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Tuesday, April 22, 2008

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.

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