Category: Personal Finance

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Guest Blog Post: Boppy’s Rules of Money and Investing

Welcome back readers! (Yes, both of you.) I know it’s been a while, but life has been… well, life.

Today marks this site’s first ever guest blog, featuring the words of wisdom of my father-in-law, the one and only Boppy.

My father-in-law is a long-time investor. He has been retired now for many years. In his working days he was a teacher, but also a cautious investor and an inherently frugal man who above all else understands the value of a dollar. I always enjoy talking to him about money and investing (among other things) and the teacher in him is always happy to offer advice to those who seek it. Between his teacher’s pension and his assets from a lifetime of investing, he now spends his days doing things he loves, which mostly involves spending time with his grandchildren and enjoying his summers at the cottage. And of course, another thing that he enjoys doing is keeping an eye on the market and his investments.

When Boppy found out I had this little corner of the internet, he was intrigued. He revealed to me that he always wanted the opportunity to share some of the wisdom that he has accumulated over the years with future generations, starting with his grandkids. So I told him I would happily offer him some space on this site to share some of that wisdom. Sure enough, Boppy has come through with his first contribution.

So to my nieces and nephews (and my own children, assuming you are reading this in the future once you have learned to read), mark this page as a bookmark, a favourite, a Pin, or what have you. Without further ado, I give you the words of Boppy.

Boppy’s Rules of Money and Investing

  1. If you take care of the pennies, the dollars will take care of themselves.
  2. No one looks after your money better than you.
  3. A dollar saved is equal to two dollars that you earn. Why?
  4. It’s not how much you make, but what you do with what you make.
  5. Never allow debts to increase. Pay all bills and credit cards when they are due.
  6. Don’t put your money in banks, but buy the shares of banks (preferably in a DRIP plan).
  7. Put your money in a true credit union. I have always been a member of at least two different credit unions so I could play one against the other for the best rates. Remember you are doing them a favour when you lend them your money.
  8. Avoid spending money on depreciating assets. Invest in appreciating assets. Name a few of each.
  9. Understand the difference between needs and wants. People that make a lot of money but have little savings spend their money on wants which are depreciating assets.
  10. Save a given percentage (10% or more) from every pay cheque. Put it in an account that gets the highest rate possible.
  11. Save for important purchases and avoid borrowing money and paying interest. Buying a house is one exception.
  12. As soon as you start becoming taxable, open TFSA accounts and contribute as much money as you are able to avoid paying tax.
  13. Use RSPs to reduce taxes, but do not contribute more than about $100,000 in your lifetime if you also have a pension. You will still have to pay tax on this money when you withdraw it, and you could put yourself above the threshold for Old Age Security benefits.
  14. When saving for your children’s education, do it through yearly contributions to RESP accounts. Familiarize yourself with the different kinds available and benefit from the yearly government contribution.

There are other specific things that require planning and strategies like; buying a used car, selecting and using a credit card, and stock trading rules. You can always ask Boppy.

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Variable vs. Fixed Rate Mortgages: An email correspondence

Subject: So You’re an Economics Kinda guy…
Boba Fett <bfett@slave1.com> Sun, Sep 24, 2017 at 5:37 PM
To: Mr CIQY <me@caniquityet.com>

hey man,

Mrs. Fett and I were talking mortgage after the Bank of Canada raised rates, and realized we don’t really know squat.  and we thought, who does know squat? and the answer was: maybe Mr. CIQY?
As one of a very few economics minded friends, wondering if you had any thoughts regarding rate increases and fixed mortgages?
Mr. CIQY <me@caniquityet.com> Mon, Sep 25, 2017 at 7:37 AM
To: Boba Fett <bfett@slave1.com>

Oh I have thoughts on a lot of things. Doesn’t always mean they’re right though.

I guess it depends on a lot of factors. Are you asking because you guys currently have a variable rate and you’re debating whether/when to lock in to a fixed? If that’s the case, then it kind of depends on the spread. We’re in that situation now ourselves. Last time I checked, for us the spread was 0.55%. So in our example, that basically represents two more rate hikes, or close enough. meaning that in two more rate hikes, assuming our lender passes both those hikes along to us, we will be paying the same rate as if we locked in to the fixed rate now. There’s a school of thought that says you’re better off going with the variable because in the interim, you’re still paying less interest. Which makes sense to me. Of course, then it becomes a question of when the hypothetical third rate hike will be, at which point you’re worse off than if you acted today. But again, you will have paid less interest in the interim.

Some people really like certainty and knowing exactly how much they’ll be paying for X years and if that’s you, then going fixed might make sense. But in most cases you’ll end up paying more interest by going fixed.

What specifically were you guys wondering about or wanting to know?
 
Boba Fett <bfett@slave1.com> Mon, Sep 25, 2017 at 8:48 AM
To: Mr. CIQY <me@caniquityet.com>

Brother, you nailed it in one.

Effectively, we’re going through the variable–>fixed should-we? talk based on essentially the numbers you’ve got there; around a .5% difference.  So, as you say, we’re looking at a likely 2-hike equivalence in the rates.
Mrs. Fett’s read that the rates could go up as much at 1%, in which case, locking in a fixed rate now would make sense.  But she’s also read that a hike like that would put a bunch of people out of their homes because people think a mortgage is a free house from the bank.
Based on your reply, can i assume you guys will remain variable?  We’re trending in thinking that way, but hoping we won’t regret it if the rate keeps climbing.
sigh.  I remember when finance talks were “should i get that comic book, or the creamsicle”.  Thanks for the thoughts (right or wrong) – it’s good to hear.
 
Mr. CIQY <me@caniquityet.com> Mon, Sep 25, 2017 at 9:14 AM
To: Boba Fett <bfett@slave1.com>
Well for us, we’ve got 3 more years left before we get to renew our mortgage. Our strategy has been and continues to be a) make minimum payments; b) save as much as we can and invest in TFSAs, hoping to earn some nice returns; c) on the eve of mortgage renewal, make a lump sum payment from our savings and investment income to the mortgage principal to try and get our monthly minimums lower for years 6-10. Trying to predict what will happen to the economy is a mugs game and if I knew how to do it properly… well let’s just say I don’t.

That said, there are reasons to believe that interest rates might not continue to climb uninterrupted over the next few years. For starters, inflation just isn’t that high yet, which suggests maybe more rate hikes might not be a sure thing. Secondly, all it takes is for another recession to hit and then we’re definitely not likely to see rates climb higher. And recessions tend to happen every so often for all sorts of reasons. It’s possible we’re about due for one soon. Looking for reasons why? I dunno… an end to NAFTA? Other major catastrophe? Start of a new war? Another big drop in oil prices? A strong Canadian dollar that crowds out manufacturing exports? A major housing collapse due to rising interest rates (irony!)?

Or who knows? Maybe we’re at the start of a historic economic boom? I’ve been wrong about lots of things before. Anyway, we’re going to stay variable for now I think. But check back with me in a year when I’m paying 5% on my mortgage and kicking myself for not locking in.

[
Boba Fett <bfett@slave1.com> Mon, Sep 25, 2017 at 10:42 AM
To: Mr. CIQY <me@caniquityet.com>

Thanks for the sanity check – i think we’re largely in the same boat, but your one-time lump sum payment makes way more sense.  We have the opportunity to pay down the principal via acceleration, but it would make more sense to invest those payments and then use the resulting interest as well.  See, you’re the economic guy for sure.  Also, thanks for the context – it’s easy to freak the f out when you hear “rate increase” but what you say also makes sense.  and some of that context is TERRIFYING.

Thanks again homes!
 
Mr. CIQY <me@caniquityet.com> Wed, Sep 27, 2017 at 10:55 AM
To: Boba Fett <bfett@slave1.com>

Hey, so uh, I started a blog a little while ago, and it’s about personal finance, frugality, etc.

I was wondering if you would mind if I mined this email thread and made a blog post out of it? I would be obfuscating your identity as well, but I kinda thought an email exchange about fixed vs variable mortgages might be a semi-interesting way to address a topic that fits within my blog’s subject matter.

Would you mind if I published this exchange, lightly edited with all identifying information scrubbed? I’ll even let you pick your alias, if that appeals to you. 😉

 
Boba Fett <bfett@slave1.com> Thu, Sep 28, 2017 at 8:01 AM
To: Mr. CIQY <me@caniquityet.com>
Yeah, absolutely, go nuts!
As for aliases, is in like the Dear Abby write-ins?  “Worried in Weston” or “Scared in Scarborough”?  or just a name? In which case, can i get ‘Boba Fett’?
 
Mr. CIQY <me@caniquityet.com> Thu, Sep 28, 2017 at 8:14 AM
To: Boba Fett <bfett@slave1.com>
You can get whatever you want. Boba Fett is a good choice.
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Savings and Investment for Noobs

A friend recently came to me with a “problem”. He had recently come into some money. Prior to this my friend didn’t really have anything in the way of savings, nor any knowledge of what to do to put this money to good use. This is one of those good problems to have. He had money, but needed knowledge. Money can be hard to come by. Knowledge is easy to acquire. You just need to know where to look.

So this post is basically an answer to my friend, as well as a handy guide to others in similar situations who maybe know they want to save and invest but have no idea how to start.

Up front, I’ll just say I understand how daunting this all can be to anyone who has never learned anything about investing or banking or finance at all. There’s a lot of factors to keep track of. I’ll do my best here to try and make it simple enough to follow.

Factor #1: What type of account

Regardless of what types of investments you are looking to hold, those investments need to be held in some kind of account. For the purpose of this piece for beginners, I’ll address four different types. Once again for my readers, this is Canada-specific. If you don’t live in Canada then the particular account options will be different and have different names, but the concepts may be similar. I have already touched on some of these considerations in a former post, but I’ll give a bit more detail here:

  1. Normal, non-registered accounts. Most if not all banks will have some investments they will happily sell you. If you happen to hold these investments in a non-registered account, then they will be subject to tax of some kind. So if the investments pay dividends or have some other income stream, then you will have to pay income tax on that income in the year in which it is received. Likewise if you sell any assets in a non-registered account and make money on the sale, you will pay tax on the capital gains. Capital gains just means profit when selling investment assets. This is the “normal” situation, so to speak. If you make money, the government wants their share of the tax on it.
  2. Tax Free Savings Acount (TFSA). This is a registered account. The main thing to be aware of here is that there are limits to the amount of money you can put into this account. The details of contribution limits are explained here. The tax benefits of this account are right in the name; any income or profits earned in this account are tax free, which is great. You are free to withdraw money out of this account at any time, but you have to be very careful about putting money back in, to make sure you don’t breach the contribution limit. This makes this account great for short-to-medium term investing if you are looking to earn a little income on your money and want access to it before you retire.
  3. Registered Retirement Savings Plan (RRSP). This is also a registered account, as it says in the name. It also has contribution limits, but those limits are much greater than the limits for TFSAs. Its main benefit is for deferring tax. What this means is any contributions made this year will reduce this year‘s taxable income. So if you contribute $1000 now, your taxable income for this year at tax time is reduced by $1000. That is because this type of account is geared toward retirement. Tax will be paid on any money taken out of it during retirement, as if you had earned it in the year it was withdrawn. Because it is designed with retirement in mind, there are witholding tax penalties if you withdraw money early. This type of account is great if you are currently in a higher tax bracket and want to reduce your tax payable this year, but not so great if you plan on using the money before you are 65 because it is locked away.
  4. Registered Education Savings Plan (RESP). This account is a bit unique because it is designed specifically for saving for a child’s education. If you have no children (or your children are already over 18) then this account doesn’t really apply to you, but I’m including it here because if you do have children under 18 then this account is a no-brainer.  Why? Because the government will match 20 cents per dollar on the first $2500 invested each year to a maximum of $500 per year, up to a maximum amount of $7200 per child. This extra money is called the Canada Education Savings Grant (CESG). This is free money, and a 20% return on your investment without doing a single thing. Of course, if your child doesn’t go to college or university then you do have to give the CESG portion back, or transfer it to a sibling who still has contribution room, but why not take that money in case your child does want to pursue post secondary education? An RESP can stay open until the child is 36, just in case he or she isn’t sure they want to go to school right away. If they definitely don’t, then the money (after returning the CESG portion to the government) can be transferred to an RRSP.

All four are useful and have their respective merits and flaws. RRSPs are great, especially when your employer also contributes to one for you, but only if you don’t plan on using that money before age 65. TFSAs are great but they don’t really do anything for your income taxes in the current year, and there are limits to how much you can put in. If you’re lucky enough to have maxed out your registered account contribution room, then you have no choice but to use a non-registered account. You get the idea.

Once you have decided which type of account you want to open and hold your investments in, it’s time to decide what to put in it. But before we get in too much detail about the different options, we have to address two major concepts: volatility and diversification.

Volatility

If you’ve ever taken an economics or finance class, and probably even if you haven’t, you might be aware of the “risk vs reward” trade-off. The idea is simple; the riskier an investment is, the greater the potential returns. The classic Economics 101 example of a risk-free asset is a government bond. So a sovereign government issues a bond and that bond has a yield of say 3%. The reason this is risk free is because the government is guaranteeing you that you will get your 3% return. The only risk in holding this bond is the risk in the government going broke and not being able to pay you your 3% (or your principal back!), but since most governments are also in the money-printing business, this risk is pretty darn low. Some countries are on shakier financial ground of course, and maybe their risk of default is greater than that of other countries. Well guess what? Those countries will have to offer a higher yield on their bonds in order to get people to buy them. That is your risk vs reward paradigm in action; riskier bond, higher yield. Corporations also can issue bonds and they tend to be a bit riskier than government bonds, which of course means they offer even higher yields. But once again, the only real risk to the investor is if the company goes broke. Bonds are safe because outside of the rare event when a country or company goes belly-up, you get your yield, guaranteed.

On the other end of the volatility spectrum, you have the corporate stock. Stock prices go up and down all the time. For the most part when you’re talking about stable, major corporations, prices do go up in the long run. But between now and “the long run”, their stock prices can go way up or way down, depending on a lot of factors. They are volatile. So say you invest $1000 in ABC Corp today, and promptly forget about your investment. Two months later you look at their stock price and realize that it has gone down and your initial investment is only worth $800. Boo! That’s terrible! You’ve lost money. But you hold onto your stock, because you’re a lazy investor. A couple of months later you check back and see that the stock price has gone up again! Now your investment is worth $1100! You’re a brilliant investor because you have earned a 10% profit on your investment and now you are rich. Bully for you!

Of course, one day, ABC Corp could get mired in a major scandal and reveal that they are completely broke, making your investment worth essentially $0.

This is the concept of volatility. Riskier assets will pay greater returns, but they are also a bigger gamble. If you can stomach watching your investment go down for a while in the hopes that it will recover and not go broke, then you are okay with risk and are capable of seeking higher returns. Historically, stocks are a better bet for making money than unrisky bonds. The danger is that in the interim, risk averse people watch their investment shrink in a crisis and want to cut their losses by selling while things are low. This is very common. It is also the wrong thing to do, because historically, most companies don’t go broke, and most company’s stock prices recover. Most. The majority of investors hold stocks and bonds, but mostly stocks. The higher your appetite for risk, the higher your proportion of stocks in your portfolio.

Diversification

This is a word that gets used a lot but I wonder how many people don’t understand what it means? Basically this is the “don’t put all your eggs in one basket” principle. Again, let’s go back to Econ 101…

Imagine you lived in a world with only two types of fruit: apples and pears. Some people only eat apples, some only eat pears, and some people eat both to varying degrees. Now imagine some event has done great damage to the apple crop. There is an apple shortage and consequently the price of apples has gone through the roof. What do you as a consumer do? Well, if you’re wealthy and you hate pears, then maybe you just pay through the nose for your apples and gripe about it. But if you’re most people, you change your consumption and buy more pears until the price of apples comes down again.

Now assume instead that rather than being a consumer, you’re the owner of Apple Co. (okay, maybe this was a bad example… Apple Corp? No, that’s no good… Granny’s Apples Inc? Whatever, you get the idea). Your supply has been hit and you’ve had to raise your prices. Consequently your sales are terrible because now everyone is buying pears instead. Well if you own this company’s stock, then guess what? You effectively are one of it’s owners. In this scenario, the share price for this company would tumble and your investment and net worth would take a hit. Meanwhile shares in Pears Inc. are probably getting a nice healthy boost from all those additional sales.

So how do you avoid this potential calamity? Well, you own both companies. By buying shares in both the apples company and the pears company, you hedge your bets and reduce the volatility of your portfolio. This is what diversification means.

In the real world, sometimes individual companies suffer. Sometimes entire industries suffer. Sometimes the economies of entire countries suffer. A well diversified portfolio spreads around your risk so that your investment can withhold certain shocks and keep things even keel, in the hopes that if one part of your investment goes down, another might go up, or at least go down to a lesser degree. Diversification can occur within a market (owning stock in both Coke and Pepsi), within an economy (owning Canadian mining stocks, banking stocks, manufacturing stocks, etc.), and also internationally (owning investments in Canada, the U.S., Europe, Asia, etc.).

Diversification is essential. It is also a lot of work. You want to pick a number of assets from different industries and countries, with varying levels of risk to make your portfolio relatively stable while also taking enough risk to get some return on your investment. Well good news: you can get others to do that for you. The downside is that everything comes at a cost. Which segues nicely into our next section.

Factor #2: What type of investment

Once you have chosen the right type of account for your situation you will want to decide what to put in it. Well, you have some choices. Once again there are trade-offs. Here is a list of investment types in order of lowest return (and risk) to highest.

A savings account

Technically I suppose this is also a “type of account”, but I’m putting it in this list here because you can get both TFSA savings accounts and non-registered savings accounts at your bank. Under most circumstances, I would not advise someone to keep a lot of money in a vanilla savings account at their local bank. The exception would be if you had some money that you absolutely 100% needed all of within the next couple of years. Most commercial banks in Canada will offer these accounts and most of them will offer 0.5-1.0% on these accounts. This isn’t very good, but still better than having your money in a chequing account that offers no interest. Want to do better? Skip the bank and open an account at a local credit union. Not all credit unions are created equal so you’ll want to do your research but their banking fees are lower and their savings accounts can offer more in the 1.5%-2.5% range, which is better than the banks offer.

Mutual Funds

Mutual funds are great for beginner investors. Why? Because someone else has already done the diversification for you. Mutual funds are managed to be balanced investments, so one share of a mutual fund is like a tiny basket of assets featuring investments in different countries, industries, and asset classes. But this management and balancing has a cost. This is why each mutual fund has a Management Expense Ratio (MER), which represents the cost. Most mutual funds will have an MER of approximately 2.5%, give or take. So what does this number mean? Well lets say your little basket of goods of a mutual fund appreciates by 7% over the course of the year. If the MER is 2.5%, then your investment returns will end up being 4.5% (7-2.5=4.5). It is this MER that gives mutual funds a bad name among many investors, because you’re not getting your full rate of return.

I would argue that if you’re a beginner investor who isn’t really sure what he or she is doing, then the MER is worth it. 4.5% is better than 1%, which is better than nothing. Really, savings of any kind is the most important thing, so complaining that you’re “only” getting 4.5% return is silly when you used to earn nothing on your money. The other great thing about mutual funds? Every bank or credit union or investment firm has them. All you need to do is approach a financial advisor or ask someone at a bank. They will then ask you a few questions to assess your risk tolerance and help you pick the fund that is right for you. Then you buy that fund (hopefully repeatedly and regularly through regular contributions) and watch your savings grow. In my mind, it’s more important that you save, rather than waste too much time worrying about exactly whose mutual fund is the best choice. Just buy one. If you find a better one, then at that point start buying that better one instead. Don’t delay!

Exchange Traded Funds (ETFs)

So let’s say you’ve been squirreling away your pennies into mutual funds for several years and watching your savings grow. You’re pleased, but also aware that maybe you have some colleagues who are talking about their own investment portfolios and they’re doing even better than you. Suddenly, you’re starting to question if that 2.5% MER is really worth it. Enter the ETF.

ETFs are actually similar to mutual funds in that they also represent baskets of assets. The main difference is that they are more focused, less balanced, less managed, and therefore have lower MERs. Maybe before, you were buying a single mutual fund with all your savings and it was doing everything for you. By switching to ETFs, now maybe you have to buy 3-5 different ETFs to achieve the same diversification that your one mutual fund gave you. So you have to do a bit more work yourself. On the other hand, you’re saving money now because while before you were paying a MER of 2.5%, now you’re only paying 0.2%. Your 4.5% profit based on 7% return has now become a 6.8% profit in exchange for you doing more of the work yourself.

But there is another catch, and it represents another cost to you. Recall that ETF stands for Exchange Traded Funds. That means they are traded on a stock exchange, like the NYSE or the TSX. How do you as an investor access those exchanges? You need a brokerage account. Getting brokerage accounts is easy enough. There are several to choose from. But the catch is you usually need to pay a commission for each trade. There may be some newer brokerages that have reduced commissions but in general in Canada the going rate is about $9-10 a trade. It might not seem like much, but think about the investor who tries to save $500 a month. Once a month, he goes to his brokerage and has to buy 3 ETFs (one for domestic stocks, one for foreign stocks, one for bonds). Once a month, he has to pay $30 in trading commissions. That’s 6% of his investment amount going to commission. And $30 a month can add up. Clearly, ETFs aren’t for everybody. This is why if you’re just starting off, mutual funds might be a better option for you since they’re less work.

(Worth mentioning: some brokerages will offer a list of commission-free ETFs. If you pick a brokerage that offers one and can come up with a nice asset mix, then the worry about commissions goes away.)

The other thing to keep in mind if investing with ETFs is that at least once a year you need to re-balance your portfolio. What does this mean? Well, let’s say you’re shooting for 70% stocks and 30% bonds. At the end of the year, let’s say your stock ETFs have outperformed your bond ETFs (the value of your stock ETFs has gone up by more than the value of your bond ETFs has).  The stocks in your portfolio now represent 80% of its value and the value of your bonds is therefore 20%. Now you need to buy relatively more of your bond ETF to get back to 70-30% and have things properly balanced. Again, this is something that the managers of mutual funds will do for you which helps to justify their larger MERs.

Individual stock and bond trading

You are confident in your abilities to pick a stock based on sound market principles. You know how to craft a well diversified portfolio to protect yourself against risk and maximize your return. You’re pretty sure you can beat the market. Congratulations! You’re far better at this than most people are. You are probably also not reading this blog entry right now. If this doesn’t describe you, then you should not do this. Stock trading is a great way to go broke and/or turn yourself off investing. Do not do this.

Final thoughts

One thing you’ll notice I haven’t done is recommend any particular funds or ETFs or assets of any kind. There are plenty of online resources for you to pick investments you think are worth buying. I like Canadian Couch Potato, so feel free to give him a try. But the online investing community is quite large and it’s typically pretty easy to find recommendations.

Everyone has their own things to consider. We all have to look at all factors. Why are you investing? When do you want access to your money? Are you looking for a way to reduce your tax bill right now, or is it not a huge problem for you? And crucially how much work are you willing to put into managing your investments? Hopefully for anyone who is able to answer all these questions for themselves, this blog post has been helpful. If not, feel free to ask me questions in the comments, via email, Twitter, or however you wish.

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Real Estate vs Investing Part 2: Time to talk about tax… wait, why are you running away?

For Part 1 of this post, start here if you would like to get caught up.

There are a lot of reasons why I like investing in securities. For one, you can invest as much as you need or can, in whatever increments you choose, and whatever frequency you choose. With a house, you need to save up enough for a down payment before you even get started. Then once you have a mortgage, you’re beholden to your bank’s mortgage payment schedule. If you happen to hit a rough patch and cash flow is tight, you still need to make those mortgage payments, or risk losing your property (and running into serious credit trouble). If you hold stocks, bonds or mutual funds, you can put a hold on investing if you find yourself short on cash for a while.

Do I think that real estate can be a good investment? Absolutely. But under the right conditions. If you have enough for a decent down payment and the rent you’re collecting is enough to cover your costs and be a source of monthly income for you, then that’s great. But consider this: in the meantime, while you’re saving for that down payment, why not put those savings into some securities and earn a little interest income on them so you can save your down payment faster? To me that’s win-win.

There’s one other issue that I must address here though, and that is tax. With a head nod to the Dividend Diplomats who did a good job here of pointing out the tax benefits of dividend investing, this is another thing to consider. For any non-Canadian readers out there, these specific considerations I’m going to mention might not apply to you, but rest assured that your own local tax jurisdiction will have its own points to consider for the tax treatment of certain types of income. If you’re in the US, that Dividend Diplomats link will be useful to you.

Let’s talk about tax

I live in Canada, so for me, any income I earn from rental properties is taxed as regular income, just like I would earn from a 9-5 job. So the additional income earned from rentals is subject to your marginal tax rate. I don’t want to get too technical here, but that basically means that whatever tax bracket you find yourself in will dictate the tax you pay on any additional dollars of income. Unless of course that income puts you in an even higher tax bracket, meaning the income you earn from that rental will be subject to even more tax than your regular pay. So while you thought your rental was making you an extra $1000 a month, it’s actually only earning you an extra $700 (assuming a 30% marginal tax rate). Still $700 more than you had right? Not bad.

Maybe now you’re thinking “but wait, can’t you deduct expenses from this income so your taxable income on that rental is lower?” Very good! This is true. In Canada, you can deduct the interest (but not any principal) from your mortgage payments on a rental, plus any maintenance costs, expenses like utilities if you pay them as the landlord, taxes, advertising expenses, etc. But you’ll still get taxed on whatever is left over at your marginal tax rate.

“But can’t you make it look on paper like the rental is losing money, so your taxable income goes down for the year?” Well look at you! You are a savvy one aren’t you? First of all, don’t commit tax fraud. You will likely get caught, and it makes you a bad citizen. Secondly, if you’re maxing out any and all legitimate expenses and deductions on your property and it shows that you’re operating at a loss as far as the taxman is concerned, then I’m afraid that means you’re not holding an investment that is earning you much money either. You can only fudge your taxes so much. Those expenses you deducted are real expenses! Your taxable income on your rental property will end up being pretty close to your actual income on your property once you have taken care of your expenses.

Now assume instead you held investments like stocks, bonds or funds. First of all, you could arrange to hold these investments in a tax deferred account like a RRSP (for my American friends, I think this is the equivalent to your 401(k)). This means that anything you put into this account will actually reduce your taxable income for that year. So all else equal, you’ll get a tax refund come tax time. Alternatively, you could hold your investments in a Tax Free Savings Account (TFSA), and in that case you will never have to pay any tax on any of the income earned from those investments, ever. Those are both pretty good options! But let’s forget them for now, because there’s even more good news.

Let’s assume for now that you hold investments in a normal, non-registered account and you have to treat everything normally from a taxation perspective. Say you own stocks. The only time you will have to pay income tax from holding those stocks is when you sell them. So if you’re buying and holding your assets and watching your savings grow over time, you don’t really need to worry about your net worth being taxed away as it grows. When the time comes for you to sell them and use the money, that income is treated as capital gains, not normal income. And while you will have to pay your marginal tax rate on those capital gains, you only have to pay it on 50% of those gains. So you’ve already cut your tax bill in half. Good for you!

Here’s an example: You buy some fund and later that year it has appreciated and you sell it for a profit of $1000. Your capital gains are therefore $1000, just like our previous example where we had $1000 of rental income. Of your $1000 capital gains, you only have to pay tax on 50%, or $500. If you’re the same person in our rental example who has a 30% marginal tax rate, then the government will take $150 (that’s 30% * $500), leaving you with $850 from your $1000 capital gains. You’re already ahead of the rental income guy by $150.

“But what about dividends?” Good question! If your stocks pay dividends then you will have to pay tax on that income in the year it is paid. But the dividend tax rate is 15%. So if your marginal tax rate is 30% for example, your dividend income is still worth more on an after tax basis. $1000 in dividend income will cost you $150 in tax, leaving you with $850. (The tax numbers are slightly more complicated than this, but I don’t want to get too deep into the taxation weeds and lose too many of you. Suffice to say that the actual numbers are close, and dividend income is going to be treated better by the tax man than any income earned on labour). In this example, taxes on dividends is the same as taxes on capital gains, but if your marginal tax rate is higher than 30%, dividends become more attractive, because dividend income is always taxed at about 15%. And again, remember that if your investment account is a registered TFSA, you will pay no tax on any of the profits.

I’m not trying to tell you that taxes are bad and that you shouldn’t pay your taxes. But let’s be honest while we’re at it and admit that nobody wants to pay any more tax than they have to. And taking advantage of these tax benefits is something that all taxpayers are entitled to. Nobody is pulling a fast one here. We’re just all trying to make the most with what we have and keep as much as we can while still playing by the rules.

“But you said your parents lost a bunch of money by buying stocks!” Yes I did, and that’s true. But the simple truth is they were doing it wrong. What my parents was doing was essentially gambling. They weren’t diversifying a portfolio or sticking with low risk funds. They bought a few stocks based on friendly advice, got unlucky, panicked and cut their losses. In other words, they did all the things you’re not supposed to do. Unfortunately they didn’t know any better. I have the benefit of learning from their mistakes. There are better ways to go about it. For example, you can buy mutual funds or ETFs and your risk will go way down. You won’t get rich overnight, but you should get a nice steady rate of return over the long term.

Finally, I do want to address that I realize for a lot of people, the idea of investing is completely foreign to them. They might like the idea in theory, but have no idea how or where to start. Real estate is just so much easier for a lot of people because they understand houses and rent. I get that, I really do. I will take some time in future blog posts to help explain things to my friends who don’t know the first thing about investing. If you have any questions about a topic you would like to know more about, please let me know and I will happily do my best to write a post about it.

For now, I’ll just say two things on the subject. First, it’s not as scary as you think, or at least it doesn’t have to be. Secondly, the sooner you start the better. There is a Chinese proverb about the best time to plant trees that often gets paraphrased for investing (thanks to My Own Advisor for helping me find the original source and quote): the best time to start was yesterday; the second best time to start is today.

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Real Estate vs Investing Pt 1: The S&P 500 doesn’t complain about pigeon poop

Mrs. CIQY has accused me of being “verbose” before. She’s probably right, but it’s who I am. So I decided to break this post in two, just to keep the length reasonable and palatable. Part 2 is here.

As I said before, i was brought up thinking real estate was king. My parents, because of their experiences, always seemed to use it as a measure of wealth. There were always stories of wealthy past acquaintances of the form of “he was so rich he owned 5 houses!” or “he had enough money to buy apartment BUILDINGS! Not just apartments, but apartment BUILDINGS!” There were also attempts at imparted wisdom in the form of lamentations like “If I had someone to show me the way when I was young and single and earning decent money, someone to tell me to start buying rental properties…” I think the implication was always meant to be that we would be sitting pretty, my parents would have retired early, and my siblings and I would have been proper spoiled, rich kids who could live their lives on easy street, never having known struggle.

I completely understand their thinking. My parents bought their first house in the 1970s. I’m guessing they probably paid something in the neighbourhood of about $15,000-$20,000 for it. (Mind you their mortgage rate on that house was also probably about 15%.) Within a generation the value of that house and others like it had increased about 10x. Meanwhile they also got to take advantage of high wages at the time; wages that have since stagnated in real terms. So if they had saved more, maybe they could have paid their mortgage off much faster and bought a second property to rent, and then a third, etc. etc.

And why not? Being a landlord was easy money, right? Instead of slaving away at a job for 8 hours a day you just showed up once a month to collect rent. Sure, once in a while you had to fix something that broke, but most of the time, ideally things were on autopilot.

At the same time, my parents didn’t know anybody who was rich from investing. Stocks and bonds were things that super wealthy (and usually villainous) people in the movies bought and sold. “Normal” rich people in their experience got that way either through inheritance or property. Or both.

By the time the 1990s rolled around and the masses started migrating online, investing became much easier with online banking and brokerages. My parents started having conversations with friends who actually did dabble in investing and eventually decided that they also wanted to dip their toes in that pool. Other people were making money, so why not them? They were at a stage in life where they felt they maybe had a little money they could afford to use for investment purposes. They signed up for an online brokerage and started buying small amounts of a few stocks.

It did not go well for them. Lesson learned: investing is for idiots. Or very clever people who knew what they were doing and had time to do their research and due diligence. I.e. not them.

This basically confirmed what they already believed, and that was that the best investment is real estate. They don’t say “safe as houses” for nothing.

I am not my parents. My experiences have been a little different. Let me tell you my story…

When I first moved to the city for my current job, I rented. In fact, I rented a furnished apartment that was a five minute walk from work. It was about as turnkey as can be. It was glorious too… I would roll out of bed, shower, have breakfast, and be at work in five minutes. Reliable and traffic proof. But I digress.

After a couple of years, my little studio apartment started to feel… well, little. I wanted more space and I wanted to have my own stuff. After looking at some other rental options, I did some math and figured out that I could actually afford to buy my own place instead. Instead of “throwing away” money on rent, I could “pay myself” by getting a mortgage and building equity. I spent a good amount searching and eventually found myself a condo that was walking distance to work, cheap to maintain, and well within my budget. I was pleased as punch with my purchase.

And then I met the future Mrs. CIQY, and things changed. As I mentioned in a previous post she and I worked and lived in different cities. When it came time to cohabit, we decided to compromise and get a place in the ‘burbs in between where we each used to live. At first, we decided to rent, for a number of reasons. I kept my condo, and rented it out, and we rented a place of our own in the ‘burbs. The rent I was collecting for my condo was the same as the rent we were paying for our new home, so things worked out reasonably okay. The plan was, when it came time to buy a place of our own, we would sell my condo and use the money to buy a house. In the meantime, while we weren’t earning any income on the rental, we were building equity that we could use for our future house. And this is pretty much what happened.

Sounds easy right? Smooth and simple right? Well, it wasn’t.

During the time I was a landlord, I had to fix a broken washing machine. I had to make three separate trips to the rental (which remember, was in a different city) to deal with a faulty heat/ hot water boiler and have it replaced. I had to miss work while I waited for service calls. I had to compensate my tenant who couldn’t have a hot shower in the dead of winter after working outside all day. I had to deal with complaints about pigeon poop. Yes, pigeon poop. And that all happened in less than a year. And that’s not to mention the cost to me to paint the entire place before the tenant even moved in because I was having trouble getting it rented. When it eventually came time to sell the condo, I had to deal with inquiries and concerns about Kitec plumbing, which caused the property to take a lot longer to sell than it should have (btw, do NOT buy a condo with Kitec plumbing).

(I just want to pause for a moment and say that my tenant was actually a very good tenant. He was perfectly reasonable, dependable, and an all around decent guy. I definitely don’t mean to suggest otherwise.)

In addition to all that, it just wasn’t a good investment for me, because the rent I was receiving wasn’t enough to cover the mortgage payments plus taxes and fees. Keeping the condo was costing me money.

Despite all this, we actually did still consider keeping the condo after buying our own place, for the sake of the equity we were getting from it. We thought about the fact that we could potentially raise the rent a bit over time so that renting it was at least covering all its costs. But in the end we decided we would rather use the equity we had built up as a better down payment for our own house, to keep our mortgage payments lower. We figured there were better investment options out there that would give us better return. And the condo had turned out to be more work than we were hoping for.

The S&P 500 does not complain about pigeon poop.

In Part 2, I will highlight some of the benefits I see with investing. Hope to see you there!

 

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Goal Set!

While writing my last post I made up a handy-dandy little spreadsheet to track net worth based on mortgage repayment and investment returns. The whole exercise was meant to prove a point and provide some visual aids for my post because charts are pictures and people like pictures.

After publishing the post, I kept on playing around with my spreadsheet, tweaking parameters and looking at numbers, because I am a data nerd and I like numbers. And while I was doing so, I played a little game of “what if” with myself. For what it’s worth, “what if” can be a dangerous game. “What if” often leads to silly things like the purchase of lottery tickets. If you play the lottery, well hey, good for you, no judgement here. But I think we can all agree that as an investment strategy it’s… um… lacking.

But in this particular game of “what if”, I went with “what if we actually did maximize saving and investment? What would that look like? How much can we afford to save per month and how would that impact prospects for early retirement?”

To answer the question, I went to Mint. If you’re not familiar, Mint is free online budgeting software. You synch it up with you banking, investment, and credit data and it helps categorize all your spending, track your investments, and give you a picture of your overall net worth. There are other budgeting tools out there, but Mint is the one I’ve tried and I’m pretty happy with it so it’s what I use.

Now savings is a function of income and expenses (income – expenses = savings). Income for most people tends to be pretty steady and our family is no different. We earn roughly the same amount of money each month. Expenses can of course be variable. Some months you spend more than others. But at this point, I have a good eight months of data of both my and Mrs. CIQY’s account information to look at our spending. So by looking at the year’s data for income and expenses so far, I can get a pretty clear picture of what we have left over on average during a typical month after doing what we already do.

And the news is good. It turns out we’re actually pretty good already at saving. By increasing our savings rate only slightly, we should be able to have our mortgage paid off in ten years, which is 13 years ahead of schedule!

This of course is based on certain assumptions. First, it assumes that our mortgage rate doesn’t climb too much higher than than it is, which is perhaps an unreasonable assumption. It also assumes no major market events that will significantly impact our average rate of return over the next ten years, which is also maybe too optimistic. And of course, it assumes that neither our income will decrease nor our expenses increase by a significant margin. Which is just way too naive. Did I mention New Baby is due to arrive in about four months? I think I have.

So do all these mitigating factors make this goal unachievable? A pipe dream? Nope! Look, I said that we’re practically at this goal already, without even realizing it, and without much in the way of sacrifice. So if life does throw us some curveballs in the form of a big market crash or a spike in mortgage rates or what have you (and it will, oh it will), it just means we have to work a little harder to hit our target. Just because we’re not sacrificing too much right now, it doesn’t mean we can’t if it turns out we need to.

They say it helps in life to achieve progress if you have a goal. Now we have one: mortgage paid off in ten years. Check back with me on August 31, 2027 to see how we’ve done. We might not get there, but there’s no harm in trying.

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Should I pay off my mortgage first before saving and investing?

At around the time I was about to turn 30, at the gentle urging of my parents and with a little help from them I entered the real estate market. Their advice was that real estate was always a good investment (something that now most people realize is not always true) and it’s better to own property and “pay yourself” via paying down a mortgage rather than “throw it away” via paying rent. I have my own thoughts on this way of thinking and I there are some points on which we definitely disagree. Regardless, I took their advice, accepted their help, and took the leap into home ownership. I’m glad I did and I will be forever grateful for their help and advice. 

At around the same time I started saving money and investing in mutual funds. I met a financial advisor through a common acquaintance and he asked me if I would be willing to chat with him about investing and let him give me his spiel. I didn’t really need too much convincing. I always understood the benefits of saving and the magic of compound interest. Namely, that money invested today will earn interest, and that interest will earn interest, and so on and so forth meaning ultimately that even small amounts invested over time can accumulate and grow exponentially. Nonetheless, I let him give me his standard “why you should invest and why you should start today” presentation. There were a couple of things that he showed me that day that really made an impression.

One element of his presentation showed a line chart featuring different lines representing the growth rate of different types of asset classes over time, going back several decades. There was a line for cash (essentially what you would earn by putting everything in a checking account, or under your mattress), a line for stocks, etc., etc. The message was pretty straightforward: a person who invested their money in the stock market would be a gazillionaire while the person who stuffed his money under his mattress would be on the street holding a sign saying “will dance for food”, while wearing a barrel with suspenders. Relatively speaking.

The other element that really drove the message home was a hypothetical example comparing two pretend young people. Young person #1 (YP#1) understood the value of investing and the benefits of compound interest, and YP#1, who graduated from college at 21 and got a job was able to save $2000 per year, and invested that much every year over a period of approximately ten years or so, at which point we can assume that YP#1 became overwhelmed with living expenses and “life happening” and stopped saving altogether. Meanwhile, Young person #2 (YP#2) wasn’t really in a position to do the same thing at the young age of 21, and wasn’t able to start squirrelling away any savings until the ripe old age of 29 or 30, at which point YP#2 began to save $2000 per year, every year, until age 60. So when both YP#1 and YP#2 were 65 years old and ready to retire, who do you think had more money saved up? YP#1, who started early but only saved for about ten years before stopping, or YP#2 who saved for much longer but started ten years later?

Well if you guessed YP#1, then you understand the power of compound interest, and you would be correct. Mind you this hypothetical example was of course cooked up to drive home a point and it only works if you plug in the parameters just right, but they’re actually all pretty reasonable assumptions. I understood all this, but I also understood the moral of the story: I had to start saving right away. In fact, I was already almost certainly too late. But as the saying goes, better late than never, right?

Since I was about 30 years old at the time, a lot of my friends were in the process of making similar moves. This was around the time a lot of my friends started buying their own houses. But when the topic of savings and investing came up, I could see that it was far less common than buying property.

There were a few conversations with friends that I did have, however, and one in particular that stuck out to me. In this instance, one of my friends stated that being the owner of a new mortgage, he would rather pay down his mortgage aggressively and then at that point he would be in a position to save and invest. After all, “saving” was what you did when you had “extra” money left over, and if you were in debt, then no money was ever “extra” so long as you were in the red, right?

Two different approaches: simultaneous investing with mortgage payment vs focusing first on mortgage and investing after the mortgage is paid off. Which one is better? We can use math to find out!

Let’s assume for our example here that we have a mortgage with $200,000 owing on it, and 25 years to maturity. Approach #1 will be what I actually did; mortgage payments based on the normal amortization schedule, and $400 a month or $4,800 a year invested at the same time. Approach #2 will instead take that $4,800 per year and pay down the mortgage faster. We will further assume that once the mortgage is paid off, each person will take the mortgage payment amount and add it to the investment amount for savings, so that total monthly savings will be constant over the 25 year period. For simplicity we will also assume a constant mortgage rate and a constant investment rate of return. What rates will we use? Based on rates over the past 10 years or so, 4% for a mortgage seems like a reasonable average, so we’ll use that. As for a reasonable investment rate of return, Mr. Money Mustache has a good explanation for why 7% seems like a reasonable but conservative estimate. And if I go back and look at my statements of my own investments over the past ten years, I can see that 7% is pretty close. So we’ll go with that.

invest70mort40v2

The above chart shows Approach #1 (invest plus mortgage) in blue and Approach #2 (mortgage, then invest) in red. So we can see with this chart the relative performance of the two approaches and conclude that Approach #1 wins. Better to invest and earn 7% while paying off your mortgage than to pay the full mortgage off first and invest later.

Okay, you might be saying, but what if your mortgage rate is higher than that? And what if your investments don’t earn 7%, but instead earn less? Good question. Let’s find out! My first mortgage was actually 6.05%, so we can use that for our second scenario. And let’s assume in this scenario that you’re saving your money in a savings account offered by your bank that’s only paying 2%. Now what?

invest20mort605v2

In this case, paying off the mortgage first wins. Weird. Why the difference?

The difference all boils down to the two rates used in the calculation. If your mortgage rate is higher than what your investments are earning, then it makes sense to pay down your mortgage first. If your mortgage rate is nice and low, there’s a good chance you can do better by investing. Conceptually it helps once you realize that a mortgage, or any debt, is the same thing as negative savings. The interest rate you pay is the cost of the debt, and determines how quickly your debt grows, just like the interest rate earned on savings is the payment received for your savings and determines how quickly your savings grow. You may have also noticed that the blue line in the first chart reaches the highest value of all four lines between the two charts. That’s why; because it represents the highest interest rate. Simple enough.

This is why you always always always must pay down your high interest debt as soon as possible. Because if you don’t, the interest rate will keep you paying it off forever. If left alone, it can balloon out of control in no time. Likewise, an opportunity to earn high rates of return should not be overlooked.

“But how do you know what rate of return an investment will earn?” you might be asking. Fair question. Bonds will tell you exactly what sort of return you will be getting, as will low interest savings accounts, but it’s not like stocks, index funds, or mutual funds advertise their rates of return, because that is unknown. It’s true that most investment assets (including real estate) are volatile; sometimes they go up, and sometimes they go down. Depending on a number of factors (including luck), a portfolio can earn 30% over one ten year period but next to 0% or even go down over a different ten year period. That much is true. But while past performance is not necessarily indicative of future performance, we can get a pretty good idea of what to expect over the long term. And like Mr. Money Mustache explained ever so eloquently in the link posted, it turns out that 7% a year is a pretty reasonable, conservative estimate of what a balanced stock portfolio can earn, on average. It helps if you can stomach some losses in the short term just by reminding yourself that when things go down they usually go up afterward.

Everyone knows how much risk they can tolerate and how much of a gamble they think any form of investing might be, so I’m not about to give any universal advice that will apply equally to everyone. But I will say this: focus on chasing higher interest rates, both in the form of high interest debt repayment, and investing in higher interest earning assets, and you’ll probably do okay.