Taking the road less optimized

I'm a numbers guy.

I love numbers. I actually enjoy working with spreadsheets, and I love the challenge of working out the mathematically optimal way of doing things. Flexo at Consumerism Commentary has a great post today on the power of a "mathematically correct" solution, and I have to say I agree with his logic.

That doesn't mean, however, that I always use the optimal solution.

Take my bi-weekly cash flow, for example:

1. Money comes into our joint chequing account on payday


2. Fixed expenses, including mortgage payment, student loan payment and line of credit payment, come out of chequing


3. Emergency Fund and Freedom Account contributions are transferred from chequing to online savings


4. Leftover cash gets transferred into my secondary chequing account, as my spending money for the next two weeks


5. As I spend money on groceries, entertainment, etc., I either pay cash, or use my credit card and immediately transfer the corresponding amount from chequing to my line of credit


6. When my credit card payment is due, I pay the bill with my line of credit

Steps 5 and 6 are my attempt to perform small-scale credit card arbitrage with my monthly spending. Because the credit card is paid in full every month, each purchase essentially represents an interest-free loan until the next payment due date. By making a corresponding interim payment to my line of credit, I'm actually using my credit card to defer interest accrual on the LOC, and saving myself some money.

I'm pretty proud of having devised this system, but I can't ignore the fact that, if I skipped steps 4 and 5, and instead just transferred all my leftover cash onto my LOC on payday, I would save even more interest. Even though this might be the "right" way to structure my cash flow, I've learned from experience that it's much easier to lose track this way than it is with the method described above. I find that transferring funds every time I make a purchase gives me a much more concrete feel for how much I've spent, and how much I have left before the next payday. The extra interest that I accrue by leaving that money sitting in the chequing account ends up being the "fee" that I pay for having a system that works for me.

True, I could be paying less interest, but I could also be paying a lot more, and I'm happy to find some middle ground.

This is partly about having training wheels on our financial bicycle, but it's also about priorities. I keep $200 of my Emergency Fund in physical $20 bills, earning no interest, so that we have cash immediately available in an emergency. Both Ms. Loonie and I have income tax withheld by our employer so that we don't have to worry about making up a shortfall at the end of the year, and also to keep us thinking of our income in net, rather than gross terms.

As the size of our Emergency Fund grows, it will become more important to optimize the vehicles we use for these savings. Similarly, as the gap between income and expenses grows, the impact of where I keep my "in-flight" cash will become more significant. However, for now, I think the small dollar amount we give up in order to have a convenient, manageable system is worth it.

Financial Archaeology: Unearthing Past Behaviour

I've been looking through my historical bank balances online, and I've noticed some interesting trends. I've already written about the trends in my overall net worth, but I thought I'd go a little deeper into the details for individual accounts. Whereas my net worth growth indicates whether I'm getting "richer", these finer details should be more indicative of changes in behaviour.

I'm a paper packrat, so I have years' worth of paper statements stockpiled at home. Over time, I'd like to go through old credit card statements to get an idea of where and how I spent my money before and after April 30, 2007 (this date is significant because it represents my first comprehensive balance sheet, and the date when I decided I had to right my financial wrongs). My online account history only goes back to the beginning of November 2006, but this is enough to get us started.

The metrics

In this analysis, I'll be looking at three metrics:

• Monthly credit card statement balance - Since I use my credit card for most of my monthly spending, my monthly statement is an excellent indication of how much I've spent in a given month. This will basically represent my monthly cash outflow.


• Month-end line of credit balance - I use my line of credit to pay off my credit cards every month. Before you bristle at this statement, and tell me that I'm not "paying off" anything at all, merely moving debt around, remember that I make a corresponding payment to my LOC for every purchase I make with my credit card. For example, if I spend $40 at the supermarket using my credit card, I come home and transfer $40 from my chequing account into my LOC. Because I manage my cash flow this way, my LOC balance represents the amount of "old" debt I'm still carrying around. As I dig myself out of debt, this number should go down.


• Monthly line of credit interest - As my LOC gets paid off, the amount of interest I'm charged each month will also go down. There's an added wrinkle here in that I've got the lion's share of my "LOC" debt sitting on a 0% credit card, but this really just means that more of my monthly LOC payments actually goes toward principal. My monthly LOC interest represents the amount that my "old" debt is costing me each month.

With these three metrics in mind, let's have a look at the history I have available. I currently have data from November 2006 through March 2008, so I really have two options:

• Compare the Apr'07-Mar'08 numbers to the Nov'06-Oct'07 numbers - This will provide me with two "year-in-review" summaries that I can compare to each other. The concern here is that I have substantial overlap between the two periods being compared (Apr'07-Oct'07), so I'm not comparing distinct time periods.


• Compare the Nov'07-Mar'08 numbers to the Nov'06-Mar'07 numbers - This gives me two distinct time periods to compare, but I'm not looking at a full 12 months' history.

I prefer the second option, since it gives me a "clean" comparison of this year vs. last year, even if it's not a full 12-month picture.

The numbers

Now let's see how the three metrics stack up year-over-year.

Credit card spending

From November 2006 through March 2007, I spent $19,229.60 on my credit cards. As I type that number, I get a bit of a queasy feeling in my stomach. That's an average of $3,845.92 per month in credit card purchases, sustained over a 5-month period. I wish I could at least attribute this to one event skewing the results, like Christmas gifts or major car repairs, but the lowest monthly spending I had during this period was $2,818 in January, so this was indeed a consistent trend.

Fast forward to the past few months, where my total spending from November 2007 to March 2008 came in at a mere $10,163.05, or 53% of last year's spending over the same period. Note that the numbers for both years cover the Christmas shopping season, so this represents a huge change in behaviour.

Whatever challenges I may still have with sticking to a budget, my habits have clearly changed a lot from a year ago.

Line of credit balance

Throughout most of 2006, my LOC balance had held reasonably steady, in the low teens. Then, from November 2006 through March 2007, the balance started a period of rapid growth, going from $12,446.82 to $18,260.50, an increase of $5,813.68, or 47%. Comparing this number to my $19,229.60 in credit card spending during the same period, I'm actually amazed that this balance increase wasn't a lot higher.

Looking at the same period this year, my LOC balance dropped from $21,040.90 to $20,044.16, a reduction of $996.74, or 5%. That's another huge improvement.

Line of credit interest

Finally, let's look at how much my revolving debt has actually been costing me. Every dollar that I pay in interest on my LOC is a dollar subtracted from my debt payments, so minimizing this number is important in paying off the debt as soon as possible.

From November 2006 to March 2007, I paid $425.24 in interest on my LOC. Compare this with the $366.68 that I paid during the same period this year, and I'm making good headway. With more of my payments going toward principal, my debt reduction will move a lot more quickly.

Conclusion

There are really three conclusions to be drawn from this dig into my recent financial past. Strangely enough, this works out to be one conclusion per metric:

• My credit card spending (and therefore my general spending) is dramatically reduced from this time a year ago. Forcing myself to spend less than I earn has really paid off. Even though I'm still using my credit card for the vast majority of purchases (as well as some utility bills), my current spending is just over half as high as it was last year. No matter how you slice it, that is a major step in the right direction.


• My LOC is being steadily paid off. The beginning of 2007 was really the time when the balance started to skyrocket, and I've managed to reverse that trend, and actually bring the balance down. This is due to a consistent focus on debt reduction, combined with some basic saving for the unexpected (as well as the expected). Balances are moving consistently in the right direction, which is a great motivation to keep things that way.


• I'm paying far less in interest on my revolving debt. This is largely due to moving the bulk of my debt to a 0% card, but regardless of the reason, it means that the majority of my debt payments are going directly toward principal. By taking steps to slow my interest accrual, I've really accelerated my debt paydown.

As I unearth more history over the next little while, I'll try to dive a little more deeply into the credit card spending in particular, but this quick analysis of my recent past has really opened my eyes to some significant behavioural changes that I've made.

Investing and Taxes

Until this year, I never really considered myself an investor. Even though I have been making bi-weekly contributions to an RRSP for the past seven years, I've only recently begun to think about how my investments are allocated, both across asset classes and across markets.

There are a couple of reasons for this:

• The Employee Savings Plan under which I make my regular contributions has a two-year vesting period. This means that, until you've been enrolled in the plan for two years, you have to leave your shares untouched, or else you forfeit the employer's matching contributions. As a result, I spent my first two years deliberately ignoring my ESP account, and this habit survived beyond the end of my vesting period.


• I'm in debt. This has automatically put me in the mindset of trying to reduce my debts, rather than grow my assets.

Because of my limited exposure to investing, I haven't had to deal with tax considerations around my investments, beyond declaring RRSP deductions on my tax return.

As I get my financial machine running more smoothly, I'm starting to see the light at the end of the tunnel, and am beginning to imagine myself having investments outside my RRSP. As a result, I need to wrap my head around the tax concerns faced by investors.

There are several ways to derive income from investments:

• Interest income from bonds, savings accounts, etc.


• Dividends paid to shareholders


• Capital gains from the sale of investments (stocks, rental property, etc.)

These three types of investment income are treated very differently from a tax point of view, and I thought I'd go into the details.

Interest Income

The first type of income has the simplest, but least favourable, tax treatment. Essentially, every dollar of interest that you earn is treated as regular income, and added directly to your taxable income for the year. This means that, if you have a marginal tax rate of 35%, and you earn $100 in interest, you will pay $35 in tax.

In Canada, interest paid on a mortgage for your primary residence is not tax-deductible. In general, interest paid on loans is only tax-deductible if the loan is used to buy investments. There is also a technique, known as the Smith Manoeuvre, which can convert your primary mortgage interest to tax-deductible status through leveraged investing.

Dividend Income

Dividends paid by Canadian corporations have a favourable tax treatment, although the formula for calculating dividend tax is quite convoluted.

Dividend income is "grossed up" by 45%, so that a $100 dividend adds $145 to your taxable income. If your marginal tax rate is 35%, then you pay $50.75 (35% of $145) on every $100 in dividend income. The flip-side, however, is the dividend tax credit. This is made up of a 27.5% credit at the federal level, as well as a provincial credit ranging from 8-18%. The Ontario dividend tax credit for 2008 is 10.15%, so the credit for a $100 dividend would come to $37.65. This means that the net tax on dividend income for our Ontario taxpayer at 35% would be $13.10. In low-income tax brackets, this net dividend tax can actually be negative, which can offset other taxes owed.

Capital Gains

A capital gain results from selling an investment from more than you initially paid for it. 50% of capital gains are added to your taxable income, so if your marginal rate is 35%, then you will pay $17.50 in taxes on every $100 in capital gains.

The nice thing about capital gains is that, with certain restrictions, they can be offset by capital losses (resulting from selling investments at a loss). So if our 35% taxpayer had a $200 capital gain and a $100 in capital loss, they would pay $17.50 on the $100 net capital gain.

Note that, just as mortgage interest on your primary residence is not tax-deductible, the sale of your primary residence does not result in a capital gain (or loss).

Diversified Income

Just as it's recommended to hold diverse investments to control risk, it's recommended to hold your income-generating investments in the most tax-efficient vehicle. Of the three types of income, interest is the least favourable, as seen below for an Ontario taxpayer with a 35% marginal rate:

• Interest: $35 tax per $100 income


• Dividends: $13.10 tax per $100 income


• Capital Gains: $17.50 tax per $100 income

For this reason, interest-generating investments should only (or at least primarily) be held in a tax-sheltered account like an RSP. Since income from an RSP at retirement is already fully taxed at the marginal rate, interest income is no less favourable than dividends or capital gains in this kind of account. In a taxable account, however, dividends are the most tax-efficient type of income, followed by capital gains, so a taxable account is an ideal place for dividend-paying stocks.