interest at the same interest rate as the loan.

  2. How did that happen?

    I was going to say that paying off debt is actually better than buying a fixed-income investment since you would have to pay tax on the income you get from a fixed-income investment. So if you are in the 43% tax bracket and you have a debt that is costing you 5% then you would need to have find a fixed-income investment that paid about 8.75% (5%* (1-43%)) just to break even (after taxes).

  3. Ray,

    Good point! I hadn’t thought of this, and I should probably change the wording of the article to read “is sort of like” instead of “is equivalent to.”

    Just small typo in your math… it should be 5%/(1-43%), should it not?

  4. Ray, does the same thing apply for an investment inside an RRSP? I know capital gains and interest/dividends inside an RRSP aren’t taxed, but they are eventually upon withdrawal?

  5. The RRSP thing just confuses things a little bit and makes it harder to figure out. Eventually you are taxed on that money but you get to not only defer the taxes on the income from the investment until you are at least 69, you get to not pay tax on the original investment. The catch is of course that you have to pay tax on everything when you take it out of the RRSP. However, since interest income (i.e. not capital gains or dividends) is taxed at 100% anyway if you can defer the tax on that there really isn’t any downside.

    So if you can find a safe fixed-income investment that pays the same or higher interest than your loan (here’s a hint, General Motor bonds are not currently safe investments) then from an overall net worth stand point it would be better to buy the fixed-income investment (and maybe use the tax refund to pay down a part of the debt).

  6. The debt on one of my credit cards is split, where just about $300 is at 12.5% APR but the rest of the balance is just 6.99%. I’d rather my monthly payment go to the small amount at 12.5% first, but I don’t think I can change that. Am I wrong?

  7. Debt Hater,

    That’s the genius of those 0%-until-paid-off offers. They are counting on the financially illerate to use them, and then continue using the credit card for purchases. Then, when they make payments, little do they realize that ALL their payments go to the no/low APR part, while the high APR balance continues to grow compounded (imagine, if your high APR was 18%, that part of the balance doubles every 4 years!)

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