Category: Personal Finance

In a previous post I talked about my method of tracking our household cash flow in order to determine if we are spending more or less than we earn. I also keep track of our spending that occurs on our visa as well as automated debits from our chequing account.

As worthwhile as I think those exercises were, I stopped doing them for the simple reason that I’ve been stressing out too much over our finances as a result of following them too closely. In particular, when following the individual expenditures I tended to get upset if we had unplanned expenses which affected our cash flow. Now I don’t want anyone to think that we are just going ignore our finances – far from it! We aren’t going to change our spending habits and the plan is to look at our bank account at the end of the month, figure out how much “extra” money we have and hopefully put that money into the mortgage. This “extra” money at the end of the month should be an indirect proxy for the cash flow calculation and will tell us how much we’re saving each month.

It was very educational to keep track of the expenses and cash flow for the last six months and hopefully we’ll do it again sometime in the future.

After getting some interesting comments yesterday in my post about what to do with my year end bonus I decided to do a post about rrsp contributions and the best way to do them.  Please check this page out for up to date rrsp deadline information.

One of the suggestions was to put the bonus into the rrsp and use the tax refund to pay down the mortgage. I’m not a big fan of this rule of thumb because it doesn’t necessarily fit everyone’s situation. Some people should put all their extra money into their mortgage and forget about their rrsp. Others should do the opposite and put it all into their rrsp. Most people should probably do some combination of rrsp contribution and extra mortgage payments.

Most people make rrsp contributions by setting up an automatic withdrawal plan from their bank account. Then they will recieve a tax rebate the following spring which is not a good thing because it means that you have made an interest free loan to the government. Another problem is that if you are trying to maximize your rrsp contribution, it is difficult to do with after-tax money. If you can make the contributions with your pre-tax then it will be a lot easier.

A better way to contribute is to get your company to reduce your income tax deductions at the source (your employer) by an appropriate amount so that you pay less tax on each paycheque and will not get a refund at tax filing time.

How do you do this? Most companies that have group rrsp plans will be able to accomodate this if you are contributing to the group rrsp plan. It’s best to talk to your payroll department to see what they can do.

Another option is to fill out a government form T1213 – you send it in and they will send a letter (hopefully) allowing your employer to reduce your deducted income taxes. This can be done on salary or a lump sum amount. This form has to be filled out once a year.
Obviously if you get a reduction in your income tax then you have to make sure you actually make the contribution otherwise you’ll owe quite a bit of tax the following spring.

An example:

If Sue is in the 40% tax bracket and decides to contribute $500/month then her employer will reduce the tax deducted by $500 * 40% = $200 per month. By doing this she is contributing the $500 from her gross salary, not her after tax salary and will avoid giving the government an interest free loan.

I get a year end bonus which normally adds about 10% to my annual salary. It’s a bit early to be thinking about what to do with it but I’d thought I’d write a post since I can’t decide. Basically the choices are to put it into my rrsp or my mortgage or split it up and do both.

Up to now this money has always gone in to the mortgage and in some cases paid for vacation trips.

This year I’d like to only use it for mortgage and/or rrsp and nothing else. Since I feel my mortgage is excessive and I worry about it a lot more than the size of my rrsp, it seems like a no brainer to put the money into the mortgage. However at the same time if I put it into the mortgage then that means I’m paying a lot of tax (43.38% to be exact) on it, which I can defer if I put it into the rrsp.

One of the strategies I was thinking about was to see how the markets perform this year and perhaps decide based on that. For example if my rrsp (I’ll use my portfolio as the index) does better than say 5% then I’ll put all the money into the mortgage – I’m thinking that considering how well the markets have done, if they continue to do well then maybe they should be avoided. Bernstein says to buy when things are looking their worst – not at their best. On the other hand if the rrsp goes down at least 5% this year then I’ll put the whole bonus into the rrsp. If the return is between -5% and +5% then I’ll figure out some ratio and split the bonus between the mortgage and rrsp.

A couple of other things – even without the bonus we make quite a bit of extra mortgage payments. We also contribute a fair bit to the rrsp on a normal basis . Regardless of the my choice, neither the rrsp or mortgage will be ignored!

Any opinions?

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?

In Bernstein’s “Four Pillars of Investing” he talks about how superstar fund managers often attract more and more money, such that they can’t get the returns they were making in the past (since to buy the “good deals”, in the quantities they need, would drive the price up before they could buy as much as they wanted).

Consider a widget that is worth $30 and we find a supply of them in a store for $10. Say we can only buy them one at a time, and as we buy them the owner increases the price by $1. We’re very happy with this situation if we only have $10 (we buy one, sell it for $30 and go and buy ourselves an ice cream with the $20 profit). Say you have $50,000 instead. You’ll buy 20 widgets, at which point they cost $30 each to buy (so aren’t worth buying any more). While we’re happy that we got some good deals, we got a slightly worse deal with each widget we bought (we only saved $1 on the last one). On this transaction we spent $390 to make $600. Good deal, but probably not the best way to invest $50,000.

I think there’s a great deal of this in life generally. Often the first $1 we invest gives us the best return, provided we’re knowledgable and making rational choices instead of investing in Pro-line. Say I’m on the verge of bankruptcy and am paying 96% annually on a payday loan. If I pay down that loan by $1, I’m making an amazing 96% ROI! Say I pay off the payday loan and put $1 to a 26% Mastercard debt, a 26% ROI is pretty hard to find too! Someone who has no investments or debt can be VERY focused on any investment he makes. Say he buys some materials, builds crafts with them, then sells the crafts. He can probably make a good ROI on this (it wouldn’t be so good if you factored in his time, but if you just look at it in terms of dollars and cents its probably going to be quite good). My mother is a retired teacher and likes to knit. If she were ever going to sell a sweater she made, she’d do very well looking at it from the perspective of how much the sweater is worth vs. what the wool cost her. HOWEVER, as soon as she factors in her time, it becomes a VERY expensive sweater (no one would buy it).

That’s the other advantage of people just starting out, their labour is probably not very valuable, so they can pursue high-labour strategies to pump up their ROI. As your networth increases, the time you can devote to growing each dollar decreases, and you get a diminishing return from any such effort (it’d be a lot easier to work at a crappy job if the alternative was starving on the street instead of working for a newer model Porsche).

Obviously its better to be in the situation of earning investment income from more money instead of less (I’d much rather have $100,000 invested at 5% then $1,000 invested at 7%). My only point with this post is that when you’re starting out, you have a labour “competitive advantage” over wealthier investors. People who take advantage of this by looking for “hands-on” investment opportunities are probably quite smart (they’re avoiding competition from the rich people).

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.

1) Find “high-return, no-risk” opportunities and give them your money

2) Do business with someone who tells you to “trust me”

3) Do business with someone who discourages you from talking to other people (“this is a confidential matter, don’t tell anyone about it”, “don’t let your friends and family be dream-stealers!”, “don’t talk to a lawyer/banker/accountant, they’ll suck the blood out of you and stop the deal because they’re overly conservative”)

4) Do business with someone who wants to teach you how to make lots of money (by doing a deal with them where you put up your money and they dictate how every element of the deal will work in order to “teach” you)

5) Blindly follow a “secret path to wealth”. Get angry at anyone who questions the path or points out flaws.

6) Pay gurus for “secret” information

7) Pay guru-students for second-hand “secret” information

8 ) Invest in “business opportunities” discovered on lamp posts, in the classifieds, on USENET or in your e-mail inbox.

9) Ignore anything that’s “too complicated” and only pursue simple strategies

10) Believe that its easy to “work smart instead of hard” (and that someone can show you how to “work smart” in a short period of time)

Any other ideas?

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.