Posted by Tim Stobbs on August 14, 2008
High interest savings accounts. Oh how we personal finance geeks love them. They cost nothing to use, yet generate money on our idle cash. We write entire articles about which bank has the best deal. Yet we have all missed something a little obvious. They actually suck for most Canadians.
Why? Well it is rather simple. They pay interest, which is then taxed at our marginal rates. So a high interest account pays me 3% per year and I’m at a 35% marginal tax rate actually pays me 3% x (1-0.35) = 1.95% after tax. Then if you include inflation at 2%, we are actually losing money at 0.05% per year. So rather than being smart I’m actually losing money.
So what’s the solution? Well obviously having a high interest account in a Tax Free Saving Account (TFSA) would help, but the interest still isn’t that good of a rate of return and we don’t have much for contribution room. So the other option that springs to mine is pay off ANY debt you have instead and keep a readvancable HELOC instead.
So if you suddenly have a extra $1000 dollars, rather than putting it into a high interest account you pay down your mortgage or HELOC instead. That way you are saving about 5% after tax dollars in interest instead of losing money in your high interest account. If you need the money down the road you merely use your HELOC to take out the money.
Of course like all good ideas this one has holes in it too. If you earn so little that you don’t pay any tax on your interest then keeping the high interest account makes a bit more sense. Additionally depending on the spread between the high interest account and your mortgage and HELOC it might not pay all that much to do this. Like everything else in personal finance the choice is ultimately up to you as well as the responsibility to determine if this would work well in your case.
If nothing else, I just like the idea. If you know other holes I’m missed please feel free to remind everyone.