The value proposition of a premium chequing account

Million Dollar Journey has a post today comparing the big five banks' high-end chequing accounts. These accounts charge a substantial monthly fee, and in return provide a number of "value-add" services, including the following:

• Unlimited transactions


• Free drafts/certified cheques


• Discount on safety deposit box rental


• Discount/waiver of credit card or discount brokerage annual fees

Some of these accounts offer a waiver of the monthly fee if a minimum balance is maintained in the account. For example, BMO's Premium account has no monthly fee if the account's balance never drops below $4,500 (otherwise the fee is $25 per month). The thinking behind these minimum balance fee waivers is that, while the customer avoids paying a fee, they also miss out on interest they would have earned on that balance in a savings account.

I was curious recently as to just how favourable the fee/interest trade-off turns out to be, so I decided to run some numbers. Using the BMO account as an example, I worked out what APR would correspond to $25 per month on a $4,500 balance. Assuming a 40% marginal tax rate (since interest income is taxed at the full marginal rate), I came up with the following:

• $25 = $4,500 X ((1 + APR / 365)^³⁰ - 1) X (1 - 0.4)


• APR = 365 X ((($25 / 0.6) / $4,500 + 1)^^{(1 / 30)} - 1)


• APR = 11.22%

This means that, in order to earn $25 per month after taxes on a balance of $4,500, you would need to find a guaranteed 11.22% APR. Since the market is currently swimming in 11.22% savings accounts, it's a no-brainer, right?

One of the best rates currently available for a Canadian savings account is Canadian Tire's 2.00%. At this rate, a $4,500 balance would earn a mere $4.44 per month after taxes. This means that, with today's interest rates, keeping the minimum balance in this account essentially means that you're "paying" a $4.44 monthly fee for the use of the account. If you take advantage of the features of the account, this can turn out to be extremely worthwhile (a safety deposit box rental can easily run $4 per month).

This doesn't mean that a high-end chequing account is automatically worth it, but it does mean that, at least for the foreseeable future, the cost of such an account is significantly reduced by maintaining the minimum balance.

Two years of progress: How am I doing?

Although I only started the blog 23 months ago, I've been tracking my finances to the penny since April 30, 2007. That means that, as of today's recap of April 2009, I have two years of progress to report. Just as I posted charts of my various metrics when I had built up one year's history, I thought I would post a graphical review of my progress to date.

Net Worth

As before, the fluctuating curve in my Net Worth represents my actual monthly numbers, while the smooth line represents the best straight line approximation of my progress over time. As you can see, the straight line doesn't do too badly at fitting the curve; it's still a generally increasing trend, although for the first half of 2008 I appeared to be over-performing, and for the last several months I've been under-performing. This can be tied to the market performance during this period, but it's interesting that my most recent month falls right on the line.

Retirement Savings

A look at my Retirement Savings confirms that most of the "off-trend" variation in my net worth over the past year can be explained by swings in market performance. Although I've been contributing steadily to my RRSP accounts over the entire period, this chart shows just how volatile the market has been over the past twelve months. The late-2008 crash is particularly evident, as is the current rally that has been buoying my bottom line for the last two months. A straight line turns out to be a terrible approximation of my retirement savings.

Cash Savings

Cash savings fare better in adhering to a straight line, although some periodic events still throw the curve off the linear approximation. You can see the build-up in October and November, followed by an abrupt drop in December, due to that constant annual surprise, the Christmas shopping season. Although I've successfully navigated through two cash-only Christmases, the impact of the holiday season can still be seen in my cash balances. It's interesting to see how, after my Emergency Fund hit $1,000 in October 2007, my cash savings have never dropped below this value, and since I set my sights on $2,000 last year, this has become my new effective cash "floor".

Revolving Debt

In spite of (or perhaps because of) its status as my most important goal, Revolving Debt has the most boring chart of the bunch. It's almost a perfect straight line, improving by a consistent $20 or so each day over the past two years. It's thanks to this trend (and two very similar trends in my Student Loan and Mortgage repayments) that my net worth has increased so consistently despite substantial fluctuations in my retirement and cash savings. This serves as a terrific illustration of the importance of focusing on the factors you can control: if I can throw $20 a day at my debt, that will always improve my net worth, no matter what the markets are doing. It's a risk-free return on investment, and more than you'll get in any savings account or GIC.

The Last Twelve Months

Over the past year, the overall trends have been comparable to what I see in these two-year views: net worth increasing, and all debts steadily decreasing over time. However, when I look at my retirement and cash savings over the last twelve months, I see something different:


Both these charts show a negative trend over the last year, although the trend is very slight for cash savings. Now, this is not really cause for alarm, since both charts show me currently outperforming the trend, and the trend for my retirement savings is clearly driven by market performance. However, it does indicate that I should continue to keep an eye on my liquid savings. Spending too much on holiday shopping, or dipping into the Emergency Fund to cover some car repairs, could leave me in a bit of a tight spot if I'm not careful.

How much are you up or down? One ugly chart, and one that's not so bad

When I calculate my net worth for the month, the data get fed into some dynamic charts that I've created, to provide a visual representation of my progress over time. I've posted these charts a couple of times, but this month's output really stopped me in my tracks. Behold the majesty of my retirement investment performance since I started tracking in April of 2007:

Despite contributing roughly $18,500 to my retirement accounts since April 2007, my investments have gained only $2,171.50 in value.

Yippee.

Now, I need to point out a couple of things here:

• This chart only shows the month-end value of my investments - I haven't done any adjustments to show "what $10,000 invested on April 30 of 2007 would be worth today", or the like. This is a very basic "what was my investment portfolio worth on X date?" view of my RRSP's value over time.


• This graph starts at a value of $36,087.43 - Although a quick look at the chart makes it look like I've come full circle, there is actually another 6 years of progress prior to April 2007 that got me up to that point. I have to keep in mind that I'm really "up" by $38,258.93 over where I was at the beginning of my career (namely $0).

Since the beginning of the year, my retirement investments are down by 7.9%. I'm OK with that, since this money is for the long term, but it still hurts to see such a pronounced drop-off over such a short period.

A post at Clever Dude made me stop and think about how I'm really doing this year. True, my investments are down (by a lot), and my net worth has been slowly declining the last couple of months as a result. However, I've been making consistent progress on paying off my revolving debt, and tucking some cash away in my Emergency Fund and Freedom Account. As a result, my net worth is actually up by 71.8% over where it was at the end of 2007, my revolving debt is down by 32.1%, and my cash savings are up by 96.0%:

There's no question in my mind that I'm moving in the right direction, and although net worth has been stagnant the past few months, I'm laying a very solid groundwork for the future. By starting with a small base, and sticking to the plan, I've survived a huge drop in the market and actually grown my net worth by over 70%. That's not too shabby.

How is your big picture looking? Is market performance overshadowing the rest of your financial life, or are you seeing small changes add up to something better?

Some perspective on a month of -38% returns

From May 31 to June 30, the market value of my retirement savings dropped from $53,547.77 to $51,463.61. That's a decrease of $2,084.16, or 3.9%, which represents an annualized rate of return of -37.8%. Let's ignore, for a moment, the fallacy of predicting annual returns based on one month's performance. Let's also overlook the fact that I added $642.10 in contributions to my RRSP during this period, which actually makes this an even larger negative return.

The point is, June was not a great month for someone invested in the stock market.

When I look at a chart of my retirement savings over time, however, I see something interesting:


I have already commented on the fluctuations in my retirement and liquid savings, but this past month's performance is worth singling out.

The straight line approximation of my retirement savings growth over time goes right through the middle of the June 2008 point. That means that, based on data starting in April 2007, last month's performance was entirely consistent with the rate of growth I've seen over the past year.

This view is a bit simplistic, since I've really only got just over a year of history on which to base my rate of growth. However, it does serve as a good illustration of the fact that my savings growth is dependent on both contributions and investment growth. I need to manage both of these factors in order to stay on track.

Make no mistake: June still sucked from an investment return point of view. However, it was not nearly the deathblow that the -3.9% monthly growth would suggest.

Time changes everything

Back in March, I posted about the dismal returns I was seeing on my retirement investments. When taking into account my bi-weekly ESP payroll deductions, my investment performance from April 2007 through February 2008 represented a 0.98% annualized growth rate. When I added in my employer's matching contributions, this actually dropped to -4.29% annualized growth.

Well, that was before the market rally that began in mid-March. Since February 29, my retirement balance has increased by $3,383.21, with only $856.12 in contributions during the intervening two months. When I put this in terms of a one-year growth rate, I now come out ahead whether I include the employer match or not. Without the match, my growth rate for the past 12 months is 6.86%, compared to 1.19% when I include the match.

It's unnerving to see such a wide swing in market performance during a one-year period. Two months of bullish growth has taken my annual growth rate from 0.98% to 6.86%. In order to turn around the previous slump, my annualized growth rate during those two months was actually 36.62%. That's a big change from the decline we saw earlier in the year.

I find it fascinating that your view of market performance can vary so widely based on the window you look at. Canadian Capitalist has a great post today about looking at your response to the recent market dips as a gauge for your actual risk tolerance. If your gut reaction to the widespread price drops was to sell, then you should probably consider a more conservative portfolio.

Personally, I was content to ride out the market swings. This may be because these investments are largely academic to me at this point. Since this is all strictly "future money", I'm able to stay relatively cool about my investment performance. As I get closer to actually planning to use this money, however, and when I eventually build up a non-retirement investment portfolio, we'll see just how calm I remain through future market adjustments.

One year of progress: charting the trends

In last week's post of my April month-end status, I noted that, for the first time since I've been tracking it, my Net Investable Assets became positive. During the month of April, my NIA went from ($1,100.67) to $3,491.19. This is a significant milestone, and it's fitting that it should come at exactly the one-year mark. I've only been blogging my progress since last June, but I've been keeping detailed Net Worth records since last April 30^th.

I was curious about the pace of my Net Worth growth, so I though I would throw together some charts plotting my progress over time. My NetworthIQ profile includes a graph like this for the overall Net Worth, but I wanted to dig a little deeper and look at the components that make up the metric.

As I touched on in an earlier post, there are several things that go into my Net Worth calculation:

• Assets
  
  
  • Liquid savings - All my chequing and savings account balances, as well as any cash I have on hand, get lumped together here. This includes my Emergency Fund and Freedom Account, as well as my day-to-day chequing accounts.
  
  
  • Retirement savings - My group RSP and self-directed RSP get added in here. At the moment, this is the bulk of my life savings, since I've been throwing a good chunk of money in here ever since I started working.
  
  
  • Non-financial assets - I include a rough estimate of our home value, as well as a slightly more informed estimate of our car's resale value. I don't update these estimates on a regular basis; they're really just placeholders to represent our most significant possessions.


• Liabilities
  
  
  • Revolving debt - This is my credit card and line of credit debt. Basically all of the debt that I would really call "consumer" debt; this is the "what was I thinking??" souvenir from my spendthrift days.
  
  
  • Student loans - Ms. Loonie and I each have student loan debt, which we have both consolidated with my bank at a very good interest rate. We're slowly but surely chipping away at these loans.
  
  
  • Mortgage - Our mortgage is my main justification for including our home value in the calculation; the estimated value of the condo really just serves to offset the huge liability represented by the mortgage. If we didn't have the condo, we wouldn't have the mortgage, so it makes sense to me to include both.

The Net Worth number is simply calculated as the total of all assets minus the total of all liabilities. I also calculate a couple of variations on this metric:

• Net Investable Assets excludes the home and car as assets, and the mortgage as a liability, leaving me only with my true "financial" holdings.


• Net Liquid Assets goes one step further, by excluding retirement savings from the asset side, leaving only the truly liquid portion of my financial position.

After one year of trying hard to make smarter choices, I've managed to increase my Net Worth by $37,364.61, my Net Investable Assets by $28,372.85, and my Net Liquid Assets by $14,162.99. Here's a representation of my Net Worth over this one-year period:

The irregular curve represents the actual month-to-month variations in my Net Worth, while the straight line represents a straight-line approximation of my Net Worth growth. The equation on the chart shows how the straight line is calculated: for every day of the past year, my Net Worth has increased by $96.30 on average.

Although it's not shown on the chart, there's a statistic called R², which shows how closely the actual observed fluctuations are represented by the straight line. The closer the R² gets to a value of 1, the more "accurate" the straight-line approximation is. This line has an R² of 0.98, which means that my Net Worth progress is matched quite well by a consistent upward trend of $96.30 per day.

This is all well and good, but where is this $96.30 increase actually coming from? I decided to plot the components of Net Worth individually, to show how each piece has contributed to the overall growth. Note that, because my estimated home and car value have not changed in the past year, I will not include them in this trend analysis.

My biggest asset is my retirement savings, so let's start there. By plotting my savings over time, I see that my investment balances have fluctuated quite a bit over the past year, with market movements. The market dips in July and the November-December time frame are clearly visible. However, despite these variations, the fitted line of $33.67 per day still has a respectable R² of 0.9, so the consistent upward trend is once again a reasonable approximation of the actual investment growth. This balance growth accounts for 35% of my Net Worth increase.

Cash savings are another story. When I plot my liquid savings over time, I see much more of a boom-and-bust cycle. This is partly due to the fact that I include my Freedom Account, which is really meant more for planned spending than actual saving, in this number. You can see that, during our trip to the US last June, and my brother's bachelor party in October, I really depleted cash savings. The upward spike in November is also interesting: this was me gearing up for holiday shopping. The R² for this chart is only 0.56, so this is the weakest straight-line approximation. Still, the daily growth of $3.45 indicated here does represent real forward progress, and the trend is consistently positive.

There is less to say about the progress against my debts. Revolving debt has been diminished at a pace of $17.34 per day. The R² for this chart is 0.98, which indicates a very good linear approximation. In fact, comparing the charts for Net Worth and revolving debt, the two appear to move almost completely in concert. This suggests that revolving debt is the factor most closely tied to Net Worth progress: when one goes up or down, so does the other. Student loans and mortgage have diminished at paces of $16.95 and $24.90 per day, respectively, and since these loans have fixed payments, they each follow a virtually perfect straight line.

The upshot of this is that, by maintaining a focus on paying down my revolving debt and contributing to my retirement savings, and by gradually growing my cash savings, I should be able to continue this Net Worth momentum. These three factors contribute 56.5% of the Net Worth growth, so it is very important that I keep moving on these fronts.

It's nice to know how far I've come, and it's even nicer to have a clear idea of how I got here.

Net worth and retirement savings

At the beginning of every month, I tally up my assets and liabilities, and calculate three financial snapshot numbers:

• Net Worth - This is my total assets, including home, car, retirement investments, and liquid savings, minus my total debts, including mortgage, revolving debt, and student loans. I use this to represent my "full" financial picture, and it tells me how much I really "own".


• Net Investable Assets - This is my total financial assets, including retirement investments and liquid savings, minus my total non-mortgage debt, including revolving debt and student loans. This represents my full financial picture in monetary terms, and basically tells me how much money I really have available, without selling off possessions like our home or our car.


• Net Liquid Assets - This is my total liquid savings, minus my total non-mortgage debt, including revolving debt and student loans. This represents my full financial picture in liquid monetary terms, and basically tells me how much money I really have immediately available, without liquidating my retirement savings or selling off possessions like our home or our car.

There's a lot of talk about exactly what assets belong in the calculation of net worth. This discussion seems to center around how you intend to "use" your net worth number. For example, if you want the number to express how much money you really have on hand today, then you probably won't consider your home as an asset (or your mortgage as a debt), since your plans likely don't include liquidating your home for extra cash. If, on the other hand, you want the number to represent your progress toward early retirement, then you likely would include your home (and mortgage), as well as your retirement investments.

I've seen some people estimate the tax penalty they would pay for immediately liquidating their retirement savings, and enter the post-penalty balance remaining as an asset in their net worth. This helps to represent retirement savings as a "right now" number. If you were facing financial ruin, and needed to liquidate everything you own, then you might very well sell your home and take the tax hit for cashing in your retirement savings.

This has got me thinking about my own calculations. I currently include my retirement accounts in my net worth and net investable assets, but not in my net liquid assets. I'm wondering if it makes sense to include an after-penalty retirement balance in my net liquid assets, to represent my total "immediate cash available".

I realize that most of the value in tracking net worth comes from keeping the calculation the same, and watching the trend over time that results from your financial behaviour. Therefore, it would seem that I'm better off keeping things as they have been, and excluding retirement accounts from net liquid assets. I still think I'll work out the after-tax balances, however, to feed my own personal hunger for data.

What do you do? How do you account for your retirement savings when figuring your net worth?

Mortgage options: is Cash Back a good deal?

With this weekend's balmy double-digit temperatures, we Canadians have finally been given a taste of spring. The sun is rising earlier and setting later, temperatures are rising, and our SAD is finally lifting.

And, of course, the mortgage advertising is once again beginning in earnest. With the majority of home sales closing between April and August, spring is the prime season for banks to push their mortgage lineup. Now that we've survived RRSP season, and are wrapping up our tax returns, it's time to be bombarded with mortgage rates and special promotions.

One of the products I've seen advertised this year is a "cash back" mortgage. Basically, when your bank advances the mortgage, you receive a percentage of the principal as a cash reward. You can then use this money for whatever you want. The banks want you to use this to pay for furniture, renovations, or vacations, but you can also use the full cash amount as a lump sum mortgage payment.

The typical trade-off with cash back mortgages is that you have a longer term and higher rate than a standard mortgage, so although you get some immediate cash in hand, you end up paying more in interest in the long run. I thought I'd have a look at the numbers, to determine just how good or bad this offering really is.

Example

To illustrate the trade-off between a cash back and standard mortgage, I'll look at the costs of the cash back mortgage, and compare them to the costs for a standard mortgage with a lower rate. For my calculations, I made the following assumptions:

• $300,000 mortgage, with 25-year amortization


• 5-year term, with 7.20% posted rate


• 5% cash back vs. 1.50% discount on mortgage rate

Note that, since I'm looking at a Canadian mortgage, I'm using the Canadian convention of rates being calculated semi-annually, not in advance. The calculations would work out slightly differently for homeowners south of the border, but the basic idea is the same.

Assuming that the borrower is making bi-weekly rapid payments (i.e. paying half the monthly amount every two weeks), the principal remaining at the end of the term will be $256,132 for the standard mortgage holder (5.70% rate), and $258,710 for the cash back borrower (7.20% rate). When you factor in the $15,000 cash reward, the cash back borrower ends up $12,422 ahead of the standard mortgage holder. If the $15,000 amount earns 3% interest in a savings account during the 5-year term, this increases to a $14,842 spread. If, on the other hand, the full $15,000 is used to make an immediate lump sum payment on the mortgage, the spread is even higher, at $18,600.

On the face of it, cash back seems to be an attractive option.

However, we're only looking at one side of the picture. The higher interest rate paid by the cash back borrower translates to a higher bi-weekly payment. In this example, the cash back borrower has made a total of $138,999 in mortgage payments, whereas the standard mortgage holder has paid only $121,307. That means the cash back borrower had to pay $17,692 more than the standard mortgage holder, which puts them behind by $2,850 unless the $15,000 was used as an immediate lump sum payment, in which case cash back comes out ahead by a mere $909. Even that $909 spread is barely a 2% return on the extra $136.09 in payments made every two weeks throughout the term.

Conclusion

Clearly, when you take into account the larger minimum payments that come with a cash back mortgage, it becomes a lot less appealing. The only way to come out ahead versus a standard, lower rate mortgage, is to throw in the whole cash reward as a lump sum payment at the beginning of the term. Even if you do this, however, you're not likely to keep up with inflation, so it's a far better idea to take a standard mortgage with a lower rate.

If you can afford the extra payments that would come with the cash back mortgage, then you can always increase the bi-weekly payment amount on your standard mortgage, and make even faster progress in paying off the principal.

Claiming the tax credit for charitable donations

Canadians can generally receive a non-refundable tax credit for charitable donations up to 75% of their net income (i.e. income minus deductions). I wrote a long post last month on the calculation of Canadian income tax, and in this post I mentioned that, for couples filing jointly, charitable donations should be pooled onto a single tax return.

The reason for this is that the first $200 of donations that you claim generate a credit at the lowest marginal tax rate (21.05% in Ontario for 2007), while anything over $200 is credited at the highest rate (40.16% in Ontario for 2007). If a husband and wife each donated $300 to an eligible charity this year, and claimed the donations individually, then each person would receive a 21.05% credit on the first $200, and a 40.16% credit on the last $100, for a total credit of $42.10 + $40.16 = $82.26 each. If, on the other hand, the entire $600 were claimed on a single return, then the the total credit would be $42.10 + $160.64 = $202.74, or $101.37 each. That's $38.22 in extra tax savings for the couple, just for claiming the donations jointly.

Until recently, I was under the impression that it doesn't matter which return you claim the taxes on, provided both returns have taxes against which to apply the credit. However, as I discovered while going over our own taxes last week, it does make a difference. The main reason for this is the provincial surtax, which is added if your provincial taxes owing are over a certain amount. In Ontario, for 2007, the surtax is 20% on taxes between $4,101.01 and $5,172, and 56% on taxes over $5,172. Because the surtax is calculated after applying any credits, the benefit of a tax credit is greater for taxpayers in higher provincial income brackets.

If your Ontario taxes (before credits and surtax) come to $4,000, then a $1 provincial credit saves you $1 in taxes, since you are below the surtax limit. However, at $5,000, your $1 credit saves you $1.20, and at $6,000, it saves you $1.56. For the $600 donation example above, the $202.74 credit is made up of $146.00 federal and $56.74 provincial. This means that someone with $4,000 in provincial taxes would save $56.74, while someone paying $6,000 would save $88.51. Clearly, it makes sense for the donations to be claimed by the person with higher total taxes.

By claiming our $1,300 in 2007 donations on my own return instead of Ms. Loonie's return, we end up saving an extra $75 in taxes as a couple. That's $75 that we can divvy up between us however we want.

Who are we to turn down free money?

The market can make you crazy.

Interesting Money posted recently about his nasty habit of obsessively checking his investment balances. I have to admit that I share this tendency to over-track my retirement accounts, whether out of excitement, concern, or morbid curiosity.

In spite of my daily ritual of checking my account balance, I've generally been able to keep a cool head during the market turmoil that started last summer. I haven't done anything drastic like selling off my investments or switching to an all-bond portfolio. In fact, I seem to have been pretty lucky with my timing in diversifying my asset allocation using low-cost index funds. Given my still-negative net investable assets, the single biggest factor in my net worth trend over time is my ongoing debt reduction. As a result, although investment performance does have an impact on my overall financial picture, this effect is often overshadowed by my progress in paying down my debts.

I was looking at my history of monthly snapshots at NetworthIQ, and thought I'd have a look at my retirement account history. Since I started tracking my monthly progress, my retirement balance has gone from $36,087.43 to $46,914.08, an increase of $10,826.65. That's not a bad balance growth, but let's not forget that I've been steadily contributing to my RRSP during this time. In total, I've added $10,487.76 in book value (meaning actual out-of-pocket contribution value) to these accounts, so my actual investment "returns" really amount to $338.89. If I factor in my employer's matching contributions of $1,856.03 over the same timeframe, I'm actually behind by $1,517.14.

To get a (very rough) idea of the rate of return represented by these numbers, I'm adding half my contributions to my April 2007 balance, and using that as my starting amount. Therefore, I get the following 10-month rates of return:

• Without Match: $338.89 / ($36,087.43 + $5,243.88) = 0.82%


• With Match: ($1,517.14) / ($36,087.43 + $6,171.90) = -3.59%

This is equivalent to annual rates of return of 0.98% and -4.29%, respectively.

Even the positive 0.98% is not exactly kicking inflation's butt.

As I look at these numbers, I remind myself constantly of the words of encouragement offered to any long-term investor:

• The real asset at this point is the stock/fund shares themselves, not their dollar value. These investments are generating dividend and interest income, which is in turn being used (through a DRIP) to buy more shares.


• The 4.29% "loss" I see when I take into account my employer's matching contributions is currently only a loss on paper. Provided I don't get cold feet and sell now with prices at their current lows, there's a very good chance that I'll more than recoup this drop over the next couple of decades.


• Even though my investment returns over the past 10 months have been poor, I'm still nearly $11,000 ahead of where I was last April. That's nothing to sniff at.


• I wish, oh how I wish, that I had some extra cash lying around to snatch up some of the investments that are currently "on sale".

I'll say this much: it's certainly shaping up to be an interesting year.

Inflation can be your friend.

JLP at AllFinancialMatters has a very interesting post on the impact that inflation has on the true cost of a mortgage. He argues that, because of inflation, the dollars used to make a mortgage payment ten years from now will be worth far less than the dollars used to make a payment today. Therefore, assuming that the amount of the mortgage payment remains constant over those ten years, the cost of the mortgage essentially goes down over time.

This is a great observation, and it has really got me thinking. I was curious what the impact would be on our own mortgage, and found that adjusting for a 3% inflation rate takes our actual cost of borrowing (total payments minus starting principal) from $190K down to $54K. That's a huge difference!

As I played around with these numbers, it occurred to me that this principle can also be used to accelerate a debt paydown. If we were to increase our mortgage payments by 3% each year, we would shorten the life of our mortgage by six years, while further lowering the adjusted cost of borrowing to $44K. Obviously, the challenge is in actually finding that extra 3% each year, but by really making a commitment and developing a sufficiently lean budget, this may very well be manageable.

I'll be looking very seriously at implementing something like this in the new year. I'll let you know how it goes.

Canadian Black Book®

I found a link to the Canadian Black Book® Web tool, which estimates the current Black Book® value of trade-in vehicles in Canadian dollars (like Kelly Blue Book for Canadians). The link is available through manufacturer websites (I found links for both GM and Toyota).

I'll be using this in the future to come up with more realistic values for our car in my net worth calculations.

Enjoy...

GM Canada Black Book® portal
Toyota Canada Black Book® portal

Demystifying Mortgage Rates

I'm a die-hard "numbers guy". I've always loved using spreadsheets to lay out and track various scenarios, typically related to personal finance. I like to know exactly what the numbers in my life mean to me. This doesn't mean that I'm particularly good at acting on what the numbers tell me (refer to my total debts in previous posts for proof of this), but it does mean that I'm always "tinkering" with the data in my life.

One thing that has always fascinated me is the tracking of loan payments over time. I had the basic exposure to simple and compound interest calculations in high school, but these calculations almost always focused on a starting principal that remained constant over time. For example, "Sam has $1,000 that earns interest at a rate of 4.0%, compounded monthly. How much money does he have after two years?" The answer to this is very simple ($1,000 x (1 + 0.04) ^ 24 = $2,563.30), because the interest is the only source of change over time. However, when periodic payments, either toward an investment or against a debt, are brought into the picture, the answer gets more complicated, and is harder to express as a single formula (there are, in fact, "simple" formulas that take these payments into account, but their form is not exactly intuitive to the average person).

For every loan I've ever had, I've created a spreadsheet that details, over time, how much interest is accruing from one payment to the next, and how much principal remains over time. These are usually pretty accurate, but when I set up a spreadsheet for my mortgage, I found that my interest calculations were consistently higher than the actual interest charged, resulting in a longer calculated amortization. It turns out that this is due to the way mortgage rates are reported in Canada.

Canadian lenders post mortgage rates that are "compounded semi-annually, not in advance". Well, that clears it all up, doesn't it? It turns out this is actually very simple, but we need to sort out the jargon.

The "compounded semi-annually" part means that the rate is posted assuming that interest will be calculated every six months. The "not in advance" part means that interest is charged after it accrues, so you don't start out your mortgage owing six months' worth of interest. That is, if you have a $100,000 mortgage with a posted rate of 7.0%, then after the first six months, you would see an interest charge of $3,500 ($100,000 x 0.07 / 2). Note that this is actually equivalent to an annual rate of 7.1225% ((1 + 0.07 / 2) ^ 2 - 1), as opposed to the posted 7.0% rate.

In the real world, however, no one pays their mortgage semi-annually; most mortgagees make monthly payments. In the example above, this means that the rate of 7.1225% needs to be converted to monthly compounding, so each month, we would expect an interest charge of 0.575% ((1 + 0.071225) ^ (1 / 12) - 1). Multiplying this rate over twelve months gives us a true effective annual rate of 6.90%. Using this calculated rate, mortgage interest works out to within a few cents of what is actually charged by the lender.

The calculations here may seem a bit confusing, but here is a summary:

R = Annual rate posted by lender

r = Effective annual rate charged by lender

r = 12 x (((1 + R / 2) ^ 2) ^ (1 / 12) - 1)

Note that this formula is based on semi-annual calculation of interest. In the United States, interest is calculated monthly, so we would end up with the following:

R = Annual rate posted by lender

r = Effective annual rate charged by lender

r = 12 x (((1 + R / 12) ^ 12) ^ (1 / 12) - 1)

r = 12 x (1 + R / 12 - 1) = R

Therefore, in the US, the posted annual rate is actually the same as the effective rate.

I was quite shocked the first time I worked this out, because I could not figure out why lenders would advertise mortgage rates above what they actually end up charging. It turns out that financial institutions are required by law to express their interest rates this way, so that consumers are able to compare "apples to apples", since all lenders are advertising their rates on the "semi-annually, not in advance" scale.

So now you know.

Fun with Negative Net Worth

I was tooling around with my net worth calculations, and something occurred to me.

I use three "net worth" metrics to track my financial progress:

• Net Worth: Total assets (retirement and non-retirement savings, home, and car) minus total debts (including mortgage)


• Net Investable Assets (NIA): Total financial assets (retirement and non-retirement savings) minus total non-mortgage debts


• Net Liquid Assets (NLA): Total non-retirement savings minus total non-mortgage debts

The first two are currently positive, since I've been contributing to RSPs since I graduated in 2001, but my NLA is significantly negative. This is because virtually all of my savings to this point have been in RSPs, so I have no truly "liquid" savings.

I always find negative numbers interesting when it comes to calculating percentage change. During the month of May, I increased my NLA by $2,306.85. Since my starting point was negative, this technically represents a negative percentage change. That is,

$2,306.85 / ($35,298.09) = (6.54%)

It's clear that this is actually a positive change, so it's trivial to convert this to a 6.54% increase, but an interesting question is raised if I consider doubling my NLA. Technically, this would mean decreasing my NLA to ($70,596.18), which is clearly not what I'm looking for. However, another way to look at "doubling" is in terms of a 100% increase. So, in a way, I will have doubled my NLA when it hits $0, or when my non-retirement savings are equal to my non-mortgage debts.

Neat.

Of course, doesn't this then mean that any increase in NLA after I hit the "break-even" point will represent an infinite increase?

Yes, I'm a geek.

Thoughts on Cash Flow

Looking at the change in my debts over the last month, I thought it might be a good idea to go through how I've decided to structure my cash flow.

From May 31 to June 30, my credit card balances rose from $1,056.55 to $3,945.72, while my line of credit (LOC) balance decreased from $25,298.84 to $22,647.79. That is, my LOC balance went down by approximately the amount that my cards increased. The reason for this is that, every time I make a purchase using a card, I make a payment in the same amount to my LOC. When I receive my credit card statement, I then use the LOC to pay the card balance in full. This has two results:

• My credit card balance always has 0% interest, since I pay in full


• I pay less interest on my line of credit, since for the duration of the month, the amount of my card purchases is not accruing interest on the line of credit

Essentially, what I'm doing is using a credit card to make a temporary payment against the LOC, thereby reducing the amount of interest that accrues on the LOC. Given that my LOC has an APR of 6.25%, this represents automatic earnings equivalent to 6.25% APR on every dollar I spend on the card. For as long as I have a balance on the LOC, this is the method I will use for managing credit card purchases.

Here's an example to illustrate the process in action:

Suppose I have a LOC balance of $20,000 (6.25% APR) at the beginning of the month, and make a $100 credit card purchase. If I wait until the end of the month to pay the credit card, then my LOC balance at the end of the month will be

$20,000 x (1 + 0.0625 / 12) = $20,104.17

However, if I immediately pay the $100 against the LOC, and use the LOC to pay off the card at the end of the month, then my ending LOC balance will be only

($20,000 - $100) x (1 + 0.0625 / 12) + $100 = $20,103.65

Either way, the credit card charges no interest, since the balance is paid in full at the end of the month. The savings in this example only amount to $0.52, but with hundreds of dollars in credit card purchases each month, this can add up.

Obviously, the major assumption here is that income for a given month will, at the very least, cover the purchases made on the card. If I spend more than I make in a given month, this approach runs off the rails, as I end up increasing my LOC balance at the end of the month. This happened for me in June, although it's only temporary, as I'm waiting for travel reimbursement which will more than cover the $238.12 gap. Also, it is important to remember to make a "real" LOC payment in addition to all the "temporary" payments throughout the month; otherwise, the LOC balance will continue to grow as interest accrues.

When I have paid off my LOC, I will most likely continue this approach, but by temporarily socking each purchase amount away in high-interest savings instead, so that I effectively earn interest on my credit purchases.