Wednesday, April 28, 2010

Financial Security

Financial Security is a buzzword used around a lot by personal finance industry. Let us go beyond the cliché and try to understand it better.
Financial Security is our comfort with current financial situation and confidence that it will continue to last into the future. It is still vague as this comfort is generated at different levels for different individuals.
Generated by combination of following there elements:
1. Net-worth
2. Liquidity
3. Solvency

Net-worth:
Net-worth is the first measure of material wealth that one possesses. It is simply what s/he owns. It is your equity in what you own after reducing the outstanding loans. You are said to have more wealth even if you have lesser assets and no debt when compared with someone with a big house and a shiny car bought with mortgages, loans and other debt.

Liquidity:
Liquidity is another, very important measure of wealth. It is often poorly understood and overlooked. It is a measure of ability to come up with cash quickly (with in a few days). Two individuals with similar net-worth may be very different when measured for liquidity. It can also be generated with ability to borrow or available credit. Someone with $200,000 equity in a million dollar house may have very poor liquidity, whereas same equity in a $600,000 property may be very liquid and easy to access.

Solvency:
Long-term solvency is most poorly understood part of the personal financial security by both the customers and may members of the financial industry. It is a measure of an individual’s ability to meet his day to day financial obligations on an ongoing basis. These obligations are the interest, debt repayment and living expenses to keep up the current lifestyle. One should be able to service these from an ongoing source of income like a job, business or income investments.

An optimal combination of the above three attributes of our finances will determine our financial security. It also helps to take better decisions and allocate our finite dollars at the right place, measuring its impact on the above listed areas.

Thursday, March 25, 2010

Investment Choices

OK, I have decided to invest. The mortgage will be paid off as per the amortization. As I get closer to the end of this mortgage, I plan to have an investment build up with:
1. My contributions
2. Tax refunds and
3. The growth of above funds.
Let us talk about the 3rd issue here assuming first two are clear.

The money invested is expected to grow to meet our objective at acceptable volatility or risk.
Risk is defined as standard deviation of returns a particular investment. In other words how much would my returns fluctuate.

To understand this we need to disintegrate our options as following:
a. Debt
b. Equity
There above two options, in varying combination, derivation and allocation give rise to our investment options.

Debt:
This is money invested as loan to an institution. It can range from GIC (CDs in the US) to bonds and debentures. You loan your principle with a defined interest rate paid on regular intervals over a period. At the end of this period, the principal is due. The value of this investment is determined by the changing interest rates vis-a-vis the loan/bond in question. No matter what the changes are, if held till maturity, investor can expect the promised rate paid annually or semi-annually and principal at the end of the contract. This results in relatively a predictable return and stable investment.

Equity:
This category is formed by investments in to the ownership of a company in pursuit of business opportunities. This ownership is in form of shares and are traded on a stock exchange. The value of this investment is less predictable and returns can fluctuate widely depending upon the specific investment. The expected returns is usually higher than fixed income/bond investments to offset the uncertainty and volatility.

A diversified portfolio of above investments holding over 50-100 such individual investments are offered by the financial institutions as bond or equity funds.
A combination of these can be tailored to match individual financial plans and investment/asset allocation strategy.

Wednesday, February 3, 2010

Common questions around paying down your mortgage

These are the two most common questions I have come across when even I had a discussion around paying down the mortgage faster.

1. Would I not pay a lot more interest on my mortgage if I don't pay it down?

Very valid question. Yes you will pay more interest on your mortgage than what you will pay if you pay it down faster. However, consider this: You pay down mortgage with your after tax income.
The cost of paying down your mortgage is 33 to 45% tax and the long term growth. It is much cheaper to keep your mortgage and save the tax and have tax sheltered growth. If you don't have any other debts than the mortgage, you may use the tax refund to pay it down. I invite you to take an opportunity to understand the real cost of paying down your mortgage so that you could take an informed decisions. You could post your questions on this forum or call me at 416 840 5943.

2. What is the other situation when paying down your mortgage is not advisable?

For most people, it is very common to have a borrowing of some sort, in form of loans credit lines and credit cards. Interest rates on these accounts are typically higher than your mortgage and in some cases as high as 20 to 25%. One can save a huge amount or interest and monthly cash obligation if any excess cash is directed to this debt.
Remember, mortgage is still our cheapest debt. In certain cases, it is cheaper to even increase your mortgage to pay off these debts. As I had mentioned before, I would love answer specific questions from anybody who would like to take the time out to understand his or her debts get a better handle on monthly payments.

Monday, February 1, 2010

Mortgage vs. RRSP

Every other person is motivated to be debt free. In this pursuit, a question begs to be answered: Do I pay down my mortgage or save for my retirement?

Unfortunately there is a lot of noise on this issue leaving the population with a lot of fog and mist to navigate through.

We pay our mortgages with after tax income. A typical mortgage, now a days carries an interest rate of 2-5%. When we make extra principle payments, our saving is that interest rate. 2-5% !
Now, consider this: We typically pay 33-45% tax on our income and then apply it to save this above mentioned interest.
Paying 45% tax to save 5% rate does not go down well with any hard working prudent person.
Moreover, if invested in a moderate investment option, we can expect a long term tax sheltered returns of 6% or more.

Let us talk in numbers. A mortgage of $350,000 @ 3.5% will need extra $278/month to reduce amortization from 25 years to 20 years.
If this money is invested in retirement savings (RRSP) at 6%, it will amount to $193,600 by the end of 25 years. There will be additional $37,530 in tax refunds at marginal tax rate of 45% ($27,522 @33% tax rate).

All this by taking extra 5 years to pay down your mortgage!
It is time to recognize the friend we have in a mortgage, a leverage tool. Instead of getting rid of it, it is more valuable to consider in terms of where do I put my finite dollars for maximum benefit. Answer lies in assessing your personal situation and seeing what it costs us in terms of opportunity.