This article was originally published in Maclean's Magazine on November 26, 2007
Six Questions on Household Finances
Everybody's financial picture is unique. That's why there's a booming industry in dispensing money advice. But if you're going to try to run a household these days, there are a few basic questions everyone will run across. Here are the answers to those questions, straight from the experts themselves.
For just about everyone, your home will be the cornerstone of your financial future. So it's no great surprise that, with its barrage of reality television shows devoted to house hunting and home renovation, HGTV has made home ownership into something of a recreational sport. Of course, the cameras conveniently turn off when it comes time for the daunting decisions that seal the deal. Figuring out exactly how much house you can afford, and finding a mortgage that won't crush you, might be the most important financial decisions you'll ever make.
The first question obviously has everything to do with how much money financial institutions are willing to lend you. And that, in turn, depends on your income and how much debt you already owe.
In loose terms, the amount of mortgage you can afford will be equal to about four times your gross income, according to Brad Compton, a mortgage broker with Invis Mortgage in Toronto. "It's more of a rule of thumb because obviously everyone is different," he says. "But an average person with a middle income and $2,000 in outstanding credit card debt will hit the four times mark."
More specifically, mortgage lenders such as the big banks will tally up your potential home ownership costs, like principle and interest payments on your mortgage, property taxes, utilities and any condo fees. Most lenders want to see those costs add up to no more than 32 per cent of your gross monthly income. Next they will add on how much other debt you owe each month, such as credit cards and car payments. Taken all together, your total debt service ratio (TDR) must not be more than 40 per cent of your income. So, for instance, if your gross household monthly income is $5,000, then the amount you owe for your house and other debt must not exceed $2,000. If your TDR comes in high, then you have to either cough up a larger down payment, or consider buying a cheaper house.
But even if you do have enough money to borrow the maximum, that doesn't necessarily mean you should, say advisers. A lot depends, of course, on where you are in life. A couple with no kids and few debts will be fine taking out the maximum mortgage. The problem is, lenders don't always factor in costs associated with raising children. "That's a wrinkle that isn't looked at by the banks," says Mike Cherney, a certified financial planner in Toronto. "A couple with children might want to ease back on how much they borrow." That could mean aiming for a total debt ratio in the low 30 per cent range instead.
Having figured out how much you can borrow, the next big decision is whether to lock in interest rates with a fixed-rate mortgage or opt for one with rates that float. There is no magic answer. Financial advisers will tell you that over the long run variable mortgage rates, which swing over time according to cuts and hikes made by the Bank of Canada, tend to be the cheaper way to go. Mark Neufeld, a financial adviser with Rogers Group Financial in Vancouver, says in some cases it can mean savings of up to $50,000 over the life of your mortgage.
But it really depends on how comfortable you are with risk. Say inflation jumps in the coming years, which, with Canada's overheated economy, is a very real possibility. The central bank will be forced to hike short-term interest rates and that will trigger a rise in variable mortgage rates, meaning it will take you even longer to own your house outright. "Are you going to be on the edge of your seat every time the Bank of Canada has a new announcement?" says Neufeld. "That will keep some people up at night." In that case, especially for first-time homebuyers, it makes more sense to lock in mortgage rates for the first five years, and then switch to a variable mortgage later on.
The tough decisions don't end once you've moved into your new home, though. Over the years, you're likely to add to your brood, and those four walls may start to feel a bit constricting. This brings up a whole new question. Do you renovate or just move into a bigger home? It used to be families spent decades in one house unless they had to move for a job. Now young people think nothing of trading up after barely five years. So what works best for a growing family?
The first thing you have to ask yourself is how much more house you need, says Mike Berton, a financial planner in Vancouver who went through this very question in 2001. Berton and his wife were planning to have a third child and needed to upsize their digs, so they got quotes from contractors about how much the renovations would cost. Once you know that, he says, look around and see if you can get a house that will be as nice for the same price. In Berton's case, his $300,000 house needed $220,000 in work. But after spending a long time house hunting, they couldn't find a house for half a million that they liked as much. With today's red-hot housing market, such a task would be even harder. "You can't buy a neighbourhood," he says. "It's hard to equate it to money, but is your old street quiet, close to a school, with neighbours you like?"
What's more, on top of the sale price of buying a new house there are other costs to consider, such as real estate commissions, legal fees, land transfer taxes and possible penalties if you break your existing mortgage. Those can easily add up to more than $20,000. As an added reason to go the reno route, the government offers a GST credit on fees paid to a contractor for a major home renovation.
Having said all that, there are some important things to consider before embarking on that renovation project. Where will your family live while the house is being ripped to pieces, and how much will that accommodation cost? What's more, can you even find a contractor you trust to do the work? Berton says the contractor he used now has a three-year waiting list.
At least that will give you plenty of time to catch up on all those home reno reality TV shows.
Congratulations, you've got a roof over your head and the baby-making part is complete. Now for the tough stuff. After paying off next month's credit card bill - the one with the Bugaboo stroller, BabyBjörn and that perfect little snowsuit from Baby Gap - it's time to start saving the $111,100 it's going to cost to send junior to university.
That's right, mom and dad, experts say a four-year undergraduate degree at a Canadian university - including room and board - will be closing in on the $30,000-a-year mark when your future doctor/lawyer/teacher/telemarketer heads to campus in 2025. Not so cute all of sudden, are they? Well, don't panic - financial experts have some advice.
Most agree that a Registered Education Savings Plan (RESP) is the best place to start when saving for your college-bound bambino. "Where else are you getting a 20 per cent return these days?" says Patricia Lovett-Reid, a senior vice-president with TD Waterhouse. Lovett-Reid is referring to the fact that the government will top up your RESP contribution with a 20 per cent bonus (called the Canadian Education Savings Grant) up to a maximum of $500 annually. There are additional grant programs for lower-income Canadians. As well, the money invested in an RESP, which can be set up through any bank, is sheltered from the taxman until your child uses it and, even then, is only taxed at their income bracket. And thanks to Jim Flaherty's 2007 budget, Canadians can now invest up to a total of $50,000 per child into an RESP.
The advantage of an RESP is clear when you crunch the numbers. If you can sock away $250 a month (including the government top-up) into an RESP, and it earns an average of eight per cent a year, after 18 years you will have paid $45,000 into the fund, but its total value will be $115,024 by the time your kid is hanging posters in their dorm room. Compare that with someone who invests the same amount (less the CESG, of course) per year for 18 years in a non-registered account and also earns an eight per cent return. Their grand total: $82,972.
But what if your child doesn't bother with university? Maybe he or she skips it for the PGA tour and there isn't another child to take over the RESP. In that case, the CESGs are returned to the government but the investment income is refunded to the subscriber (you) as taxable income. There's a 20 per cent surtax on top of that, but parents can avoid it by putting the money into an RRSP.
"Parents should use the RESP as the cornerstone" of education savings, says David Ablett of the Investors Group. But if you think you'll need more than an RESP will provide (perhaps your little darling has her heart set on Harvard), there are other options. Formal trusts can ensure that the money will be used for education, but can be expensive to set up (a lawyer and annual tax returns are required). Informal trusts are cheaper, but, warns Ablett, the lack of a formal arrangement could result in the Canada Revenue Agency deeming all the investment income taxable in the hands of the parent.
Another top-up alternative is an insurance policy, which is less expensive and time-consuming than creating a trust. By transferring ownership of the policy to the child at 18, says Ablett, the child can access the cash surrender value and likely pay little tax. If your child doesn't use the policy for education, it can provide life insurance coverage with low or no premiums for when he or she is older.
Almost as important as investing early is starting the discussion with your kids about paying for university as soon as possible, says Lovett-Reid. She suggests getting them involved by saving through a part-time job (after all, it is their education). And, in the case of parents who really can't afford to help, Lovett-Reid says it's a bad idea to sacrifice your own retirement savings for the sake of the kid's college fund, "because the parent doesn't have as much time to make up the lost ground." If that means the kids have to take on some student debt to get a diploma, so be it. You can't baby 'em forever.
Once you've got the house and the college fund taken car of, it's time to think about filling the driveway. Buying a fun car is one thing, buying the right car with the right financing is more difficult. But if you want to pick up the most financially sound vehicle you can, learn to love the 2005 Dodge Caravan.
Sure, maybe it's not the hottest looking vehicle on the road, but what it lacks in style, it makes up for in other ways - ways that make it the savvy car-buyer's dream purchase, explains George Iny, president of the Automobile Protection Association in Montreal. It can be picked up off-lease (having depreciated about 50 per cent) for a little over $10,000. It's a reliable car - with seating for seven and air conditioning, no less - yet that isn't reflected in its market value, unlike most Toyotas and Hondas that hold their value better. When financed with a bank loan, the monthly payments would be roughly equivalent to leasing. And by 2014 or so, it would probably still be worth $2,000.
The used car today is the best value, says Iny. Particularly with the strong dollar and the large supply of used cars in the United States that trickle into Canada, there are a lot of good deals to be had. Of course, the used car isn't for everyone. Buying a ride is a very personal experience (even an irrational one when it steers into questions of taste and style), and there are advantages and drawbacks to all the methods of buying: whether used or new, buy or lease. "Depending on how you cut the numbers, it's really close either way. It comes down to a lot of other factors rather than just mathematics," says Greg Holohan, an executive with ScotiaMcLeod
Leasing has emerged as a popular option in Canada in the past decade, as cars have become more expensive. Among Canadians in their 30s, 45 per cent lease compared to 48 per cent who still buy with a loan, according to J.D. Power and Associates. The popularity of leasing has to do with the low monthly rates - you don't pay for the whole car, just for the three or four years you have it. It works well for those who want a new car regularly, are concerned about monthly cash flow, and don't want to worry about breakdowns.
The flip side of leasing is that, in the long-term, it's far more expensive than buying. "Over three leases, you'll be behind someone who buys a car by at least $15,000 dollars," says Iny. When you buy and when the payments are done you own a car that still has, ideally, many good years left under its hood. But there are no guarantees. "It's just like the market - if you're an owner you bear the risk," says Holohan. And a car, unlike a house, should never be looked at as an investment, since it depreciates very quickly. Anyone who plans to sell a car after four years should forget about buying, says Iny.
One of the trickiest questions in car buying is financing. Should you do it through a dealer or a bank? In the end, there isn't a whole lot of difference between the two options. Some find it convenient to do both the buying and financing at the dealership. Banks, on the other hand, may be able to offer a slightly better interest rate than what the dealer is offering, so it's worth shopping around. "A credit union is a good choice," says Iny. "You may be able to go back to the dealer and say, 'I know you can do better.' "
When it comes to the fine print on leasing, put as little money down as possible, says Iny. If the car is written off, or if you have to end the lease early (which can be expensive on its own), it's money you will never see again. If you have money lying around for a sizable lease down payment, it would be far safer to invest it someplace else.
Still, if you're looking for the best bang for your buck, and you've given up on impressing the neighbours, learn to love the Caravan.
So, if you've got a house, kids, and a car in the driveway, chances are you've also got debt. The question is, how much is too much and what can you do about it? "If you're spending more than 15 per cent of your income paying for your consumer debt (that excludes house and car debt) you're in deep doo-doo," says Gail Vaz-Oxlade, a financial adviser and tough-talking host of Til Debt Do U$ Part on the Slice network.
For many Canadians, who've opted in recent years for spending over savings, staying below that mark isn't easy. In 2006, Canadians charged $215 billion on their credit cards, up from $170 billion in 2004. Not everyone pays the balance off in full every month, which means that many of us are getting killed by interest rates of 18 per cent or more. Things are even worse for those enticed by the introductory rates offered by many American credit card companies that have come north. Some charge 35 to 40 per cent (including all the fees and insurance) after the six-month trial period is up, says Vaz-Oxlade.
If people can't control themselves in the mall, they should at least help themselves by transferring to cheaper credit cards (in fact, just threatening to take your free-spending ways elsewhere is often enough to get a couple of points shaved off your interest rate). Vaz-Oxlade also recommends passing on department store cards, which commonly charge 28 per cent on unpaid balances. The exception, she says, is to sign up for the one-time-only 10 per cent discount, pay off the balance in full and then cut up the card. Also avoid payday advances. As for "buy now, pay later" purchases, even those with the best intentions fall on hard times and can't pay it off in full when the time comes, and that can lead to spiralling debts. "Interest is immediately calculated on the 12 or 18 months they've given you," says Vaz-Oxlade. You're better off putting a big purchase on a line of credit. In fact, she recommends consolidating all your high-priced debt into a credit line - especially one tied to the equity of your home - because it's "relatively cheap."
Of course, no matter how inexpensive the debt, your troubles will multiply if you don't pay down the principal. Vaz-Oxlade was recently working with a couple who had a combined income of $135,000 and a $15,000 line of credit with a 9.5 per cent interest rate. Nothing to worry about, right? Wrong. The problem was, their monthly payments were $125. "It was going to take them 47 years to pay it off at a cost of about $46,000 in interest," says Vaz-Oxlade, who recommends an emergency fund of three to six months of expenses to protect against an unexpected credit crunch.
In Richard Cooper's world, all debt - aside from mortgages - is bad. And the problem with consolidation, he says, is that many people trying to stave off a financial crisis have a credit rating that is so bad only subprime lenders charging 25 per cent or more will be willing to take a chance on them. "It's pretty tough," he says, "to borrow your way out of debt."
That's where Cooper's Markham-based company, Total Debt Freedom, comes in. Cooper's staff approach creditors and try and negotiate a settlement on the unsecured debt of their clients at a reduced amount. This works, "as long as you can give them a reasonable hardship story, like this guy just didn't wake up in the morning and decide to rip off his creditors," says Cooper, who started his company in 2005. "Bad choices, bad business decisions, a divorce, whatever. You have to let them know that he didn't do this intentionally." The goal is for the client to pay about half (including the creditor's settlement, Total Debt's fee and GST) of what is owed, says Cooper. "[Credit card companies] don't want to take it, but they know it's better than the guy going bankrupt since they'll get next to nothing that way," he says. Though his business is in a "recession" right now due to the economic boom, it will likely be the business to be in if the economy cools, as many suspect, and debt catches up with Canadians in the next couple of years. The best way to avoid being one of his clients is to keep debt to a minimum and pay it off as fast as humanly possible.
Okay, so you're living the good life. Or at least the pretty good life. You're paying off the mortgage and dreaming of retirement. But one of the most important decisions has to do with what happens come the end of it. Your life, that is. Pondering your ultimate demise isn't high on anyone's list of fun things to do. Yet financial planners say even spending a little time asking yourself some important questions can help you decide whether life insurance is right for you. And if so, how much your family will need.
The key is to figure out what you want the coverage for in the first place. Is it to replace lost income after you're gone, or for estate-planning purposes? For those with young children and the burden of a mortgage to consider, the key is to have enough insurance to keep surviving family members comfortable after you're gone. "Besides the grief of losing the insured person, you don't want your dependents to have to significantly adjust their lifestyles," says Mike Cherney, a financial planner in Toronto. "If you have children, you need enough income to support them until they are old enough to be on their own." As a rule of thumb, planners say, that means providing a pile of cash that's between eight and 10 times your current salary.
In many cases, that means looking at term insurance. As the name suggests, the policies exist for a certain period of time, say 10 or 20 years, and then expire. Planners compare it to leasing an insurance policy. In the case of a family with very young children, it might be wise to take out a 20-year policy. If the kids are much older, five years might do. The thing is with each year you age, the cost of the premiums can go up dramatically, so you want to buy early, and make sure you have enough coverage, but not too much. At the very least, planners suggest having enough insurance to cover the outstanding balance of your mortgage. The bank lending the mortgage might even demand it.
There are other types of insurance out there, of course. Whole life insurance is a permanent policy you pay into over your entire life. The premiums remain the same and are usually less than in the case of term insurance. But the ultimate payout can wind up being much smaller, depending on how much you've put into the policy.
Meanwhile, the insurance industry has been busy coming up with new types of policies. Critical illness insurance pays out a lump sum if you must stop work due to certain illnesses, while long-term-care insurance is slowly catching on now that people are living so much longer and require special care. But the costs for all that insurance can quickly add up.
Exactly how much life insurance is going to cost you depends a lot on how you've been living your life. A male in his mid 30s who smokes and is overweight can easily expect to fork out steep premiums of more than $80 a month for term insurance. If, on the other hand, you're very fit and smoke-free, premiums can come in at around $26. Premiums for women are cheaper across the board.
Deciding which insurance company to go with is something best done with a financial planner, but thanks to the Internet it's easy to do your own research first. One good website for comparing term insurance policies is term4sale.com, which offers quotes from 20 different companies based on a short list of questions about your health and insurance needs. But, cautions Wayne Lang, a financial adviser with Assante Capital Management, it doesn't always pay to shop by price alone. "You may never have heard of them," he says. "You want to ensure that they'll be there when you need them." Or, to be more precise, when your family needs them.
At the end of it all comes the reward: the chance to put up your feet and enjoy the fruits of your working life. At least, you hope so. The popular notion about retirement these days is that few people think about it early enough in life, and even fewer manage to save enough money to realize their retirement dreams. There's no shortage of grim statistics to back it up. A survey last week by Desjardins Financial Security, for instance, found that 66 per cent of Canadians don't have a retirement savings plan at all.
The message is that today's workers are destined to pass their golden years in crummy nursing homes and trailer parks. But experts say you should take the ugly numbers in stride. For most, there's no reason to panic. For those who still have a good number of working years ahead of them, a comfortable retirement is within reach. It may require some foresight and simple planning, but not the kind of superhuman saving Canadians are often led to believe is necessary.
Everybody wants to know how much money they'll need to last them once the rat race is over. Unfortunately, as any financial adviser will say, there's no magic number. "Retirement isn't so much a financial event as it is a life transition," says Greg Holohan, with ScotiaMcLeod. What you need depends on how you plan to pass your retirement (in a La-Z-Boy or travelling the world?) and how comfortably you want to do it. Most advisers recommend planning to live in retirement on 70 per cent of the income earned in your working years. But even that can be flawed. It's actually quite high, argues Malcolm Hamilton, a consultant and actuary with Mercer. Even 50 per cent would probably suffice, given that in retirement people typically have far fewer of the big expenses and debts they had in their prime working years, he says.
Regardless of the exact ratio, it can add up to a lot of money, and getting to that number might seem daunting. Any middle-income Canadian with a mortgage, children and a car knows that at the end of the day, there isn't much money left to save. But people shouldn't feel "unduly depressed and unduly burdened early in life if they can't save a lot," says Hamilton. "Most Canadian families trying to pay off a mortgage have no choice but to live frugally, so I cut them slack on their retirement savings."
While it's okay to focus early in life on mortgage payments (which are, after all, a form of retirement savings), don't get carried away focusing exclusively on building up equity in your home. Advisers warn that housing markets fluctuate, and house values can drop significantly. "The one rule that has almost no exception is, diversify. If you've got all your eggs in your house, you're breaking that rule," says Hamilton.
It is important to find a workable balance early on between paying off debts, and putting at least some money into an RRSP, which has the big advantage of deferring taxes. The "pay yourself first" concept is still a very powerful one, says Holohan. And it's a good practice to get into for later in life when retirement savings should be a higher priority.
Another key question is how to invest your savings. RRSP contributions can go in a variety of places, from stocks to equity funds to bonds. Advisers say that the younger you are, the more your investments should be weighted toward stocks (over time, the market will outperform bonds). As years go by, you can gradually shift toward more conservative, slower-growth investments. Not everyone is comfortable being heavily invested in stocks, however. "You have to be able to sleep at night. That's the most important thing," says Jamie Golombek, vice-president of taxation and estate planning at AIM Trimark Investments. The biggest mistake is to get beyond your comfort level, he adds. That's when people begin to get emotional, selling low and buying at high points in the market.
It's also important to note that mutual funds come with fees attached - some high enough that they can seriously hamper returns. The fees are measured in what's known as a management expense ratio, or MER. Funds with the lowest MER aren't necessarily the best, but be wary of anything much higher than the average of about 2.5 per cent.
For those lucky enough to have a pension, which draws contributions off of paycheques automatically, there's even less reason to panic about retirement. Public sector employees often find they've saved enough through their pension to comfortably retire early.
Saving for retirement is, in the end, about balance and choice. Get help from an adviser, but don't be bullied into a plan you're not comfortable with. Hamilton says that if you want to scrimp and sacrifice for 30 years to live wealthy in retirement, do it. If your savings are more modest in your early years, where mortgages and kids are your priority, well, that's okay too.
Maclean's November 26, 2007