Tuesday, July 31, 2012

Rule #12 Use Leverage for MORE positive cash-flow!



Under the right conditions, we are very comfortable using leverage to buy stocks.  Big amounts too.  A lot of people will warn against doing this.  I don't advocate that you necessarily do it, unless you understand the risks and are comfortable knowing what the possible outcomes are, and of course if the investment makes sense in the first place.  If the investment value craters, you are still obligated to pay your debt, so do your due diligence and make sure your really understand what you're getting into before borrowing to invest.    An example of a trade gone wrong would be Research in Motion.  If you borrowed to buy RIM a few years ago you would have lost your shirt on that trade by now as the stock is down 95% off its 2008 high, yet you would still be required to pay back everything you borrowed with literally nothing to show for it. Yes, it really can be that bad.  I would not have invested in RIM because they pay no dividend.

If you are starting to use leverage I would suggest you start in very small amounts until you become comfortable with it.   With all of that said I still don't consider it quite as risky as most will tell you it is, IF you pick stable conservative investments and NOT put all you eggs in one basket.  I have also observed that most people have been conditioned to believe that leverage on investments is risky, yet borrowing (leveraging) to buy a home is not.  I view leverage on a house to be just as risky as using leverage on stocks, perhaps even more risky.  This has to do with my view of a home being a liability.  It pays you nothing, and if it drops in value you are still on the hook to pay for it.  Buying something that is overpriced or built on shaky ground, whether its a house or a stock, can lead to a loss, and leverage can amplify those losses if you sell at the bottom.

I will tell you how I use leverage to increase our cash-flow and pay for itself, while minimizing the risk of the loan over time.  I do not try and hit home-runs with large capital gains, I try and hit base-hits.  Lots and lots of base hits, by creating a cash-flow positive situation while borrowing money to juice it up.  To be clear, what I am talking about is borrowing money, most likely from a bank, to purchase income producing assets.  I prefer Canadian stocks that pay dividends, but you can use a similar strategy to buy an income producing property such as a house or multi-family building, or any other investment with an income stream.  Usually its difficult to find investments with a high enough yield to use the strategy I use, but do your research and you may find some opportunities out there.   Note that I have no experience in rental properties, so I will give an example from a stock that I watch.

There are four basic criteria I use when using leverage.
  1. I typically leverage for 50-60% of the position... that is to say that I only borrow when I am willing to put up 40% of the money myself
  2. The dividend/distribution must be stable, preferably growing, and never have been cut.  
  3. The cost of borrowing must be relatively stable or be going down in the next 1-2 years.
  4. The leveraged investment portion must have a positive and growing cash-flow that covers the cost of borrowing today. If it doesn't make sense today to make the investment, I don't rush it.
So here's an example of a leveraged position I might take.  I will use an example for a corporation I follow call Leisureworld Senior Care (LW on the TSX).  They own Retirement Luxury condos and Full-Service Retirement Homes.  Full disclosure: They are on my watchlist, but I do not own any LW and I am NOT suggesting you buy any...  I am just using them as an example.  Lets go down my criteria

#1 I am willing to put up $4000 to purchase some LW stock, I will also borrow $6000 from the bank to make a total investment amount of $10000.  

#2 The retirement home industry is a stable one and will likely grow in the future as Boomers move into retirement lifestyle living centres, I would expect the dividend to be stable and likely grow at or near the rate of inflation.  At present, the dividend yield is 7% 

#3 At present, I dont see interest rates rising much, if at all, within the next 1-2 years due to the slow growth situation right now with the economy... rates are at all time low.  Now may be a good time to use leverage.  RBC currently has a Home Equitly Line of Credit that is set at prime +0.5.  With Prime at 3%, thats an interest only loan for 3.5%.  Thats pretty low.  You could also lock in a rate of some sort through other lending products at the banks, but I typically use a HELOC as you tend to get the best rates, although they are almost always variable and may fluctuate abruptly.

#4 I would get paid a dividend of 7% annually, and use that cash-flow to pay the loan interest of 3.5%, leaving a spread of 3.5% in positive cashflow. This means on the $6000 that I would borrow, I am making $210 annually.  Congratulations, the leveraged portion of this investment is is cash-flow positive!  The Dividend would have to be cut buy 50% or the loan interest rate double before it becomes neutral to cash-flow negative.  Sounds safe in the near term.  

Now that I've established this as a candidate, how might this look with respect to cash-flow?  In most cases I use the cashflow from the total position (both borrowed portion and my own portion's cashflow to pay down the loan).  As the cash-flow pays down the loan, no additional monies need to be injected into the position.  We treat the whole position as a closed system until it pays off the loan.  You can essentially start saving new monies for your next investment as this one pays itself off.  Here's a  spreadsheet showing what happens whey you use the money to pay down the loan assuming no change in dividend or interest rate.  



After 10 years, the loan is paid off and you have $10000 of LW stock.  This spreadsheet DOES NOT consider the likelihood that LW will increase the dividend, or that the annual interest rate will rise into the future.  Both considerations are quite likely... you can test different scenarios in your own spreadsheets.  This spread just shows that if left alone the dividends will pay off the loan in about 10 years and then you will have about $700 a year in free cash-flow from your initial personal contribution of about $4000.  Thats a 17% yield on the money you put up.  Not bad. Not bad at all.

This strategy works well on stocks that are in conservtive sectors with healthy stable cash-flow and if you don't go hog wild with leverage all at once.  I would never use this strategy on a company that doesn't have a healthy balance sheet, a sustainable dividend or if its in a volatile sector like high tech.. its just too risky.  With that said, I believe using leverage conservatively and under the right conditions can be very profitable.

Monday, July 30, 2012

Rule #11 Dividends - Buy Stocks for the Cash Flow

A major part of our financial independence plan is to build a portfolio of income producing assets.  These assets will be our income into the future and will replace our need for other types of income such as employment.  Our preferred type of income is Dividend Income from stocks that we own.  Dividends are a form of passive income that provide cash-flow with virtually no "work" on our part to maintain the asset.  The dividends are paid by the corporations to shareholders over a set period, usually quarterly, throughout the year.  The corporations take a portion of their earnings and send a cheque to shareholders as a benefit to owning the stock.  While it is a strategy that has risk - and don't forget every strategy has some risk - if you choose stable companies that provide goods and services that people use everyday, the risk is greatly reduced to almost nothing... note that I said almost.  There are many companies, with decades worth of dividend-paying history, that will continue to pay dividends well into the future.  Another great thing about dividends is that many companies make it a point to increase their dividend at or above the rate of inflation each year.  These are the companies we want.  If the company increases the annual dividend by 5%, and inflation is 3%, we've just gotten a raise that out paces inflation.  Ultimately this means we have increased your buying power that year.

The sectors that we invest in are primarily sectors in which goods and services used by people will either continue or increase in the future such as: Real Estate, Oil and Gas, Energy Delivery (Pipelines and Electricity Transmission), Banks, Insurance, Consumer Staples, Booze etc... We generally stay away from High Tech, Food Retail, Clothing Companies, and Consumer Discretionaries, because these companies are built on ever-changing innovation, thin margins, or primarily good economic times (non-recession proof).

One stock that I have owned for the last 8 years is Bank of Nova Scotia or BNS on the TSX.  It has payed a dividend for 179 years, without ever having cut it.  Most years it has increased its dividend above the rate of inflation, some years increasing the dividend by 10% or more.  ThePassiveIncomeEarner.com did a great summary of BNS last year that does a better job than I ever could could at explaining why its such a great company to own for dividends.  You can check that summary out here.

We view buying dividend stocks as akin to buying mini-pensions that will pay our way into the future.  If, at age 25, I buy $10000 of BMO stock today, with a 5% dividend, that stock will now pay me $500 a year this year and every year after that until I sell the stock.  What if I hold this stock until I am 85 years old?  Great! I get to collect that little mini-pension for as long as I hold the stock.  I can do whatever I want with that money along the way... spend it, re-invest it, earmark it for Christmas, whatever.  Sweet!  BMO has never lowered or missed a dividend payment in the past, and there is a pretty good chance that they will keep paying it into the future... and they will likely increase it inline with or above inflation under normal economic conditions.  This way of looking at dividend stocks is different than how most people have been taught to look at stocks.  They look at the price at which they buy the stock and then fret over what price they are going to sell it at.  Timing of the buy/sell trade is particularly important.  We buy the asset for the cash-flow and and then sit on it as long as the company can meet its dividend payments.  We don't fuss on when to sell it, because we have no intention of selling it.

Thats one of the great thing about owning shares specifically for their dividend is that it removes the day-to-day worrying that goes with watching a stock portfolio go up and down in volatile markets.  Because I own the company primarily for the cash-flow, if the stock goes up or down it makes little difference to me, because I don't intend on selling it any time soon  What I do keep track of is the company's ability to pay me that cheque now and in the future.  So long as the company is healthy and selling their goods, I am happy to own the stock.  During the 2008-2009 financial crisis, only 1 of the 20 or so stocks that we hold cut their dividends, the others either held their payment at the same level or a few even increased their payments.  So our dividend income actually increased overall during the financial collapse because the stocks we owned kept chugging along, regardless of the economy.  Capital appreciation will most definitely happen gradually as earnings and growth continue with the company, and if we really need the money we can liquidate some stock to free up some capital, but thats only under emergency conditions.

During our working (employment) years we roll all the dividends back into the portfolio to buy more stocks, so the dividends also act as a source of income to continue buying even more stocks... Hey, this sounds a lot like the compounding affect.  The bigger our dividend income gets, the more our portfolio grows as we plough it back in with more income.  The longer you can leave it alone, the bigger the cash-flow will be when you pull the plug on working.  When we are finished working or if we are taking a mini-reirement, we stop re-investing the money and just turn on the dividend spigot for our day-to-day cash-flow.




Thursday, July 26, 2012

Rule #10 Thumb your nose at the Joneses


One book that has influenced me a lot, with respect to finances, is  The Millionaire Next Door by Thomas Stanley and William Danko. In it the authors discuss how American Millionaires accumulate their wealth, how they handle their money, what neighbourhoods they live in, what cars they drive, what beer they drink and so on....  Its a bit dry and it states and restates the same basic themes over and over, but it has loads of useful data and anecdotes that show the true self-made-millionaire way of living.  I have it on audiobook so I listen to it on my iPod when I'm out for a walk or a skate.  Yeah, I'm just that cool, longboarding down the street listening to self-help tapes.

Anyways... a significant amount of the book focusses on lifestyle choice, and how "Keeping up with the Joneses" makes it very difficult to accumulate wealth.  There are those that live like millionaires, to impress friends or colleagues, who cant afford it (The Jones keeper-uppers), and then there are those who really are millionaires.... and they dont get that way by buying a new iPhone every time Apple makes an upgrade.  They get that way be being frugal and not buying crap to impress other people.  The book shatters all the typical stereotypes that the wealthy drive expensive cars, live in big swanky houses, and drink expensive champagne.   All these perceptions are typically not true for the truly wealthy... People who do live like that typically have lousy balance sheets.


Impressing other people seems like one of the stupidest reasons to buy or upgrade things that are fully functional or still modern.  I know a couple that bought a really big $1000 barbecue when they had a 4 year old fully functional one already.  The catalyst for that purchase was that their neighbour backing on to their yard had just bought a fancy barbecue himself, and our friend just couldn't live with the barbecue they already had once he saw his neighbours... He was being outdone.   So now they have a shiny fancy new barbecue, yet all they do is grill meat with it... well, their old barbecue already did that and it was in fine shape.  So there is $1000 spent on a needless item.  I wouldn't tell them how to spend their money - the earned it, they can do whatever they want with it - but for us, impressing others is very low on what motivates us to buy anything.

A rule-of-thumb that we live by is that we don't compete with friends of family on things we own.  We dress, drive and live in what's comfortable or what our profession dictates is a minimum - that's it.  Why drink expensive wine, when beer is what we like to drink?  Have we been financially successful? We've done okay.  But we don't flaunt it and we don't try and meet a standard of a particular social class... that's just not our scene.  This "not looking the part" is one of the best ways to save money.  In general, a consumption-based, status-driven lifestyle makes it very difficult to accumulate assets , no matter what your paycheque is.


Wednesday, July 25, 2012

Rule #9 Spousal Financial Compatibility is VERY Important.


"It takes two to make a marriage a success 
and only one to make it a failure." - Herbert Samuel

There is a married couple in our circle of friends who are definitely NOT financially compatible, and their marriage has almost ended in divorce a few times. They both have reasonably good paying employment, but he is a spender and she is a saver.  It has caused a lot of friction between the two of them.  Both of their credit ratings were shot because he didn't pay the family bills on time.  She basically had to take complete control over the couple's finances to make sure they didn't end up in the poor house, and now he resents her for controlling all of the money.  It certainly is not a great situation.



It's pretty important to find a life-partner who shares the same values as you do with respect to money.  This may sound like something your Uncle Jack says to you, and then you brush him off as some old fart who doesn't know what he's talking about.... Old People... What do they know about love anyway?  The fact is, whether you like it or not, finances will play a huge part of the day-to-day operations of a household, and you better make sure that you are both on the same page or it can kill the mood (if you know what I mean).

Money issues is one of the top 5 reasons couples split up, so it's pretty important.  If one of you is a saver and the other is a spender, and there is no agreed upon financial plan in place, it can be really hard for a couple to be pointed in the same direction to achieve your financial goals.  We look at OUR relationship as being similar to jointly owning a business called Fraser Holdings.  We both do what's right for the 'business' so our family can become more financially stable and meet our long-term needs.  Most people would never enter a business relationship with someone who spends the company money like a drunken sailor, so why do people not make sure they are in alignment when getting hitched or shacking up?

Tuesday, July 24, 2012

Rule #8 Your Home is not an Asset.

This is one of the topics where people tend to get a little bent out of shape with respect to our perspective on what makes something an asset or a liability.

If you buy something that pays YOU to own it, it is an asset. If you buy something that YOU PAY (net) to maintain or own, its a liability. Those are two definitions that WE use to describe almost everything we own or think about buying.  By these definitions a bought home is not an asset, it is a liability.  A lot of people have bought in to what they've been told by Realtors, Banks, Big Box Home Centres and HGTV - that their home is the biggest asset they own...  It certainly is one of the biggest purchases that people make, but is in an asset?  A home, whether it be a condo or a stand-alone house, does have intrinsic value, but the bricks, wood, fencing, and countertops if neglected or without maintenance, are most likely depreciating in value over time.  The only thing that is truly increasing in value is the land value.... because God's not making any more land.  It is a scarce and limited resource.

Then there are the monthly costs.  Lets have a look at a $300000 house that someone might purchase... What kind of expenses does a house of that size have? That home owner would now have to pay the following things... these things are pretty much non-negotiable... they must be paid: Mortgage, Property Taxes, Insurance on the home, Utilities, and General Upkeep.  If you buy a house or condo with monthly fees, you can add those in as well, but lets assume there are no monthly condo fees. We'll also ignore Land Transfer fees and all the other costs that it takes to make a Real Estate Transaction.




If you add all those costs up, the house costs about $2150 per month to keep it in your name. Of that $2150, only about $400 of the monthly mortgage payment will go on the principle in the first few years or so.  Lets also not forget the 25% downpayment or $75000 that needs to be put down in order to keep the CMHC fees low... I hate extra fees.  After the $400 is deducted from the $2150, that adds up to about $1750 of monthly costs.  So for the initial $75000 that you put up, you now will pay $1750 a month in costs that will fill other peoples pockets.  Its actually quite an expensive liability that you've purchased.  This is not to say that you shouldn't buy a house, because we all have to pay to live somewhere, but if you think of it as a liability and a lifestyle choice as opposed to an asset, you begin to view it quite differently.



Another path you could take with that $75000 would be to invest it in something that has a higher growth rate than a house, and pays you either a rental cheque, distribution or a dividend as a shareholder.  It should be reasonable to rent a house for the same amount... lets say $1750 all in and then save the $400 per month that would have gone on the house principle and invest it somewhere instead.  It certainly adds more flexibility if you wish to move within a few years and don't want a significant amount of your equity tied up in a house.

What about appreciation of my home/property?  Well, the average appreciation of real estate has been about 3.5-4.5% per year in Canada for the last few decades.  This is in contrast to the 2-3% typical inflation we have in Canada.  What this says is that either housing has been very undervalued in Canada and the market values are steadily catching up, or housing prices are, or will be, overpriced and due for a correction.... I tend to believe in the latter case.  Much of this market appreciation has occurred due to historically low interest and bond rates, which control mortgage rates, and the sustainability of low rates is always in question.  There are hotspots like Toronto, Vancouver, and Calgary that may be due for a correction, and local markets will vary, but lets not fall into the trap that real estate values always go up... because as we've seen with our neighbours to the South, house appreciation is not a given.  If you are banking on the house appreciation game, then you are also playing the timing game, and timing can be a difficult game to play....

There are lots of reasons people might want to own a house: pride of ownership, control over where they live and for how long, the ability to modify a home to make it their own.  These are all good reasons to buy a home for your own living... But by my definition, it is not an asset.

from tinyhouseblog.com


Sunday, July 22, 2012

Rule #7 Maximize income in AFTER TAX money.

If, as a big severance package, your company offered you $60000 in any of the following income streams: pension income, capital gains income, employment income, or dividend income, what kind of income would you choose?  Did you think about the taxes?  Most people don't.

I hate paying income taxes. I wont go into it in any detail because it gets political... and I only talk politics if I have a beer in front of me, and I don't right now, so you are spared the rant.  But with that said, we all hate paying taxes, especially on income.  Doesn't it make sense then to try and minimize the amount of tax one pays on your income?  Sure it does. This is called tax avoidance and it is perfectly legal... structuring your income in such a way as to be tax efficient.  I was introduced to this way of thinking about a decade ago when I came across a blog talking about the virtues of dividends... Canadian Corporation Dividends in particular.  There is something called the Canadian Enhanced Dividend Credit, and I won't bore you with details of it, only to say that it results in a lowering of the marginal income tax rate on those dividends.  You can find out more about it here.  

For those who don't know what a dividend is, its a when a company shares a portion of its earnings with shareholders by sending them a cheque... usually quarterly throughout the year.  Those companies have already paid taxes on those earnings, so you don't have to pay as much taxes as you would if it was standard employment income.  Let's have a look at a couple scenarios, where income could be from one of these different streams...  Employment, Capital Gains, RRSP or RRIF withdrawal (remember its taxed when you take it out), Dividends from American Corporations, Dividends from Canadian Corporations (those eligible), and other income.  "Other Income" could come in the form of a pension, rental property, royalties, typical government benefits, some income from REITS, servers tips etcetera.... all of which are taxed at the same rate as employment income.  I don't include business income as I have no experience with owning my own business, nor do I know the intricacies that go with it. 

The two scenarios are $60000 and $100000 in annual income.  The income tax regime is Federal and Ontario, Canada.  The basis of the calculations is from the taxtips.ca calculator page where you can run your own scenarios.



So the Total in-pocket amount is the most important column because thats the one that tells you how much you get to keep.  Notice the big difference in taxes from the Investment rows such as Capital Gains and Canadian Dividends (eligible) in comparison to the Employment, RRSP/RIF Withdrawal, and Other Income rows.  Markedly different isn't it. If you made $60000 in Canadian Dividends you would get to keep 97.6% of it, vs the 80% you'd get to keep in employment income.  Note that as an employee you would also be required (don't get me started) to pay CPP and EI premiums which will run you another $3000 a year or so in tax obligations that you wouldn't have to pay if you made your income from dividends or capital gains.  Again with $100000 income, the investment income rows fair substantially better in tax treatment.  When I recognized this a decade ago, I started thinking that there was a type of income that I wanted more of, and other kinds of income that I wanted less of.  It was one of those "Eureka!" moments for me.

So... 

Guess what kind of income I prefer. Then guess what I look for when I'm building an investment portfolio.




Friday, July 20, 2012

Rule #6 Forget the Latte, Its the Car/Vacation/Renovation Factor

"Screw giving up your Latte!" - me.

People who have read David Bach's books will be familiar with the Latte Factor.  Its the idea that cutting out small expenditures such as your daily cafe-bought latte, and socking the money away to save and invest, can add up to a really large pot of money further on down the line.  You know, save $5 dollars a day and it adds up quickly.  I don't disagree with this strategy... It intuitively makes sense.  Making your own morning jet-fuel can cost pennies a cup as opposed to paying $3 for a large black coffee at Starbucks.  But if I get some good social interaction while drinking that Starbucks coffee, it might be money well spent, at least thats the way I see it.  After work drinks are another example.  Not having a social life, or eliminating the simple pleasures in life, is not the cure for troubled finances.... And if it is, you probably have an income problem, not a spending problem.

In general, while we agree with the concept of the Latte Factor, we do not subscribe to the practice.  Rather than focus on cutting out the daily small costs, we focus on the bigger things that we can cut out.
If the objective is to save money, people who scrutinize every little purchase, but then drop $5000 on a family vacation, would probably be better off cutting out the vacation if they want to get ahead.  To me this is "not seeing the forest for the trees".  For us, lots of small daily luxuries can be paid for by just cutting out one big one.  Some of the big-ticket items that we have cut out of our lives, while still maintaining our daily coffee or happy hour fix with friends, are a second car, a motorcycle, a second home or cottage, vacations, and cosmetic house renovations.

Imagine how much money you could save if you got rid of your second car, your motorcycle, or that cottage you only go to 3 weeks of the year.  "The kitchen we have now is functional, but dammit I want stainless steel everything... and I'm willing to pay $20000 to get it."  That just sounds silly. Cut back the second car and if you only put away half of what you would typically spend on it, you'll still be saving more than most people do.

Here's mud in your eye... and in your cup!







Thursday, July 19, 2012

Rule #5 Know your Monthly Expenses!

Know your monthly expenses!

We don't really have monthly budgets - we pretty much pay everything off every month - thats about our only rule regarding budgeting we have.  If we can't pay off something in one month, we've spent too much and its time to cut back our spending.  We do however know where our money goes because we've tracked our spending 3 times in the last 8 years, and thats my rule... know where your expenses are and what you spend on them... but how can you really know what you spend your money on?

At least once in your life, the earlier the better, keep detailed records of household expenses for a three month period.  Three months are better than one because it lets you smooth/average out expenditures such as groceries if you do the odd Costco run for example.  Diligently tracking your expenses is one of those exercises that is a royal pain-in-the-ass when you are doing it, but it can really be an eye-opener and a very useful tool to determine where your money is going.  Whats that? You already know where you are spending your money? I did too until we did it for the first time about 8 years ago.  We thought we were spending about $500 a month for the two of us for groceries.  The thing was, we were both buying groceries so we weren't always aware of what the other was spending.  In the end we were actually spending about $700 a month on groceries.  It wasn't a bad thing to spend that much each month for groceries - the point was we were spending 40% more than we thought we were spending.  We talked it over and said to ourselves "Is that a reasonable amount for a couple to spend each month on groceries?" In the end we changed a few things and settled on a number that we were prepared to pay and adjusted our spending habits.

We noted a few expenditures and then challenged ourselves whether we thought the money was well spent... I discovered I was spending about $80 a month for coffee at work.  I didn't realize I was spending so much on coffer for me and for other people.  People who know me, know that I am a very frugal man so spending $80 for coffee at work sounds like an excess, and on paper it was.   The thing is the industry I worked in had a coffee culture - one where relationships were usually built over a cup of coffee - and in that business, relationships were often just as important as technical ability.  I saw this as an investment in my career and work satisfaction so the $80 coffee budget stayed in.

The great thing about tracking expenses is that if and when you do decide to save and invest more, you know whether you even have left-over money to save, or whether you are going to need to make some adjustments.  Some of monthly expenses will be fixed such as rent or mortgage payment, but others will be variable such as spending on entertainment, booze, gasoline, heating costs etc...

Tracking your spending also has an interesting side effect.  Knowing that you will be documenting your purchases, I am pretty sure it will make you think more about what you are buying.  It actually makes you more conscious about what you are buying while you go through the exercise.  Give it a try.

Here are some of the buckets we group our spending into

Fixed Housing (Rent)
Variable Housing (Utilities, Heat, landline, internet)
Groceries
Entertainment
Booze
Car (gas, insurance etc...)
Clothing for Work
Clothing for our Kids
Gifts





Wednesday, July 18, 2012

Rule #4 Never Carry a Credit Card Balance... Ever



"Money is just the poor man's credit card" - Marshall McLuhan.


This one is super easy. Nobody is going to say its a bad idea.... If you do think its a bad idea, you may need your head checked.   Carrying Credit Card Debt to the point where you start paying interest, especially when you have access to cheaper interest rates, is a no-no.  I just did a quick search online and the lowest rate I could find in Canada was about  a 10% annual interest rate.  The majority of the standard credit cards, including the ones we have, charge about 18%.  And if you get a Sears, Canadian Tire, Home Depot credit card, or any other Non Visa or Mastercard, you end up paying 22-28%.  But Ryan, my monthly payment is so low, why should I be fussed about paying it off?  Because its two to five times the interest rate you could be paying if you just got a regular line of credit at 5-7% and moved the balance over.  Or better yet, save your money first and then buy it without having to borrow.  We generally never pay interest on something that depreciates in value (another rule I will write about later) so we almost never carry a balance on any of our credit vehicles.  We view it more as emergency credit.

Okay okay, some people won't save, or want to make purchases before they have the money.  Lets assume you do decide to borrow money to buy something on a credit card and let it ride from month to month. What is the comparison on the amount of interest you pay? Lets say you bought yourself a washer and dryer and it cost $1000, or maybe a hot tub for $5000, or how about a motorcycle for $10000.  Here's what you'd pay in monthly interest for an 18% credit card vs a 6% Line of Credit:


Quite the difference. Remember this is interest... the first 15, 75 or 150 bucks you pay each month on that credit card just goes to servicing the interest...As opposed to the Line of Credit amounts that are one third the credit card rates.  If this isn't a no-brainer I don't know what is.  Use a credit card to buy stuff, and then each month flip the complete balance over to a Line of Credit or better yet pay it off. Easy Peasy.  Don't you feel like a dumb-ass now for buying that motorcycle on credit card and NOT moving the balance over to your LOC?  If you ask me, paying that kind of interest, for consumer items that are worthless within a few years, is the beginning of the death spiral for your finances.

A note about introductory incentives... I once got a card from Sears just so I could get a smokin' discount on some patio furniture. Once I got the bill I paid off the balance and then canceled the card... That card had a 28.8% interest rate.  I kept getting solicitations for opening another card with Sears for years after that... I was in the vortex of their mailing and phone list just for signing up that one time... and I like my privacy... so now I wont even get a card for one of their promos.  They are just looking for a way to rope you into that mega-interest rate.

We use our credits card quite regularly for their convenience - mostly so that we don't have to bring money with us for bigger purchases when out and about, but we always pay them off within a week of making the purchase so that we are in the grace period where no interest is tacked on to the balance... This grace period is something like 21 days but there is nothing stopping the credit card companies from changing that, OR more likely if its not paid off right away I would forget about it and eventually get charged.

In the last 10 years, we have used our credit cards every month, but have not paid 1 red cent in interest on those cards.  We never ever leave a balance on them.  Ever.

Tuesday, July 17, 2012

Rule #3 Defining Assets and Liabilities

We aim to accumulate Cash-Producing Assets that increase their cash-flow over time at or above the rate of inflation.  This is one of our big overarching rules for our Financial Independence strategies.  At a later time, I will talk more about this strategy, but for now I want to tackle some definitions.    This strategy revolves around how we define things we own in our lives, and it is one of the rules where we tend to deviate from other financially-minded people.  We view almost everything we own as either an Fiscal Asset or a Liability.

Here are OUR definitions:

Asset: An asset is a thing that you own that produces positive cash-flow
Liability: A liability has negative cash-flow.... it pays you nothing or costs you money to own.

This sounds fairly straightforward until you start putting things you own in each of the buckets.  So lets list off some.

Some Assets would be:
  • Rental Property 
  • Stocks that Pay a Dividend 
  • REITs 
  • A Profitable Business you own or have shares in
  • Bonds 
  • Farm Land that is being rented for farming 
  • Royalties from something you created, designed, or have the rights to 

Some Liabilities would be
  • A Car
  • A Home 
  • Bare Land 
  • Gold
  • An iPhone
  • Stocks that Don't Pay a Dividend
  • A Television
  • A Computer
  • A Swimming Pool
  • An Unprofitable Business
  • General "Stuff"
  • A Pet

While taxes and debt are also a liabilities, I will talk about those at another time as we treat them differently.  People often take exception of us putting a car, home, and swimming pool in the liability bucket.  Especially their home.  All of this things have intrinsic value so on a typical net worth statement, they would go in the Assets column, however the way we look at it, all of those things cost you money to maintain them once you own them.  So by buying them, you are also adding on a monthly-burden of other costs such as fuel for your car, taxes and upkeep for your home, a mortgage payment on bare land, a monthly plan for your iphone, cable for your TV, Internet for your computer, and chemicals for your pool.  You also need to store your "stuff" which may require that you rent or buy a bigger place to live in.   Its not to say that we don't own some of these things because we do, or have done so in the past, but we are very conscious of how much these things will add to our monthly operating expenses as a family.  These are not one-time buy-and-then-you're-done items.  They can add a lifetime of monthly costs to you.  Ultimately our goal is to minimize things in our life that create monthly-burden payments.

Gold and Stocks that don't pay a dividend are a bit special because many would consider them assets as they have a reputation for going up in value. Well, if you bought Gold at $1000 and it went up to $2000, how much have you made?  The Answer is $0 unless you sell it.  We don't count paper gains (or use mark-to-market valuations) as true gains like the banks do.  The very next day, your gold could go down to $900, and if you didn't sell it on the way down from $2000, now your gold is in a losing position.  Gold pays you nothing to hold it, the price can fluctuate up and down, and it never sends you a dividend cheque for all of your trouble and not to mention the risk you put up just to hold it.  I'm not saying you shouldn't buy some because it may make sense to you to do so.  Gold has appreciated in value quite a bit a these last few years, but there is nothing to say it won't go back down again.  This holds true for non-dividend paying stocks as well (Think Research in Motion - You only made money on it if you got in and out at the right time)  This is why we do not consider Gold, and Stocks with no dividends, assets.

Monday, July 16, 2012

Rule #2 "Lotteries are taxes on the stupid"


Rule #2 is pretty straight forward.  We don't play the lottery or do any other gambling where the odds are not stacked in our favour (and none are).

I played the lottery once about 14 years ago. It was one of those deals where someone from the office went around and convinced everyone to chip in a buck and then he went and bought a bunch of tickets for the department and if we won the Lotto 6/49 we would split the pot.  I quickly forgot about it, and then next week this person came around and asked me for another dollar.  "Is this going to be a regular thing?" I asked. "Yes! Now that we have our numbers picked, we have to keep playing them or someone else might take our winnings."  I decided there and then that I would cut my losses and not participate in the weekly Lotto pooling.  Being a numbers guy, I was keenly aware of the odds of winning the big pot of the Lottos 6/49 are low - 1 in 14 millions or so - so low that its like pissing money away... and if I am going to piss money away, I might as well do it drinking beer with buddies instead.  I at least see value in the socialising that goes along with the beer drinking.

Some polling shows that in some demographic groups of Canadians, 30+% expect a lottery win to fund their retirement.  This is shocking.  And the government is an accomplice to this ridiculousness.... it puts out all these advertisements that prey on people's fantasies of getting rich without having to work or save for it.  Sure, "Dream of all the stuff you could buy with $50 million dollars.... Every week somebody gets a big cheque and all they had to do was buy a ticket... This week it could be you!"   Approximately half of 6/49 revenue is returned to winners and the other half goes to the government... and its not unreasonable to think that some of that money goes to support people who haven't looked after themselves, because they were too busy buying lottery tickets instead of saving their money!

I view lottery tickets, and gambling in general, as "Taxes on the Stupid", or perhaps "ill-informed" would be a more PC way of describing it.  It sounds harsh but I believe it to be true...  If you remind yourself what the odds really are its baffling that people play it at all.  I did a quick calculation and here is an interesting way to look at it:  If a person played once a week from age 20 to age 80, that person would have to play 4500 lifetimes before the odds would go in your favour... and then when you did win, you would only get half of your money back.  Thats right, 4500 lifetimes... Amazing!

I don't want to tell people how to spend their money, and if they are truly doing it because they get a rush out of the beyond-longshot chance they might win, good for them.  But if people think the lottery is going to fund their retirement, they need a good shake.


Sunday, July 15, 2012

Rule #1 The Power of Compounding - Earlier is Waaaay Better!

When I was in Grade 10 math, Mr Gunter once put up a handmade chart that showed an example of how compounding interest worked.  The first scenario was for a person named Gordon, who at the age of 18 started saving $2000 per year and managed to get a 10% return on it each year. He continued to save $2000 every year and placed it in the same investment vehicle until he was 28 years of age.  He then allocated his money on other things in his life such as a buying a house, starting a family, saving for his kids' education etcetera and etcetera.  He never touched the money in the investment account.  That would be his retirement account.

At the age of 65, Gordon would have about $1.3 million in his account.  Wait a minute Mr. Gunter, can that be right?  Yes, it is! Its the power of compound interest Ryan, and Einstein called it the 8th Wonder of the World.  Its just that great!  This was one of those "Eureka!" moments for me. $2000 isn't that much to come up with each year... about $175 a month, and to think that I could just do it for 10 years and then I'd be set, well sign me up.  But, maybe I will buy that used car I've been eyeing up... it only costs $2500, I will start it next year... or maybe after I am done University, or Grad School, or after I've traveled the world.  Yeah, thats it, I will wait 'til I am a little more established before I start saving and investing.

Then Mr. Gunter showed us a second scenario.  This time he put up a chart of Gordon's friend and classmate, Simon. Simon waited until he was out of school and established in his career before saving and investing. He had a nice car, was renting a sweet condo, and dressed very smartly.  Simon saved $2000 a year starting at age 28 and then continued to save the same amount every year that he could. He had waited a little longer to get started at investing, but would contribute longer towards his savings and investing, perhaps until he was 65 and ready to retire. He too would get a 10% return and not touch the money in this account as this money would be for his retirement.  At the age of 65, Simon would have only $800000 for his retirement. Not too shabby, but still about half a million dollars less than Gordon.



So Gordon saved and invested $20000 for his retirement and it was worth $1.3 million at age 65. Simon saved and invested $76000 for his retirement and it was only worth $800000 at age 65. Simon put up almost 4 times as much in savings as Gordon, yet finished half a Milsky lower. The difference of course is the time factor... compounding needs time to work its magic and the longer you have it working for you, the bigger the paycheque is at the end of the investment period.

This example that Mr. Gunter showed us in class has stuck with me since that day, and I owe him a big thank-you for showing it to me.  It wasn't part of the curriculum (no money smarts strategies are) but he felt it was one of those things we just ought to know.  Its one of the most important money lessons I've learned: To start as early as possible and let the compounding work its magic for a long time.