Tag: investing

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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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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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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.