Monthly Archives: June 2015

Retire 5 years earlier by ditching your mutual funds

Just imagine, retiring 5 years earlier than planned, simply by switching from mutual funds to exchange traded funds. The difference between retiring in 30 years, instead of in 25 years, can be all just due to mutual fund management (MER) fees. How is that possible? Aren’t mutual fund fees something tiny like 1 or 2%?

Mutual fund fees need to be compared against the benchmark expected return

Mutual fund fees are always quoted based on the amount of money you have invested in the fund, not on the amount of money you are making from owning the fund.

The way mutual fund fees are presented is a bit like dividing maintenance fees on an investment condo by the full price of the condo. It’s a great way to make those fees look small, but not a very accurate way of measuring their true cost. If we want to assess whether the condo is a good investment, we would instead check how those fees compare to the rent charged to tenants.

Similarly, we need to compare the fees mutual funds charge to the investment returns they are likely to provide.

How much does an average mutual fund tracking the S&P 500 really charge in fees?

Let’s say we invest $10,000 in a mutual fund tracking the S&P 500 and charging a 2.11% management fee. This type of fund, if it does it’s job well, should return approx. 10% per year over the long term with dividends reinvested (before fees).

Therefore, in an average year we will pay 2.11% out of the 10% annual return or 21.1% of our expected return in fees.

In dollar terms, that’s a potential return of $1,000 on the year being reduced by $211 to earn us only $789. That’s a huge difference!

What about the lower fee bond funds?

The news does not get better with lower fee funds because they also generally offer lower expected returns. For example this bond fund charges only a 1.47% fee, which might seem like a bargain compared to the one above, however the fund is also only expected to return 5.2%.

This means the fund fee is actually 1.47% out of 5.2% yearly return, or 28% of our expected return in fees.

In dollar terms, that’s a potential return of $520 on the year being reduced by $147 to earn you only $373. Despite this fund charging a lower fee on your investment, it’s actually more expensive than the S&P 500 fund when compared to it’s expected return!

How about over the long term?

I hope you can see, from the two examples above, that mutual fund management fees are actually far bigger than they first appear. The problem just gets worse over time though because of compounding.

Assuming a 10% annual return on the S&P500, here is a 3 year comparison between the mutual fund charging 2.11%, and a comparable exchange traded fund charging a 0.17% fee.

Per $10,000 invested

End of	End of Year Balance 0.17% fee	End of Year Balance 2.11% fee	Additional fees paid for 2.11% mutual fund over 0.17% ETF
Year 1	$10,983.00	$10,789.00	$194.00
Year 2	$12,062.63	$11,640.25	$422.38
Year 3	$13,248.39	$12,558.67	$689.72

We can see that the total of additional fees paid after 3 years, is greater than 3 times the 1 year additional fee ($689.72 > 3 * $194). Why? The fee reduced balance after each subsequent year is smaller, which in turn means the same 10% return generates less money. This effect is called compounding and it greatly amplifies small differences over long periods of time.

After 25 years, assuming a 10% annualized return, a $100,000 mutual fund investment (2.11% fee) will turn into $667,621. That’s not bad, but the same $100,000 will be worth $1,042,376 if invested into the 0.17% exchange traded fund.

That “little” 2.11% fee ends up costing us around $330,000, or 30% of our total potential retirement nest egg!

Incidentally, it takes an extra 5 years before the mutual fund balance comes close ($975,969) to that of the exchange traded fund.

What would you do with an extra 5 years of retirement?

Note sure where to start? See my article on how to set up an exchange traded fund (ETF) based retirement portfolio in 3 easy steps.

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Weekly Links – Keep it simple, slow and steady

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Why do regular people always under-perform investment advisers, who in turn under-perform the market? It’s tempting to say it’s because the pro’s know more, are better educated, have more money, and/or better access to information. These advantages certainly make a difference, but really only on the margin. The real reason was identified back in 1949 by one of the founding fathers of modern security analysis, Benjamin Graham, who wrote “The investor’s chief problem, and even his worst enemy, is likely to be himself.”

This week’s theme is all about investing, and how keeping your emotions under control, ignoring whatever the hot investment of the day is, and sticking to your long term plan is the best way to ensure a prosperous future.

The Intelligent Investor: Saving Investors From Themselves (Wall Street Journal)
This article talks about how difficult it is to keep a level head when everyone else is losing theirs. Whatever the hot investment of the day, it’s very hard to stay away from it when everyone else is making money.

Five things I try to do on this Blog (The Irrelevant Investor)
The biggest danger an investor faces when investing in the stock market is not staying invested. Investors who try to time the market, sell at the bottoms, and buy near the tops. After repeating this pattern for a couple of cycles, they give up and label stocks “dangerous”. It’s when things look really bleak that keeping a steady head, and doing what at the time feels wrong, is most important.

Correlations aren’t Constant (The Reformed Broker)
This one is a bit on the technical side but the message is the same. Investors who patiently stay with their asset allocations over the long term, by buying “losers” and selling “winners”, tend to do very well. Everyone knows this but yet very few can actually do it. It’s extremely hard to sell that high flying fund that’s making you feel happy, and use that money to buy that dog that’s making you sick to your stomach every time you look at it.

The subprime mortgage crisis wasn’t about subprime mortgages (Fortune)
This article may seem out of place at first glance, but it very much belongs in this list. There was a time when the vast majority of people in the US truly believed that real estate could never go down, never-mind actually crash. This is the belief most Canadians have today. The arguments as to why this time is different are countless and eerily similar to the ones heard in the US. One argument heard a lot these days is how Canadian banks are far more responsible than US banks, and how the US crisis was caused by loans that are not even available in Canada, so no reason to worry. This article throws some cold water on that idea by describing exactly which mortgages caused the crisis. Real estate has a place in an investment strategy, just like any other asset class, but it needs to be kept within those limits. I know I won’t convince die hard wanna-be real estate magnates, but maybe I’ll give a pause to one or two people before they make some terrible mistakes.

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3 easy steps to a fully diversified retirement portfolio

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I am always surprised how much confusion exists regarding various account types and investment options. The majority of people I talk to either do not have an investment account at all, or if they do, it contains some mutual funds that the guy or girl at their local branch recommended. I think what scares most people off is the financial industry’s love for acronyms and making simple things seems difficult.

I work in the financial industry and I can tell you it’s not coincidence that you’re finding it hard to understand. It is in the industry’s favor to make things seem difficult and confusing, so that you do not try to do anything yourself. This is what makes their revenue flow and profits grow, and it the end, it makes you that much poorer. While picking individual stocks and analyzing companies is in fact complicated, the approach I’m about to outline is not only easy, but is likely to work for you far better than paying for stock picking and analysis. (not convinced? See the most up-to-date analysis here)

In my previous posts I’ve already discussed why investing in the stock market over the long term is near risk free, but I’ve never really explained how to practically do it. Without further delay then, the 3 steps to a full diversified portfolio

Step #1 – Establish a self-directed investment account

There are plenty of brokers out there but the best option for simplicities sake is to go with whoever you already bank with. All the big 5 banks in Canada have what are called “discount brokerages” which offer self-directed accounts (RBC Direct, TD Waterhouse, BMO InvestorLine, CIBC Investor’s Edge and Scotia iTRADE) . The nice thing about going with your bank is that your account will be integrated with all your other internet banking and moving money between accounts will be very easy.

One thing to keep in mind is that an account is not an investment. Technically you do not invest into an RRSP or a TFSA but you contribute or deposit money into it. You then use that money to purchase investments. This is an important distinction because it underlines that you can choose the same investment regardless of which account you choose.

If you don’t already have a self-directed investing account you should set one up as soon as possible. There are 3 major account types for individual investors under the age of 65. I list them in the order of importance.

RRSP (called an IRA in the US) – contributions to these accounts are deducted from your income for tax purposes. In other words the government gives you an interest free loan for somewhere between 30% and 50% of what you contribute. Best of all this loan may never really have to be paid back, or at least not in full. It’s like getting an immediate return on investment between 30% to 50% and is the single most powerful way to build wealth for individual Canadians. In addition any investment returns you generate in this type of account are generated completely tax free.
TFSA (called a Roth IRA in the US) – contributions are NOT tax deductible, however, you can withdraw the money tax free at any time. The investment returns in this type of account are mostly tax free. There are some exceptions but describing them goes beyond the scope of this article. These are best if you have either maxed out your RRSP contribution room or if know you will need the money before retirement.
Regular/Margin – these are regular fully taxable investment accounts and should only be used if you have exhausted both your RRSP and TFSA room.

One note of caution on the RRSP. The amount you are allowed to contribute is cumulative, so if you have a Mutual Fund RRSP account or an RSP plan at work, you may have already used up some of your room. Talk to your HR department.

Step #2 – Figure out the allocation that is best for you

The 60/40 rule has been used for over 70 years as a default “balanced” stock/bond allocation. It means that 60% of your portfolio should be in stocks while 40% should be in bonds. Most financial advisers use this as a starting point but make various adjustments based on a number of factors. The most important adjustment is based on the age of the investor and how long they have until retirement.

The rule of thumb generally used is to take 100, 110 or 120 and minus your age to get at a stock allocation. This is an oversimplification because it fails to consider that one 30 year old is not necessarily in the same stage of life as another 30 year old. However it is generally a good starting point and will work well for the “average” investor.

The reason this simple rule works rather well is because, during the wealth accumulation phase of an individuals life, the exact allocation of their retirement savings is not all that important. This is because over a long enough period of time the stock market always ends up providing a solid return. The purpose of the bond part of the portfolio is to reduce the volatility (ie. large swings up and/or down in the value) of the overall portfolio and help you stay on track. However, if you close your eyes, and wake up 25 years later, the best return is still achieved by going 100% stock.

The calculations are very different if you are either nearing or in retirement. In that case the primary purpose of an allocation is to provide you with a steady stream of income that can support your life style. Because life styles and incomes vary so much and because the consequences of not getting this calculation exactly right are far more serious I am going to stay away from suggesting allocations for anyone over 55. If you are near or in retirement I strongly advise you to hire a professional adviser to help you structure your portfolio.

Having said all that, assuming the following:

You are putting this money away for a minimum of 15 years and have no need for withdrawals
You are not already retired

Here are the approximate allocations based on a 120 – your age calculation:

Age	20-30	30-40	40-50	50-55
Stocks	100%	90%	80%	65%
Bonds	0%	10%	20%	35%

I chose 120 instead of 110 or 100 for the following two reasons

Interest rates are near 0, therefore upside for bond investments is limited while downside is significant. A very minor move in interest rates can destroy decades of returns. Allocating a large percentage to bonds right now is the equivalent of picking up pennies in front of a steamroller.
Volatility (up and down swings in value) of your portfolio is not an actual risk if you plan to keep your money invested for over 15 years. Why not get paid more to take this volatility on?

I am sure I will hear comments from various corners that the allocations I’m suggesting are too aggressive. The truth is there is no standard in the financial world and for every 10 people you ask you will get 20 answers. I think getting too hung up on whether someone should have 10%, 20% or 30% allocated to bonds makes people paralyzed with fear and prevents them from investing all together. Remember, in the grand scheme of things, the exact allocation matters far less than minimizing your fees and being in the market in the first place. Speaking of minimizing fees…

Step #3 – Use ultra-cheap ETFs to construct your balanced diversified portfolio

Exchange traded funds are similar to mutual funds except they are traded on stock exchanges. This gives them the following advantages:

Since any financial institution can sell an ETF on the US or Canadian markets it means a much larger selection than your local bank offers in mutual funds.
The huge number of investors and assets in ETFs means the management fees (MER) are kept ridiculously low. None of the funds I’m about to describe charge more than 0.2%. That’s not a typo, it’s less than one fifth of a percent.

The ETFs I suggest to build your quick fully diversified portfolio are all from Vanguard, a company that prides itself on having the lowest management fees in the world. The funds can be bought using your self-directed brokerage account, just like you would buy any other stock being traded on a US stock market exchange. The difference being that you’re not just buying a single stock but rather thousands of stocks and/or bonds that cover virtually the entire world of invest-able assets.

VT – Buying this ETF is equivalent to buying 7,137 different stocks/companies in 48 different countries across every sector of the world economy. This fund charges a 0.17% annual management fee. A similar mutual fund would charge around 2.3%. That’s a savings of $2,130 in fees over 10 years for every $10,000 invested.

BND – This ETF is the equivalent of investing in 6,512 different high grade bonds across the US bond market. 63.4% are classified as US government bonds and therefore can be considered default risk free. For this one you will pay a 0.07% annual management fee. A similar mutual fund would charge around 1.4%. That’s a savings of $1,330 in fees over 10 years for every $10,000 invested.

BNDX – This ETF is the equivalent of investing in 3,613 different high grade bonds across 98 different countries (outside of the US). This one charges a whopping 0.19% management fee. Once again a similar mutual fund would charge around 1.7%. That’s a savings of $1,510 in fees over 10 years for every $10,000 invested.

The following allocations would be excellent suggestions and cost you little to nothing in expenses.

Age	20-30	30-40	40-50	50-55
VT	100%	90%	80%	65%
BND	0%	5%	15%	25%
BNDX	0%	5%	5%	10%

Or if you hate percentages, the following per each $1,000 invested

Age	20-30	30-40	40-50	50-55
VT	$1,000.00	$900.00	$800.00	$650.00
BND	$0.00	$50.00	$150.00	$250.00
BNDX	$0.00	$50.00	$50.00	$100.00

For example, if you have $10,000 to invest and you are between 30-40 you should buy the following amounts:

10 * $900 = $9,000 of VT
10 * $50 = $500 of BND
10 * $50 = $500 of BNDX

One note of caution is that all the above funds trade in US dollars. Therefore first convert your Canadian Dollars to US Dollars at whatever rate your bank is offering before calculating how many shares of each fund to buy (or you can use this handy little excel spreadsheet to calculate the # of shares to buy).

I bought the funds, now what?

Now you forget all about investing and NEVER check your account until you retire!

I’m actually only half joking as you’d be surprised how well this approach would work! The biggest risk to a long term investor is checking their portfolio too often.

Hyperbole aside, you should in fact re-align the allocation as you age and go into different age thresholds. Eventually you’ll move from your 30’s to your 40’s and as you do you should put more money into bonds. This is the only action I would strongly recommend for everyone.

If you want to do even better than this, you should check your portfolio no more than once a year, and re-balance it to the target allocations you chose when you first started. There are a couple of reasons why the portfolio will get misaligned over time without you changing anything:

The prices of the funds fluctuate in different directions and by different amounts. This causes you to become over-allocated to the “winning” funds and under-allocated to the “losing” funds. Re-balancing forces you to buy a little of the “loser” fund while selling a bit of the “winner” fund to keep your allocation in-line.
The funds pay you dividends which are cash payments that get accumulated in a cash balance in your account. This means your allocation to non-return bearing cash increases over time. This cash balance should be periodically invested using the same target allocations as the rest of the portfolio.

Once again if you choose not to re-balance regularly it does not mean you’ll do badly. You might do slightly worse than a regularly re-balanced portfolio, but still far better than letting your money sit in a savings account or pre-paying your mortgage. Therefore don’t let this stop you from putting your money to work.

In general there is really no need to check up on your investments or “watch the markets”. There are no tenants (real estate) here to check up on, no quarterly reports to read (individual stocks) to make sure management isn’t embezzling money, and no employees slacking off at work and alienating customers (small business). Since you are invested in literally the entire world economy you are protected against any particular part of it failing. If Tesla is a flop, then maybe GM and Honda will take over the market and make you rich, if Tesla ends up dominating the car industry that’s great for you too. If the car industry fails entirely and cars get replaced by Star Trek-like transporter machines, you will own the company that makes those transporter machines and benefit regardless.

The only risk you have is the entire the world economy imploding in on itself and everyone going berserk Mad Max style. Something tells me in that scenario your retirement portfolio would be the least of your worries!

Note: This article does not mean to imply hiring a financial adviser is a bad idea. There are plenty of wonderful girls and guys out there helping to keep people on track to reach their financial goals. The service a good adviser provides minimizes your costs, stops you from making emotional decisions, tweaks your allocation to better suit your risk profile and helps you with tax implications and planning. They are also very likely to use ETFs similar to the ones I’ve described in this article when constructing your portfolio. However, if your financial adviser thinks their primary job is to “pick the best stocks”, run as fast you can!

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Weekly Links – Senators, Astronauts, Millionaires and Travel

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I have been a bit busy with my wife getting oh so very close to giving birth to our second son. However, I am working on a new original article and will be publishing it early next week. In the meantime please enjoy the following round up of great articles I’ve read recently.

It appears that being a United States Senator does not mean you have to be particularly good with your money. You can lecture people on their finances and get paid to give speeches on being fiscally responsible, while yourself binging on debt by buying multiple properties and luxury cars you cannot afford. Who knew? OK — not exactly an earth shattering surprise that a government official can’t manage finances, but the degree of fiscal irresponsibility is more than I would have expected.

However, let’s start with some positives examples of making good choices regardless of income and/or wealth.

Good lifestyle choices don’t change much whether you’re rich or poor

One family’s downsizing strategy to live within their means (Globe and Mail) – I like this story because it really illustrates how important the choice of where to live is to a families financial health. The biggest difference, between this family and the struggling family I mentioned in one of my previous articles, is that this family chose a place to live that matched their budget and their actual needs. No amount of saving on anything else can fix the monumental mistake of buying too much house.
Millionaires Who Are Frugal When They Don’t Have to Be (New York Times) – The habits that make you sustainably wealthy do not just disappear as soon as you hit some particular wealth level. There is no number at which a frugal person turns into a Marco Rubio (more on that below). It’s amazing how much self-made financially secure people have in common with each other.

On the other hand bad choices lead to financial ruin regardless of income

Marco Rubio’s Career Bedeviled by Financial Struggles (New York Times) – maybe Marco isn’t exactly financially ruined but he does remind me a bit of a ponzi scheme. The more money is given to him the more he needs to keep going. I believe his situation is actually very similar to many middle and upper middle class families, which is why I started this blog. Still, the level of ineptness here is epic, I just couldn’t help hearing the Benny Hill Show music in my head as I was reading this article.

So where does travel fit in?

How we quit our jobs to travel (BBC) – I am certainly not advocating this as a career strategy for everyone, however, it illustrates the importance of understanding your goals. Too often people focus on the progression of their careers and ticking off all the proverbial life-achievement boxes dictated by mainstream society. Others focus on achieving financial independence or a comfortable retirement without a good idea of what they’ll do when they get there. It’s critical to clearly understand why you are pursuing your goals, and what you plan to do once you achieve them, as early on as possible. You may realize you can actually “retire” to your dream activity right now.
Why I love the world (BBC) – The more I learn about Chris Hadfield the more I like him. On the surface this may not appear to have anything to do with personal finance, but I believe there is a very important message here. It goes back to the myopia that drives us to pursue things simply because others around us think they’re valuable. Travel opens your eyes to ways of living that you would have never imagined or thought possible. It reminds you that a large number of concerns everyone in your community is so obsessed with, are actually very specific to the time and place you happen to be living in. They are just distractions that keep you off course. There are values that are universal (same across cultures and geographies), and there are values that are fleeting, and knowing the difference can be extremely positive for your finances.

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Providing for your kids does not have to be expensive

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As my wife is getting closer and closer to her due date we are starting to get really excited about meeting our new little guy. We are packing all our hospital bags and making sure everyone knows “the plan” when the day finally arrives. We are also preparing ourselves mentally for the long months with lack of sleep. One thing we are not particularly worried about is the additional costs of having another baby.

In fact I can’t wait to take my two months of paternity leave when my son is born! I will be able to spend time with both of them during the summer months and help my wife with the first 2 months of having our 2 boys under 2.

How are we able to afford a second baby without any worries? It’s because we make boat loads of money of course!

OK, just kidding, I’m guessing you already know that I turn to the income side of the equation only as a last resort. In fact, my wife has only been working part-time since returning from maternity leave after our first son was born, and I took a sizeable pay cut in order to have a job within a shorter commuting distance.

Yet, we bought a new house last year and I took last July and August off to spend with my son. We’ve even managed to somehow increase our total savings over the course of last year. How is that possible?

Sometimes a picture is worth a thousand words so I’ve decided to show you guys what we’ve been able to give my son at little to no cost.

Vintage Glider Chair

Cost: $0
Comparable Retail Cost: $400 – $1,100 (or maybe infinity)

Vintage glider

Gliders are EXPENSIVE!!! You can really spend a ridiculous amount of money on these.

This baby found its way into our hands through our awesome friends who saw a neighbour throw it out on the curb. It squeaked a bit initially but we WD40’ed it and cleaned the crap out of it, while my mother in-law sewed up those cushion covers. Since she’s retired she loves little projects like this. This glider would command a serious price at a “Vintage” furniture store in a hipster neighbourhood.

Chest

Cost: $0
Comparable Retail Cost: $200 – $1,700 (I’m just googling West Elm <insert item> to get the highest possible price)

Awesome free chest

This is where we keep our baby supplies. You can see there is a little work that needs to be done on the bottom drawer to make it look completely respectable, however, I think it has a very nice modern look. We inherited this from my brother in law as we bought our in-laws house and he eventually moved out. Thanks Andrew!

The best part is it has a friend…

Dresser with mirror

Cost: $0
Comparable Retail Cost: $500 – $2000

Free dresser with mirror!

These drawers are where we keep the majority of my sons clothes. Again thank you uncle Andrew! This piece is actually in an even better shape than the chest. Score!

Crib

Cost: $100
Comparable Retail Cost: $80 – $1,100

This is the most expensive thing I’m going to list in this post. It was bought for a crazy $100 on sale at IKEA. It wasn’t even the cheapest IKEA crib. Horrors! However, we are going to use it for at least 4 years, and we really wanted to spoil ourselves with a brand new crib. So there!

As I’ve mentioned a few times on this blog my philosophy is not to cut costs down to the bone. Sure we could have found a cheaper second hand crib, but we could have also spent $1,100 on some hard-wood Pottery Barn monstrosity. Because, you see, it’s worth the $1,100 because it’s going to last forever and even has storage! Never mind that your kids are not some baby vampires that will stay 2 years old for eternity. Or maybe they are and that’s why this crib even exists?

Toddler Tricycle

Cost: $5 (including delivery to my door!)
Comparable Retail Cost: $60 – $160

One of my sons first words was car. It wasn’t dada or mama or please or thank you. It was CAR!

He absolutely loves anything on wheels that makes a vroom sound or that he can mount. Leads to some pretty funny scenes when he tries to ride his one-foot long fire truck.

I was biking down to the local Shoppers Drug Mart when I saw this beauty sitting on the curb at a garage sale. I didn’t stop because even if I liked it I couldn’t strap it to my back and bike it home. However, on the way back I stopped and inquired about the price. I immediately liked the home owner, good guy, and after a little banter he answered “Whatever you think is good, we just want it gone”. I told him I can give him $5 but I’ll have to go home and drive over first. “We’re going to be packing up soon. Do you live nearby? My car is right there, would you like me to drop it off at your house?” he inquired. How could I say no? A $5 tricycle with delivery included!

Toddler Wagon

Cost: $0
Comparable Retail Cost: $70- $200

Toddler Wagon

I take my son everywhere in this thing. I think it’s his second favourite form of transportation after my coupe. It makes getting to all 4 neighbourhood playgrounds a breeze without having to worry about him falling out, and it gives me some exercise in the process. Who needs a gym membership?

Yes, I actually walk to the playgrounds, I was shocked to discover this is not the normal thing to do around here. People I spoke with were apparently equally shocked that I actually walked the 5 minute walk rather than take out my car to get there. One conversation went like this:

Them – “You took the wagon here?”
Me – “Yes, he loves riding in it!”
Them – “So you must live near the playground?”
Me – “Yes, not too far away, on street abc, where do you live?”
Them in an awkward tone – “I live on cba street” – which happens to be closer than my house
Me – “Ahh I see”

More awkwardness and eye contact avoidance happens later when they take their kids into their gigantic SUV to drive them home.

OK sorry about the rant. Where was I again? Oh right, the wagon came to us courtesy of my wonderful frugal parents who overheard a neighbour saying they wanted to throw it out.

Playroom full of toys

Cost: $0
Comparable Retail Cost: ????

Playroom full of toys

Nothing you see in the screenshot above cost us any money. Some of these toys are old toys that my wife and my brother in-law used to play with as kids. Other toys are gifts from family and friends, and often things that their own kids have grown out of. There is one particular item that deserves extra special mention though.

Matthews Playhouse

Cost: $0
Comparable Retail Cost: $150 – $400

This piece of art is truly magnificent! It is the brain child of my extremely talented sister and my ridiculously frugal dad. The whole thing is made of discarded cardboard boxes which means its light and therefore very safe. My boy loves to run in and out of it and I can’t count how many times he has smacked his head right on the top of the door way. Thank goodness its cardboard!

I’m lucky because my sister is an amazing artist which you can see through the attention to detail and level of personalization of this play house. It is not something everyone can do but it is something that we are taking full advantage off.

Thank you Ciocia Sylvia and Dziadek Janusz!

Note: If you have any art or graphic design work you need done don’t hesitate to contact sylviat.design@gmail.com for a quote!

What does this all add up to?

Let’s do some quick math here, this is after all a personal finance blog.

Our total cost for all 7 items: $100
Comparable retail cost – Low end: $1,460
Comparable retail cost – High end: $6,600

Overall savings: $1,360 to $6,500

My personal feeling is that most people fit somewhere in the middle of the above range. They buy some things high end, some low end and most mid-range. This means we saved approx. $2,500 over the average family on just these 7 items!

If we invest this $2,500 into the stock market at the average 10% total return for 25 years we will have $27,000 more in our retirement account for virtually nothing!

Obviously these items are not all the costs associated with having a child. The post would be much too long if I tried to list everything we saved money on. It’s the right mental approach when making purchasing choices across the board that makes the big difference.

The thing is we are not even actively trying to be frugal. We are not going out of our way to clip coupons or scour garage sales or check every flyer for a sale. You could do much better than us if you did! All we do is take advantage of all the opportunities that fate provides us with instead of passing them up for silly superficial reasons.

You can say were lucky to have awesome friends to pick up the glider for us, to have a brother in-law who decided to leave his furniture behind, or to have such a talented sister. I agree completely! Yes, we’re lucky, but we try to take advantage of all the opportunities we are presented with. Have you grabbed a hold of and taken advantage of all the opportunities you’ve been presented with?

Look around you and try not to get tunnel vision as to what is you need to get. When it comes to chance there are the things you can control and the things you can’t. You cannot control what opportunities will present themselves. What exact brand or type of item will become available to you free or at a ridiculous discount. I could have easily decided that my brother-in-laws furniture wasn’t quite the right color or style and purchased an entire new baby room furniture set. What you can control is whether you take advantage of the opportunities that do present themselves to you.

Focusing on the part that you can control, rather than worrying about what you can’t, applies equally well to savings money on kids items as it does to everything else in life.

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Should I pay down my mortgage and borrow back the money to invest?

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This question was raised to me in response to my first article on why pre-paying your mortgage is not a good idea. It is also known as ” The Smith Manoeuvre”. The key idea behind this strategy is to deduct the interest paid on an investment loan from your income.

What are the steps for this strategy?

Assuming you have $10,000 saved up at the end of the year you would do the following:

1) You put the $10,000 into your mortgage to save on the mortgage interest
2) You then borrow the same $10,000 to invest
3) You invest the $10,000 into a diversified portfolio
4) You deduct the interest paid on your investment loan from your income

Since the investment return is the same as investing the $10,000 directly instead of paying off the mortgage first the only difference is in the borrowing rates and tax treatment. The idea is that the interest deduction will more than compensate you for the higher borrowing rate you will have to pay on an investment loan vs. your mortgage.

Why makes it difficult to determine whether this works?

What makes this particular strategy difficult to assess is the fact that it’s profitability relies on an individuals marginal tax rate after all other deductions have been counted. In non-accountant speak it means it depends on your personal income and spending situation.

Gettin’ down and dirty with the math

I know this is everyone’s favorite part and believe me I’m excited! Nothing like poring over tax brackets and figures to make me jump around in joy. Yeah I’m weird like that.

Apples to apples

We are going to compare a variable rate mortgage versus a HELOC loan.

Why?

This is because the cheapest investment loan you are likely to get is a HELOC (home equity) loan. It also takes off the table any perceived benefit of not pledging your home as collateral since both loans are backed by the house. Since all HELOC loans are variable rate loans they must be compared against a variable rate mortgage.

It’s easier to compare a variable rate mortgage because comparing a fixed rate mortgage versus a variable rate HELOC would require the stripping out the rate benefit you get due to taking on the interest rate risk (just like you do when you get a variable rate mortgage versus a fixed mortgage). It’s easier to just compare apples to apples. Picking a fixed rate mortgage versus a fixed rate loan would not change the conclusion but I do invite you to do the math yourself and perhaps post your results in the comment section.

After-Tax Interest Rates

The next step is to make the interest rate on the mortgage comparable to the interest rate on the loan through reducing the investment loan rate by the tax benefit.

This is actually very easy to do as all you need to do is multiply the HELOC rate by (1 – your marginal tax rate). Here is a table based on a 3.35% HELOC rate which is the best rate available on RateHub.

Gross income up to	Tax Rate	HELOC 3.35% after tax rate
$40,922	20.05%	2.68%
$44,701	24.15%	2.54%
$72,064	31.15%	2.31%
$81,847	32.98%	2.25%
$84,902	35.39%	2.16%
$89,401	39.41%	2.03%
$138,586	43.41%	1.90%
$150,000	46.41%	1.80%
$220,000	47.97%	1.74%
Above $220,000	49.53%	1.69%

Benefit versus a Mortgage

Once we have the table above it’s really easy to compare whether we could save any money by pre-paying our mortgage and borrowing to invest versus just investing the $10,000. Since the HELOC rate is already tax-benefit-adjusted we only need to compare it against the best variable rate mortgage on RateHub which today stands at 1.99%.

Therefore the benefits of the borrow-to-invest strategy per $10,000 for various individual income levels are as follows:

Gross income up to	Tax Rate	HELOC 3.35% after tax rate	Savings vs. Variable Mortgage ( 1.99% – adjusted HELOC rate)	Annual benefit per $10,000
$40,922	20.05%	2.68%	-0.69%	-$68.83
$44,701	24.15%	2.54%	-0.55%	-$55.10
$72,064	31.15%	2.31%	-0.32%	-$31.65
$81,847	32.98%	2.25%	-0.26%	-$25.52
$84,902	35.39%	2.16%	-0.17%	-$17.44
$89,401	39.41%	2.03%	-0.04%	-$3.98
$138,586	43.41%	1.90%	0.09%	$9.42
$150,000	46.41%	1.80%	0.19%	$19.47
$220,000	47.97%	1.74%	0.25%	$24.70
Above $220,000	49.53%	1.69%	0.30%	$29.93

Does this mean there is a benefit to the strategy?

It would seem from the numbers above that there is a minor benefit if you make 90K+ in gross income (the first tax bracket level where the benefit from the strategy is larger than 0) and the benefit increases a little bit as you get into higher income brackets.

However, we need to not only consider the gross income but also other deductions available to reduce this income.

Why?

Because the interest rate deduction does not apply to any loans where money was contributed to either an RRSP or a TFSA.

The tax benefits of contributing to your RRSP or TFSA will far outweigh the very minor tax benefits derived from deducting the interest. (Note: while the TFSA contribution is not tax deductible the returns are completely tax free. In the long run this tax free return benefit will be far bigger than the interest deduction.)

Adjusting the chart to account for RRSP contributions having been made

In order to determine whether it still makes sense to follow the borrow-and-invest strategy there are some adjustments that need to be made. You will need to add the RRSP contribution room available to you at each income level to the income ranges in the chart above above.

Alternatively, and maybe more intuitively, you can also subtract the RRSP contribution room from your income and compare against the chart above.

These two calculations are equivalent but I’ll do the first one to give you one easy final chart that will show you whether the borrow-to-invest strategy could work for you.

The calculation in each tax bracket is as based on 18% of your income being contributed to an RRSP up to the maximum of $24,930 allowed by the CRA.

Gross income up to	Tax Rate	Max RRSP contribution	Gross income up to (adjusted)
$40,922	20.05%	$7,365.96	$48,288
$44,701	24.15%	$8,046.18	$52,747
$72,064	31.15%	$12,971.52	$85,036
$81,847	32.98%	$14,732.46	$96,579
$84,902	35.39%	$15,282.36	$100,184
$89,401	39.41%	$16,092.18	$105,493
$138,586	43.41%	$24,945.48	$163,531
$150,000	46.41%	$24,930.00	$174,930
$220,000	47.97%	$24,930.00	$244,930
Above $220,000	49.53%	$24,930.00	Above $243,087

Once we have the adjusted tax brackets we just map them back to our previous benefit table to arrive at the benefits for each RRSP contribution adjusted tax bracket.

Gross income up to (adjusted)	Tax Rate	HELOC 3.35% after tax rate	Savings vs. Variable Mortgage (1.99%)	Annual benefit per $10,000
$48,288	20.05%	2.68%	-0.69%	-$68.83
$52,747	24.15%	2.54%	-0.55%	-$55.10
$85,036	31.15%	2.31%	-0.32%	-$31.65
$96,579	32.98%	2.25%	-0.26%	-$25.52
$100,184	35.39%	2.16%	-0.17%	-$17.44
$105,493	39.41%	2.03%	-0.04%	-$3.98
$163,531	43.41%	1.90%	0.09%	$9.42
$174,930	46.41%	1.80%	0.19%	$19.47
$244,930	47.97%	1.74%	0.25%	$24.70
Above $243,087	49.53%	1.69%	0.30%	$29.93

The adjustment for RRSP contributions increases the required individual personal income to approx. $106,000 (the first adjusted tax bracket where the benefit from the strategy is larger than 0). This means that the minimum gross income level where a salaried employee should even consider this option is $106,000.

The TFSA factor

Let’s say you are lucky enough to earn $106,000 in annual income, have enough savings to contribute the full allowable $19,080 to your RRSP, and still have money left over that you need to put to work. In that case the first place you should look to put that money to work is in your TFSA. The TFSA allows for $10,000 in annual contributions but the RRSP contribution will return a nice big chunk of your taxes to you that you can use for that purpose. In the case of a $106,000 income contributing $19,080 will yield approx. $8,000 in tax return leaving you only $2,000 short of the maximum. If you contribute the full $8,000 tax return + $2,000 extra in after-tax money to your TFSA and still have money left over you might want to consider pursuing the HELOC borrow back and invest strategy.

What if you are stuck in a high fixed rate mortgage?

This is probably the only case in which it would actually be worth the effort to go out of your way and follow this strategy. However, lets understand why that is. It is not due to the interest rate tax deduction. The reason it works is because you are in fact re-mortgaging a portion of your house at a lower variable interest rate.

If you take $10,000 out of a 3% fixed rate mortgage by paying it down, and then borrow back at a HELOC 3.35% after-tax rate of less than 3% (again depends on your marginal tax rate, see chart above) you will see a benefit. However, please keep in mind that majority of the benefit is due to the refinance of a fixed rate to a variable rate. The moment you are able to refinance your entire mortgage at a lower rate you should do that because the savings from doing that will be far larger than the benefits from the HELOC borrow back and invest strategy.

Instead of doing the HELOC borrow back strategy a more profitable approach would be to reach out to mortgage lenders and see if they would be willing to pay your penalty fee to earn your business a bit earlier.

So, should I pay down my mortgage and borrow back the money to invest?

If you earn more than $106,000, have fully contributed to your RRSP, and have maxed out your TFSA, any additional money can be used to pay down your mortgage and borrow back the money for a minor tax benefit.

Would I suggest doing it?

Let’s just say it wouldn’t be at the top of my priority list. For the vast majority of the population making less $165,000 per year in individual personal income you can save far more money expanding your energy into making sure you invest in only the lowest cost investments, limiting your trading commissions, or even bringing your lunch to work one more day a week. We all have limited time, energy and resources and the return on this strategy is so low that I wouldn’t pursue it until I’ve made sure all my other bases are covered. Given that only approx. 10% of Canadians actually exhaust their TFSA contribution limit and plan to do so in the future I think the HELOC borrow-back strategy is more of a distraction than a help for the majority of the population.

We all want to believe that there is some complex way to make extraordinary profits and if we could just figure it out and put all our energy into it we would reap amazing rewards. We chase intricate tax saving strategies and look through screens of hundreds of stocks based on obscure detailed metrics to find the perfect investment. The truth as to what is important when it comes to retirement investing, is very different, and conflicts with the way we’ve evolved to think. The important things are dead simple and really do not require much intricate knowledge (maybe some knowledge of yourself), while the complex things usually just lead to lots of time spent and very little benefit.

So save yourself some time and money and forget that expensive book or paid financial adviser pushing the next great investment or tax strategy. Instead focus on the little things that work and have always worked for generations. In return I’ll promise I’ll concentrate my posts on more useful things in the future 😉

Question, concerns, want to yell at me about how wrong I am? I invite you to click the “Leave a Reply” link below or use one of the social networks to leave a comment.

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