Author: Mike Holman

I just started reading the book “Smart Couples Finish Rich” and one of the first things it mentions is to “pay yourself first”. This advice is similar to the “Wealthy Barber” and probably every other personal finance book ever written. Usually this involves getting money deducted from your bank account automatically so that you don’t miss it and it gets saved for retirement or vacations or whatever.

While I think this is a good strategy for a lot of people, in some cases it’s really bad advice. In particular, people that have excessive debt should be focusing their saving efforts on their debts and nothing else – not their retirements or vacations. Now someone in that situation might ask why they shouldn’t be paying themselves first as well and the answer is that they already have paid themselves, in some cases they might have overpaid themselves by a long shot. The reality is that debt results from spending more than you earn, in some cases this can’t be helped but in most cases it results from a deliberate decision to spend more money ie on a bigger, more expensive house (I did this), more vacations, newer cars etc. Sometimes it results from just not keeping track of your finances properly. Regardless of how you end up in the situation of having excessive debt, you eventually have to pay the piper. Some people choose to tackle debt head on by cutting their spending and reducing the debt as fast as they can. Others will cut back a bit and reduce the debt at their leisure. The remainder will ignore it completely and will pay during their retirement when they have a lower standard of living because they still have debt they have to service.

Please note that I’m not referring to deductible debt ie the type you have with an investment loan.

Do you have a lot of debt? How do you know if it’s excessive?

This post is a continuation of Monday’s post which concluded that making an extra rrsp contribution is better than making an extra HBP repayment. Today’s issue is whether it’s better to make an extra HBP repayment or pay down the mortgage.

This one is not as clear cut as the rrsp vs HBP issue. If you put money into the rrsp then you could potentially make a better rate of return compared to the interest on your mortgage, on the other hand, paying down the mortgage gives the guaranteed return of your interest rate.

I would say that for a typical example of someone who owes a lot more on their mortgage than they do on their HBP, the deciding factor is interest rate risk. This is something which I’ve talked about previously and basically it refers to the risk involved if interest rates go up. One great feature of the HBP is that there is no interest rate risk because there is no interest paid. Regardless of what the prime rate is, or mortgage rates are, the amount you owe on the HBP is constant. Your mortgage however, has no such benefit since the interest charged will go up or down with the mortgage rates.

If you have extra money and you make an extra HBP repayment, then your interest rate risk will not change. If you instead make an extra payment to your mortgage, then your interest rate risk will decrease.

Bottom line then is that you should consider making extra mortgage payments and rrsp contributions before paying extra HBP payments. In my case I plan to completely pay off my mortgage and max out my rrsp and only then will I consider making extra payments to the HBP.

I’ve been of the opinion that financial products that guarantee that you won’t “lose” any of your original investment and also offer an upside due to an equity component are not a good deal because of the high fees involved. Jonathan Chevreau covers some of these products today in his blog and article which got me thinking about the fact that financial companies are no different than any other companies in that if there is a market for a product then they will produce that product and try to make as much profit as possible. The reason that it’s possible for them to offer inferior financial products at a profit is simply because of the ignorance of the consumer.

If an investor buys a principal guaranteed product which entitles them to get their original investment back regardless of how the equity portion does, have they really conserved all their capital? In fact if you invest $10,000 today and then sell the investment in 10 years for $10,000 then your investment will be worth only $7374 in today’s dollars at 3% inflation. Inflation is one of the more important aspects of financial planning and cannot be ignored.

That investor would be better far better off to create their own low cost portfolio of at least 40% equity in order to keep up with inflation.

Even if said investor was still willing to ignore inflation and wanted to guarantee their “principal”, what they should do is create their own guaranteed product by buying a combination of GICs and equity (low cost index funds or ETFs). If for example you could buy a 10 year GIC at 4% then the above investor could invest $6755 in the GIC and the remaining $3244 in a couple of equity index funds. After 10 years, the worst case scenario is the equity component is worth $0 and the GICs will be worth $10,000 which will mean that the investor still has his original $10,000. A more likely scenario is that the equities will obtain a return – let’s say 7% which will mean that the equity portion will end up being worth $6382 and the final investment will be worth $16382 which gives the investor a return of 5% which beats the inflation by 2%. Obviously over a 10 year time period the equity returns could vary greatly.

I had a discussion last year with my wife where we talked about whether to give our home buyer’s plan debt priority over rrsp contributions.

Although it initially seemed like a good idea to pay the HBP back as soon as possible since it was a smaller amount (about 30k combined), it occurred to me that if you have any rrsp contribution room then you are much better off just paying the minimum HBP repayment amount each year and use any extra money that you want to put into the rrsp for a contribution.

The reason behind this is that whether you are paying back HBP or making an rrsp contribution, the amount that gets added to the rrsp is the same so since the rrsp contribution will give a tax rebate, that is generally the better choice.

For example, let’s say if I have $5000 that I want to put into my rrsp and my minimum annual HBP payment is $1333 and my marginal tax rate is 40%.

If I were to make the minimum HBP payment and contribute the remaining $3667 into my rrsp then my rrsp would have an extra $5000 in it and I would get a tax rebate of $1466.80.

If I were to put the entire $5000 into a HBP repayment then my rrsp would have an extra $5000 in it and I would not get any tax rebate. I would however owe less money to the HBP and future minimum payments will be smaller.

So it’s pretty clear to me that if you have the choice between contributing to your rrsp or extra repayments into your HBP – the rrsp is the winner.