When Not to Use a High Interest Savings Account

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.

6 thoughts on “When Not to Use a High Interest Savings Account”

  1. I agree, pay ANY debt before you invest
    Personally, I’d pay down mortgage before RRSP as well

    I wish TFSA could come sooner…

    ICICI is paying 3.4% for HSA (and a bit higher for GIC’s), but those will be taxed 100% interest

    Or if you like risk, go for high yield dividend stock or income trust. Taxed at 100% still though

    For example, Yellow Page (YLO) is about 10% yield, but be warned: this is not a stock tip, and there is a chance stock will fall and you lose more than your interest income!!!

  2. A potential problem with putting cash savings against debt is that if you lose your job, banks may not lend you any money. So, this extra money you put against debt becomes inaccessible. In general I like the idea of paying down debt, but it does make sense to have a modest amount of cash available for emergencies, particularly for single-income families.

  3. I agree with Mike about not allocating money in the extremes. Yes, high-interest savings accounts are not as ideal as most think it is but you do need to have cash around because in an emergency if you draw down on your HOLEC for short-term cash, your cost of cash is higher than using up your reserves first.

  4. I agree with the concept and actually this in practice with my finances.

    The only problem that I see is with respect to your comment “If you need the money down the road you merely use your HELOC to take out the money”.

    It is also easy to see the available room on your HELOC as “available money” in that is is very easily accessible. You are blending savings with debt and although it all shakes out in your net worth, it takes discipline to view a reduced liability as savings.

  5. I agree with the post. Good point by M.James though.

    These use of these accounts amoung Canadians will always be high though because they are simple, common, and perceived to be safe.

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