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The Magic of Compound Interest
Albert Einstein was a pretty smart guy – I think we can all agree on that. The man who gave us the Special Theory of Relativity and the General Theory of Relativity famously said that the most powerful force in the universe was….?
Compound Interest!
Would you agree then, that this is something we should take a closer look at since it relates to investing and not atomic theory? :) Okay, if you are still reading I’ll assume you are, in fact, in agreement. Now it is time to either excite you or depress you based on your age!
First let’s define compound interest. Compound interest means that the interest you earn on an investment is based on both the principal (the amount you started with) AND the accumulated interest as well. So the interest you earn is always being calculated on an ever growing amount, meaning the interest you earn is always more than in the previous year. This is different than “simple interest” in which the interest you earn is only based on the principal amount at any given point down the road (i.e. the interest you earn is the same year in and year out). What’s the big deal? Well, I think it is best explained with an example…
Let’s suppose we have a fictitious GIC which earns 10% (compound interest). And let’s say we start with $1,000. Here is what the investment looks like over time:
Start of Year + Interest Earned = End of Year Amount
Year 1 $1,000 + $100 = $1,100
Year 2 $1,100 + $110 = $1,210
Year 3 $1,210 + $121 = $1,331
Year 4 $1,331 + $133 = $1,464
Year 5 $1,464 + $146 = $1,611
…
Year 10 $2,358 + $236 = $2,594
Year 20 $6,116 +$612 = $6,727
Year 30 $15,863 + $1,586 = $17,449
Year 40 $41,145 + $4,114 = $45,259
Year 50 $106,719 + $10,672 = $117,391
You can see that it started off pretty slowly, but at year 50 the interest alone was 10 times the original $1,000 investment. Now, what if you put $1,000 into this fictitious GIC EVERY YEAR? At year 50 you would have $1,280,299. Yup, $1.25 million.
Do you know how much $1000/year is on a monthly basis? $83.33 per month.
In fact here is something to think about. Let’s say we have two people, Johnny Saver and Joe Blow. Johnny Saver saves $1,000/year for 8 years and then stops saving his money. Joe Blow PROCRASTINATES like everyone else on the planet. He starts saving $1,000/year 8 years from now (when Johnny Saver has stopped adding money to his savings.)
In year 8, Johnny Saver starts the year with $11,436 saved and earns $1,144 in interest. Please note that $1,144 in interest (which is added back to his account) is more than the $1,000 that Joe Blow is starting to save to HIS account. Joe Blow comes to a very sad realization. He could save $1,000 per year for eternity and Johnny Saver would never again have to add a penny to his savings and Joe Blow will never have more money saved than Johnny Saver!
Let’s look at the results if this started at age 18 for both of them (and assume a retirement age of 65):
Johnny Saver starts saving $1,000/year at age 18 and stops saving at age 26 (total years of saving was 8, for a total investment of $8,000). At age 65 he would have just under $500,000 to his name.
Joe Blow starts saving $1,000/year at age 27 and doesn’t stop saving until age 65 (total years of saving was 38, for a total investment of $38,000). At age 65 he would have around $400,000 to his name.
So you can see that TIME IS ONE OF THE MOST IMPORTANT INGREDIENTS TO CREATING WEALTH!
What is an RRSP?
RRSP stands for ”Registered Retirement Savings Plan”. It is a type of savings or investment account which was designed for Canadians to facilitate retirement savings. It is “Registered” with the Canadian Revenue Agency.
Many people think that they “buy” RRSP’s every year – that the RRSP is the investment. NO – think of an RRSP as an “account”. You can hold a wide variety of investments INSIDE this account so long as they meet the definition of a “qualifying investment” as listed by the CRA (The Canadian Revenue Agency). But don’t worry, almost everything is a qualified investment.
You can of course use non-RRSP accounts to save for retirement, but the reason most Canadians choose the RRSP option are for tax purposes. There are three main tax advantages that exist:
1. Immediate Tax Relief
You can get a refund at tax time if you put money into your RRSP. The government will basically allow you to deduct your RRSP contribution from your total income for the year. Refer to the post on “What is a tax write off?” as this is the same principle. If you were in a 50% marginal tax bracket (for example purposes) then your $10,000 RRSP contribution will give you a $5,000 tax refund (all else being equal – assuming you don’t owe back taxes, and the normal amount of tax is deducted from your paycheque).
2. Tax Sheltering
While your investments remain inside your RRSP they are not subject to tax like your non-RRSP investments – that means that they can grow faster since there is no tax deducted from the value every year. And when your investments grow faster, you have more money when you are ready to retire – perhaps you can even retire earlier…
3. Tax Deferral
You only pay tax on the RRSP funds when you withdraw them. This really is just an extension of tax-sheltering, but you will find it listed as the third tax advantage for RRSP’s. The real reason it is listed as a stand-alone third advantage is that they assume that you are in a lower tax-bracket when you are ready to withdraw the funds. So if you were in a marginal tax bracket of 50% when you put it in, you got half your contribution back in the form of a tax refund. If your income is lower in retirement (usually) then perhaps you are in a 30% tax bracket. So when it comes time to finally pay money on that tax you earned when you were in a 50% tax bracket, they only charge you 30%.
I need to point out that while these tax advantages look very appealing on the surface their are many opponents to RRSP’s out there. Many have argued that your net overall tax bill will actually be higher over the course of your lifetime with RRSP’s versus non-RRSP’s. This debate is VERY complex and I will address it in a future Advanced Level posting. I can tell you that there is no clear divisor and that it really boils down to your personal financial situation – variables such as how much you have saved, how you plan to withdraw it, if you can split income, etc. all come into play.
But for beginners – remember: ANY savings is good savings. If you are just getting started and don’t know what to do, feel confident to start an RRSP account. Once you get more experienced with your finances and do some reading you will be able to determine yourself if you should continue to save to RRSP’s when you get older, or if you should switch to non-RRSP savings for retirement. Many people have both types of accounts.
Read MoreWhat is a "tax write off"?
One common misconception that people have is their understanding of a “tax write off”. Often you will hear someone say “I can write that off…”, in this case they are referring to the ability to write off an expense incurred from their income tax filing.
So what is the misconception? I often hear that people assume it means that the expense becomes free as the person writing off the expense will get the money back at tax time. THIS IS FALSE! (How I wish it were true!)
I think the best way to explain it is with a simplified example: Let’s say Joe Smith is a self-employed salesman. His sales commissions per year are $100,000 and let us assume he pays 50% in tax (again, just to demonstrate the mechanics behind a write off – the tax system is a bit more complex than just a flat rate for everyone!). This means he has to pay $50,000 in tax and is left with $50,000 to spend. BUT the government allows Joe to deduct the COST OF DOING BUSINESS from his income through these tax write offs. Let’s say Joe spends $10,000 on a newspaper ad. This is clearly a cost of doing business for Joe so he can “write this off”. That means that $10,000 can be deducted from his $100,000 in sales commissions leaving a total of $90,000. If we apply the same 50% tax rate to this new amount we have Joe paying $45,000 in tax and taking home $45,000. SO, he spent $10,000 and it only reduced his take home pay by $5,000. His net cost to purchase the newspaper ad is not $10,000 but rather $5,000.
So the next time someone says, “I can write that off” it means they still have to pay for it, but they get some tax money back at the end of the year.
Picking investments based on past performance
Invariably people will see a ranking of highest performance funds for the last year or so and ask “Are these good funds?” Others will just go and blindly buy them. In fact, there is a huge proportion of investors out there who base most of their decision on the past performance of an investment alone. They do not research any further than the performance report for the last year. This is no different than gambling in my eyes!
To paraphrase a quote I once heard, if all that was involved in achieving the highest rate of return was looking at past performance – librarians would be the richest people on earth! Last time I checked, they were not (at least on average).
In fact there have been numerous studies that have looked at mutual fund rankings year over year. What they all find is that the #1 performing mutual fund over the last year will be very close to the worst performing fund the next year. These studies are numerous and they all have the same results. In fact, the worst performing funds also have a tendency to shoot up the rankings the following year.
So what does this tell us?: That you cannot blindly look in the newspaper and look for last year’s best performing fund and expect it to give you the same performance every year. In fact, if you take nothing else away from this post take this: Next time you see a mutual fund returning over 50% in the last year, take a look at it’s 5 and 10 year averages. If the longer term averages are, say closer to 10%, then doesn’t it stand to reason that to revert to the mean will require some dismal performance in the future?
What I’m really trying to advocate is that you should take some time to get advice and do some research on what you are buying. I’m convinced that people take more time choosing between fridges for their house than they do their long term investment selections! I realize that a lot of people are quite intimidated by the task, but do your due diligence! Again at the very least, if you are still going to go out and buy yester year’s hot performer – ask for a professional’s two cents on the fund first! Even the fund company who sells the fund will tell you not to expect the performance to continue forever!
Mutual Funds: Great for portfolios up to $100,000
I suppose many financial advisors licensed to sell ONLY mutual funds will cringe at this information. First, I want to say that if you have more than $100,000 in your portfolio it does not automatically mean that it is time to get out of mutual funds. But certainly once you pass this threshold you will want to look at alternatives to mutual funds as your options open up (based primarily on the fact that buying in bulk reduces your trading costs). If you remember in my first post on Mutual Funds we defined mutual funds as being the ideal investment for SMALL investors because trying to build your own diversified portfolio would cost too much in trading commissions.
So once you have built your portfolio past $100,000 it is time to compare costs of paying a mutual fund manager versus the costs of having a stockbroker build a custom portfolio (or yourself with a discount brokerage trading account if you have the knowledge).
Let’s look at the average Equity Mutual Fund. It has an MER (Management Expense Ratio) of approximately 2.6%. That means that for every $100,000 in your portfolio, you are paying $2,600 per year for management. When you were starting out your savings, perhaps you had $5,000 in the fund at the end of your first year – you were only paying $130 in fees. In fact, that is quite a bargain considering your advisor probably spent much time meeting with you, learning about your situation and creating a plan and investment recommendations. He or she does this so that when you become a larger investor, you become a larger source of income for the advisor. Also, by having built a relationship over time, it becomes a strong bond and there is less likely a chance that another advisor will lure you away (all thing being equal).
But let’s say you stay in this fund and now your portfolio has reached $1 million. You still pay 2.6%, and in this case you are now paying $26,000 in fees for the same management. It starts to get depressing if you consider that $26,000 every year could buy a new mid-size family car!
So let’s look at two options:
1. Fee based advisor
A fee-based advisor works on a set percentage of assets – think of it as similar to an MER, except that in the industry it is called a “Client Advisory Fee”. You don’t pay a trading commission for each stock purchase setting up the portfolio and similarly you can sell those stocks and buy new ones without incurring a separate commission. The Client Advisory Fee pays for all your trading costs, account admin fees, everything. Even if the Client Advisory Fee was the same as the MER (2.6%), it is advantageous because this fee can be written off for tax purposes whereas an MER cannot (for non-registered investment accounts only, you cannot write off fees for an RRSP). For easy math’s sake, let’s assume that our client is in a 50% Marginal Tax Rate. If they could write off the 2.6% Client Advisory Fee, then it effectively becomes reduced to 1.3%. That is a huge saving right off the bat.
But, it only gets better. While Client Advisory Fees usually can only be offered for $100,000+ sized accounts, this fee can be reduced automatically as the portfolio grows even larger. For example, the fee might be 2.5% up to $249,999 but once you reach $250,000 the fee might drop to 2.25% (and that would apply to the whole account, not just the funds over the threshold). Every advisor and firm have their own set of thresholds and fees – but know that you can negotiate the fee. As accounts grow to $1 million you should easily be able to negotiate the fee down to 1.25% (which, for a non-registered account could be written off and effectively reduce the fee to 0.625%) . When you set up your fee-based account, you will sign a document that clearly outlines the thresholds and fees for each level.
2. Transactional Advisor
In this case you pay a commission for each transaction – i.e. to buy or sell an individual stock. While it would take you maybe 20 purchases to setup the portfolio initially, and just for argument’s sake let’s say each transaction cost you 3% of the purchase price, then your first year would cost you roughly 3% in fees. BUT, once you’ve setup the portfolio most of the work is done, and the rest is maintenance. For example, you made 20 transactions in the first year, but in the second year you only made 6 transactions because it was time to sell 3 stocks, and you needed the other transactions to buy replacement stocks. So perhaps in the second year your total fees were only 0.9%. It all depends on how many trades you make in the year. (If you are an active trader, endlessly trading stocks then you already know you should be on a discount trading platform designed for active traders. )
It is important to note that you can replicate the characteristics of the mutual fund you’ve left with individual securities. But it might be more important to note that you can modify it now according to your personal preferences as well as paying a lower amount of fees every year.
I recently moved a client from another institution to my care. He had a portfolio of $180,000 entirely in mutual funds with an MER of 3.03%. We setup a fee-based account with a client advisory fee of 1.5% up to $1 million, and it would reduce to 1.25% over $1 million when he gets there. It was a non-registered account so he can also write off the Client Advisory Fee. Let’s do the math:
Before:
$180,000 x 3.03% MER = $5,454 yearly cost
After:
$180,000 x 1.50% Client Advisory Fee x 50% Write off of fee = $1,350 yearly cost
This client will save roughly $60,000 in fees over a ten year period. This will be due to the fact that the portfolio will appreciate over time and the yearly savings will also increase.
This is another “no-brainer” investment decision quite frankly. If you have over $100,000 in your investment portfolio, it’s time to speak to your advisor about fees. They would rather lower their income and keep you as a client then lose you and get NO income… And of course if your advisor can only sell mutual funds, it may be time to look for a full service broker who is authorized to sell everything (mutual funds, stocks, bonds, etc.).
Refinancing your home
I’m going to offer up an example in a following post, but this post is to deal with the psychological aspect of refinancing your home to consolidate debt.
First, let’s just make sure we’re on the same page and define “refinancing your home”. This is basically when you have some equity built up in your house (after paying your mortgage payment for a few years or having put a large down payment on it) and you use that equity to pay off OTHER debts so that instead of having a mortgage payment, a credit card payment, a line of credit payment, a vehicle payment, etc you will only have one slightly larger mortgage payment and that’s it. I say slightly because you have taken all the other debt payments and in effect turned them into debts with longer repayment time lines, thereby reducing how much you pay monthly. So why do people want to do this? Cash flow – plain and simple. People can free up $1000/month in some cases which can be used for building up an emergency reserve, long term savings, and in many cases allows them to just breathe easier. (Refer to my upcoming post using a real life example with hard numbers.)
When you refinance you will generally reduce the overall amount of interest you are being charged on all of your debts as well. For example some credit cards are charging 19.9% per year, and department store cards are sometimes charging 28.8%. Once you refinance that debt into your mortgage you get a lower interest rate since the debt is now SECURED (by your home) as opposed to UNSECURED. Secured means that you basically agree that if you can’t pay your debts, the bank will get the value by selling your home, taking what you owe them and leaving you with the rest. Since the bank has a better chance of getting their value back when you secure your debt, they will lower the interest rate to reflect their reduced risk.
So the equity in the house is the total value of the house MINUS your mortgage balance. Example: you bought a $200,000 home and put $50,000 as a down payment. That would leave you with a $150,000 mortgage. Your equity would be $50,000. After a few years, you’ve paid some principal and interest back in the form of your mortgage payments and now maybe the mortgage balance is $135,000. PLUS maybe the value of the house has gone up to $235,000. At this point the value of the house ($235,000) minus the mortgage balance ($135,000) leaves you with $100,000 of equity.
One reason refinancing has become so popular is that housing prices have really appreciated, in fact we are in the longest housing bull market in history. This has created a lot of equity, and to refinance to clear up debt and reduce the overall cost of borrowing is a sound strategy (until you look at the psychological aspect of it.)
People are doing this en masse these days as people are perpetually spending more than they earn. Why do people put so many purchases on credit? Well, these days one of the main reasons have been the incredibly low interest rates – it makes the carrying cost seem very reasonable – and people became used to using credit, hence: they have a lot of debt!
So the only real problem of refinancing your home to consolidate debt? If you don’t correct the spending habits that created the situation in the first place you will start spending your new found cash flow similarly to before and end up even further behind within a few years. I’ve seen it happen and the next step will be bankruptcy! So make sure you can adjust your habits. Use a financial advisor, set up a forced savings plan with the new money and stick to it!
Your savings account choices could save you $100,000 over your working life!
Let’s take a look at how a relatively simple decision can make such a huge impact. Many traditional banks charge monthly account fees. My personal account with my previous bank charged $11/month and it paid 2% in interest.
Some “virtual banks” like ING and President’s Choice Financial have savings accounts that have no monthly fees. They typically pay a higher interest rate as well, for this example let’s call it 4%.
Let’s examine what the real cost is:
$11/month x 12 months = $132/year
But let’s take is a step further. Many banks offer a lower-fee or fee-free account to students or kids until they turn 18 – so let’s assume that we have this $11 monthly account fee from age 18 to age 65 (again, many banks have a reduced monthly fee for seniors).
Let us also assume that we are wise and decide to invest this saved money into an investment portfolio that averages 8% per year.
$132/year @ 8% rate of return x 47 years = $59,783 that could’ve been in my pocket!
So if you have a savings account at a bank that charges a monthly fee, you can see that even a few dollars a month makes a big difference. If anyone would like to step up to the plate and provide their monthly account fee and age, I will calculate your “money lost” and post it here as well. (Warning: it’s depressing!)
Note: we haven’t looked at how much less interest you earned inside your savings account during that time! Since the average, free high-interest savings account pays roughly 2% more than a traditional bank, and assuming that the savings account holds an average balance of $5000, then you are foregoing an additional $100 year in interest paid to you.
I guess I’m feeling sadistic, so let’s look at the new final total:
($132/year (account fee) + $100/year (lost interest)) @ 8% x 47 years = $105,073.
So, about 15 minutes to setup your new account today could save you over $100,000. What are you waiting for?
Disclaimer!: Most people will not invest the savings because it is not an established habit – in which case your savings will be a *paltry* $10,904 over 47 years. That is the magic of compound interest – which I will cover in another post!
I hope this post helped you out! :)
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