Mortgage Advice - Go Variable

I have often wondered why so many people opt for 5 year fixed rate mortgages. Yes, they want the security of knowing exactly what their payments are going to be over those 5 years but they sure are paying through the nose for that security. As I write this, interest rates on a 5 year closed variable rate mortgage are 4.15%. Take that instead to a fixed 5 year closed mortgage and you are looking at 5.65% or more. Yes, a whole extra 1.5 points for the privilege of knowing what your payments are going to be over those 5 years. Essentially you are buying an insurance product. 1.5/4.15 x 100 = 36% . Yes, you get to pay 36% more interest in order to cover your "insurance" premium. So just how much is that? On a $200,000 mortgage, that 1.5% extra interest = $3000 per year. Over 5 years, that is close to an additional $15,000 assuming interest rates don't change and ignoring principal reduction. You're effectively giving up a new car every five years!!!

But of course interest rates don't stay unchanged, they could go shooting way up. Sure, but they could also go down too. So why does anybody go with the 5 year fixed? Simple, because somebody convinced them that they could get screwed and not be able to make their mortgage payments if interest rates go shooting up. Fear can be quite the motivator. But there is a feature of most variable rate mortgages that they don't want you to know about. Most of them allow you to convert them to a fixed rate mortgage at any time. So if interest rates start to rise and your payments on your variable rate mortgage jump up and you get all scared, then simply convert it to fixed. But there is another tactic that I'd rather you use.

Take out a variable rate five year mortgage, but at the same time ask them to tell you what your payments would have been if you had've taken out the five year fixed. You are effectively going to insure yourself with this scheme. Take the difference between your mortgage payments and the hypothetical fixed rate payment, and place that amount into a savings account. In fact, place it into a new Canadian tax free saving account (TFSA) that becomes available to us taxpayers on Jan. 1, 2009. This amount, of course, depends on the size of your mortgage and the difference between the variable and fixed mortgage rates, but could easily be around $125 per month for many of you. As interest rates fluctuate, so will your payments into this account. If your payments ever reach the point where they exceed the hypothetical five year fixed payments, then simply draw money out of the account to cover the difference. At the end of the five years, when your mortgage now needs to be renewed, simply liquidate your savings account and put that extra money down on the mortgage. Alternately you could use this money to top up your RRSP and put the tax refund against the mortgage. But in either case you should be immensely better off by using this do-it-yourself approach to a "five year fixed" mortgage rather than the bank's conventional way of simply charging you a much higher fixed rate.

How to Invest Your RRSP for the Long Term

Today I'm going to tell you how to invest your RRSP for the long term, and beat the returns of about 75-80% of the mutual funds out there. This addresses long term investments only, not RRSP funds that you plan on liquidating in 2-3 years for the Home Buyer's Plan (HBP) for example. If you're saving for the downpayment on a home, you will want very low volatility on those savings, so go with a decent GIC or Altamira's Cashperformer or other money market type funds. Once you start paying your HBP withdrawal back to yourself, then you can follow this long term approach.

This approach in the industry is often called the couch potato portfolio or other names which implies a passive technique to your investments. I'm giving you my little spin on it as well. The idea behind the approach is to simply buy a set of low cost index mutual funds. What do I mean by low cost? Well, I mean low cost in terms of how much the fund manager charges the fund to do his job. These management charges are referred to as the MER (Management Expense Ratio) of the fund. The MER is expressed as a percentage, which reflects how much of the fund is bled off every year by the fund manager to pay himself. The beauty of index funds is that there is very very little work for the fund manager to do since it's the index (eg. DOW Jones Industrial Index, or S&P 500) which dictates exactly what the fund will hold. Since there is hardly any work for the manager to do, he charges a very low MER for the fund. This leaves more money in the fund to experience compound growth.

The common stock market indices typically reflect a large diverse basket of high quality stocks. Active fund managers typically buy and sell stock within their managed funds to try and beat the index. Some years they do, other years they come up short. But every year they bleed off the MER from the holdings. The net result is that over the long term, 75% of active fund managers fail to beat the index. They would rather you not know this!

So armed with this new knowledge that index funds beat most managed funds in the long term, let's go forward with the couch potato portfolio approach. The approach is simple, with the main rule being "take your age in years and put that percentage of your RRSP into a Canadian bond index fund (DEX Universe Bond Index)". For example, if you're 40 years old, then 40% of your RRSP should be in a Canadian bond index fund. The idea is that as you age, you should have more of your holdings in bonds which are typically much less volatile than stocks. The rest of your portfolio (in our example, 60%) should go into the stock market via index funds, and you have a few choices here.

Approach 1: All Canadian
Buy a Canadian stock index fund. Your complete portfolio only contains two index funds, namely your bond fund and the stock fund. In our example of a 40 year old, his RRSP consists of 40% Canadian Bond Index (DEX Universe) and 60% Canadian Stock Index (S&P TSX Composite)

Approach 2: North American
Split your stock component equally between Canadian and American index funds. With American funds, there are typically two to choose from, namely the Dow Jones and S&P 500. So the 40 year old example would look like:
40% Canadian Bond Index
30% Canadian Stock Index
30% Dow Jones Index or S&P 500 Index. Or you could instead do 15% each for more diversification.

Approach 3: Global
Split your stock component equally in three pieces, namely Canadian, American, and International. So the 40 year old example would look like this:
40% Canadian Bond Index
20% Canadian Stock Index
20% American Stock Index (could be 10% each Dow and S&P)
20% International Stock Index (eg. MSCI EAFE Index)

It's called "couch potato" because you have nothing to do except once a year, near your birthday, rebalance the holdings so that the percentages are back to where they should be. Let me make this even easier for you, and point you to some specific funds. I like the TD efunds, since they are essentially setup exactly for this. The "e" means that they are environmentally friendly (or electronic) in that no paper will ever be mailed to your door. Instead, they send transaction slips to you electronically. The paper/printing/mailing savings are passed on to you in the low MER. Also, they offer no advice/personal contact and again the savings are passed on to you.
https://www.tdcanadatrust.com/mutualfunds/prices_EF.jsp
They also have currency neutral versions of some funds if you don't want to expose yourself to other currencies such as the US dollar or Euro. But one can argue that it is good to diversify yourself a bit out of Canadian dollars. The beauty of these funds is that you can hold a bit of each type if you like, namely the currency neutral and non-neutral version. By blending the two versions of any given non-Canadian index fund, then you can precisely control your exposure to foreign currencies. This may make a good future blog topic.

There are other index funds you can use to accomplish the technique, including exchange traded funds (ETFs). Ishares are one such example: http://www.ishares.ca . But keep in mind that you will need a brokerage account to buy and sell these units, and that will add some extra cost on top of the (albeit very low) MER.

Other banks and fund companies offer similar index funds, but I recommend that if you cannot easily find the MER for such funds listed on their website, then just take a pass. It irritates me that some fund companies make you download a prospectus and go searching through it to try and find the MER. It smacks of them having something to hide.

I hope you found this interesting and educational. Investing doesn't have to be hard. Oh, and by the way, you can apply this same investing technique to your holdings outside your RRSP. There is nothing really RRSP specific to this technique except that it is geared to the long term. Please don't forget to rebalance your holdings near your birthday!!!

More Financial Advice - Intermediate Level

Today I'd like to provide a bit more financial advice, but this time it's a little less basic in nature. Thanks to some discussions with my friend Christine, I thought of these three common tactics and now want to lay them out in the blog. While these approaches apply to Canada only, your particular country may have similar programs.

Saving for Down Payment on Your New Home

Seriously look into using the Home Buyer's Plan (HBP). This allows you to borrow money from your RRSP interest free to apply to your home purchase. You can borrow up to $20,000 and have up to 15 years to pay yourself back. If you buy with a spouse, you can each pull out the $20,000 if you qualify. While aimed at the first time home buyer, it can apply to others. Read the rules carefully here. One of the great things about using this approach is that your savings grow tax free inside the RRSP, but the biggest advantage is the tax refund your RRSP contributions produce. Your $20,000 of RRSP contributions can trigger $6000 or even more of tax refunds, which you can apply to other debt or use towards next year's RRSP contributions.

The RRSP vs Mortgage Conundrum

Many people struggle with what to do with extra money. Should they put the extra money down on their mortgage or put it into their RRSP? In general, always maximize your RRSP contributions and apply the tax refund to your mortgage. Your likely marginal tax rate of 30-40+% far outstrips your mortgage rate. By making those contributions, you "make" a rate of return equal to your marginal tax rate which is huge. Plus those contributions remain in your control and start earning tax free compounding growth on top of it all. Of course this is an oversimplification since an RRSP is really just a tax deferral account, but over the long term the tax free compounding growth is what really matters to your net personal worth. If you crunch the numbers for yourself, you should see that you are much better off doing this rather than just paying down the mortgage. However, you must be diligent in using the RRSP tax refund against the mortgage.

Interest Free Loans

If you have interest free loans such as student loans, do NOT pay them off early before they start to charge interest. The best scenario has you paying off such loans in full the day before they start charging interest. Instead, save your payment money in a decent no-fee high interest savings account such as ING Direct or President's Choice Financial's "Interest Plus" account. At the last interest-free moment, liquidate these accounts and pay down the loan. Depending on the amounts here, this can put a few hundred dollars into your pocket. Starting Jan 1, 2009 you can save up to $5000 in a new tax free savings account (TFSA) and save tax on these earnings, making it even more worthwhile to apply this approach.

Liquid Assets and Loans at the Same Time?

Normally you should keep 3 months worth of your normal expenditures in liquid assets such as savings accounts for a rainy day. Anything beyond that should be applied to your debt, in order of the highest interest rates first. But what to do if rich Aunt Mabel gives you a tidy sum of money such as a basket of mutual funds that she stipulates must not be touched until you retire? She wants to see your yearly statements so you can't pull a fast one on her. Use this technique: sell all the funds and apply the proceeds to your debt. Then borrow that same amount of money at the lowest rate you can and invest it by buying those exact same funds. The interest on this money you have borrowed to invest is now tax deductible. Congratulations, you have effectively made a portion of your mortgage or other loan interest tax deductible and kept Aunt Mabel happy. Keep immaculate records. More information is here. Please note that the investment purchased cannot be something which will only potentially generate capital gains.

Basic Financial Advice

Today, I'd like to speak to a few points about finances. In general, borrowing money so that you can have something now, will, of course, cost you extra. That's the whole concept of interest which is paying to have access to money. Nobody likes to pay more for things, but when it comes to getting something earlier, people seem willing to cough up a lot more money without actually realizing it. Stop doing this! Get a dose of patience, save your money and adopt a pay as you go mentality. 10% or more of your paycheque should automatically go into savings, and you should consider it to be untouchable money in terms of your monthly budget.

In general, avoid borrowing money to buy depreciating assets.

The first big thing that you likely borrow money to buy is a new car. This is a rapidly depreciating asset. Instead, buy a used car. Get one that is just coming off a three to four year lease. Make sure that it is a make and model of car that has an excellent quality history. This car will still be a depreciating asset but the depreciation will not be as rapid as in those first few years.

The next big thing you will likely buy is your home. This is an asset that will likely not depreciate, but should track to inflation over the long term. Shop for your mortgage and negotiate! By getting the lowest interest rate that you possibly can, you will likely save tens of thousands of bucks if not more, over the life of the mortgage. This can equate to a 1000 dollars per hour of effort you put into this. So don't be an idiot, put in the effort and pay yourself this massive amount of money! Duh!!! If you can't manage this effort or detest negotiating, then at least consider going to a mortgage broker. Also, go with a variable interest rate if you feel secure enough doing so. Fixed interest rates are simply an insurance product. Insurance isn't free, this will cost you in terms of higher rates. But know the risks involved in going with variable rates. With the baby boomers no longer borrowing money but instead are investing, there is less demand for borrowed money these days and thus rates should remain relatively low for the forseeable future. Thus, in my opinion, the risk of going with variable rates is fairly low. Also, do not mortgage yourself to the hilt. Get something you can easily afford and strive to pay it off early.

My last point for today is bank accounts and credit cards. Are you paying money to a bank in terms of service charges or a service plan just to have an account? Please stop doing this and open up an account with the likes of President's Choice Financial here in Canada. This can save you well over a $120 per year in service charges. Also, if you are not paying off your credit cards in full every month, then cut them up. You are being severely gouged. Look at consolidating your credit card debt under a personal line of credit for a fraction of the interest you are being charged now.

The Banking System

I thought I'd start off my first post with an editorial on the banking system. It all begins somewhere in the depths of time, when possibly a caveman or dirt farmer needed something urgently such as food and was unable to immediately trade for it. Some kind soul, call him KS, decided to give him the food, say, a chicken on a promise to replace the chicken at some point in the future. Thus was born the concept of credit, a pivotal point in the development of mankind. The dirt farmer, call him DF, gave KS a marker which could be exchanged for a chicken next year when DF would successfully have raised a flock. In the meantime, KS needed something else, and traded DF's marker for it. The person accepting the chicken marker knew DF and felt secure in DF's ability to provide a chicken in the future. Guess what? The marker just kept changing hands and nobody came to DF to collect the chicken. DF was no idiot, and saw what was happening. He issued more markers, traded them for goods, and never had to pay the debt back. In reality, he noticed that only about 10% of his markers ever came back to him with people collecting their chicken, so if he had 100 chickens he felt secure issuing 1000 markers. This approach is known as a fractional reserve system. As you have almost certainly figured out by now, DF became what we today call a banker.

Instead of using chickens and markers, a modern banking system used gold and notes/coins. The really early systems just combined the two and used coins made out of precious metals such as gold and silver. Nixon took the USA and thus the world off of the gold standard in the early 1970's by decreeing that the US dollar would no longer be gold backed. It is simply now backed by the economic might of the USA. "In God we Trust" has never been more literal. Money only has value because somebody else is willing to accept it for goods or services provided. By definition, this money is called "fiat currency", since its value is only based upon a declaration that it should be accepted for payment. Again, there is nothing tangible backing it, there are no chickens. I am constantly surprised by how many people believe that gold still backs their money.

Going back to the concept of fractional reserve, banks can lend out more than they have on deposit. Let's say that a bank has $100 in deposits, it can lend out $1000 if the reserve is at 10%. If the person borrowing the money turns around and deposits it all back in the same bank, then the bank's deposits have grown to $1100 and now they can loan out $11000. This money just gets created out of thin air. By controlling interest rates, the central banks can control the demand for money, and thus control the supply of more money. Low interest rates encourage people to borrow. Borrowing creates more money, and thus aids in liquidity. When borrowing gets greatly curtailed, as is happening now with the subprime crisis in the US, the money supply takes a hit, and liquidity becomes a problem. The central bankers in the US, namely the Federal Reserve, are lowering interest rates in an attempt to entice people to borrow money, thus getting more into circulation to deal with the liquidity crisis. Fractional reserve is kind of a necessary evil, due to charging interest on money. Paying interest means that the money supply has to grow somehow, else there won't be enough in circulation to make paying interest possible. There would be a major liquidity crisis.

Inflation really is simply the growth in the money supply. When lots of people are borrowing money, as happened when the baby boomers were borrowing money to finance their homes in the late 70s and early 80s, inflation goes up and the central bank raises interest rates to try to contain it.

I'll end this post with the comment that historically fiat currencies fail because they get abused by the people in power, past the point of no return. This type of money is also extremely vulnerable to a crisis in confidence, since nothing really backs it. Let's hope that the world banking system has learned from the past and survives this latest liquidity crisis.