In this episode of The Money Scope, we discuss how to build a stable financial platform to launch from. That is key to successfully work towards your goals, weather bumps along the way, and live your best life. Specifically, we reveal how to use your money like a time machine.
Through debt, saving, and investing you can move your lifetime economic value through time. Used well, it will not only smooth the journey, but also help you to grow your wealth overall. Of course, if you mash the controls, just as in any time machine movie – bad stuff can happen. We’ve got the flux capacitor juiced up with 1.21 Jiggiwatts. So, join us to learn how to safely use that kind of power.
Transcript
- Introduction
- The Economic Time Machine
- Good Debt and Bad Debt
- Financial Resilience
- From Saving to Investing
- Account Types and Products
- Duration Matching Savings
- Pay Down Debt or Invest?
- Post-op Debrief
Introduction
[0:00:03] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[0:00:18] MS: Well, welcome to our next episode. In our last episode, we talked about setting long-term goals, using our internal values. We even had some exercises in there to help us define some of those values. And out of those, financial independence is one of the most commonly cited goals that people have, which does make sense since that financial independence gives you the flexibility and the freedom to then achieve many of your other goals. It’s a primary objective.
We also talked about strategies to set measurable targets, which are sort of waypoints along that journey towards the bigger goal. And how to make that long-term financial journey more rewarding. Because that’s going to be where you spend most your time. And, of course, it makes it easier to avoid some of the distractions along the way.
In this episode, we’re going to talk about starting with the personal finance side of what we’re going to be speaking about. We hope to help you build a solid financial platform to launch from. Specifically, we want to help you to understand how debt, and saving and investing can help you to move your lifetime economic value through time actually. It’s kind of like a financial time machine. And that’s important because it helps you to live the life that you want to live both now and in the future as well. It’s important to understand that.
And the other thing with a time machine, and if you watched any time machine movies, it’s pretty easy to get yourself into trouble too. We’re going to make sure we cover that side of dealing with debt as well.
[0:01:44] BF: All right. The Money Scope is prepped and the bite block is in. We’ve repaired the teeth marks from the last episode.
[0:01:49] MS: Excellent. Well, debt could be uncomfortable. I think we’re gonna need it.
The Economic Time Machine
Okay. We’re going to start off talking a little bit about debt, saving and investing. And that’s actually the order in which those tend to progress in people’s lives as well. When people are young, they usually have very little financial wealth. They borrow money to finance their educations, homes, businesses.
As their financial position improves and they pay down that debt, they can build up savings to create a strong financial foundation. And when you have that foundation there, then you can invest to build more wealth. And that’s important, to be able to spend that eventually in retirement.
Once we have that solid financial footing, that allows us to take some risk. And investing is what allows us to take that financial wealth and compound it. And taking some risk doing that allows us to grow that exponentially compared to what you would have if you just let that money sit in a savings account somewhere.
Diminishing Marginal Utility
Using debt early in life makes sense from an economics perspective. And that’s because of something that’s called diminishing marginal utility. Just to use a food analogy for that. Most people would get joy from eating one piece of pie per day. At least I would. And they get a lot more joy out of that than just eating one giant pie once per week and in one sitting. Debt’s kind of like that. It lets you spend some of your future wealth today. Instead of starving today and being stuffed later on, you can consume your lifetime wealth pie more evenly over time. There’s a good economic rationale behind the usage of debt that goes with that.
Now, just like food, it’s more complicated than that because we also have this emotional relationship with debt. And that can change how we use it beyond the rational economic model. And this is one of the topics that scares people. Debt could be scary for people. And particularly, for those who grew up in a household that struggled with debt. Because it can be one of those things that crushes people financially.
And for most of us that are professionals or run a small business, we may have likely taken on way more debt. Particularly, non-mortgage kind of debt. We’ve taken probably more of that on than most people and maybe even beyond what the experience of our parents would have ever seen. We needed to do that for our training and to start our businesses up. And it’s beyond the experience of ourselves or even our families a lot of the time. That just makes a little bit more intimidating.
Mental Accounting
We also tend to make some errors when we think about debt. We can compartmentalize our debt and kind of seal it off and ignore it. If we do that, then we have risks of over-borrowing and not dealing with it properly. That’s not a really healthy way of dealing with debt.
We have to avoid getting ourselves into trouble, but we can also use debt to flourish. And help ourselves along the way. We need to know how to use it and think about it in the context of our lifetime wealth.
[0:04:48] BF: Yeah, money is called fungible, which is a word that means that money in one bucket is identical to money in another bucket. All money is the same. Compartmentalizing it, like you mentioned, Mark, doesn’t make sense. And that same thing is true for money that you borrow. Thinking about your debts is one bucket that’s distinct from your savings doesn’t really make sense. It’s all kind of one bucket that affects your wealth.
Money is a tool that ties the future to the present and the present to the future from an economic perspective. When Present-You spends more than you earn, you have debt that needs to be repaid by Future-You. You can kind of see how it’s that string that ties your current and future self to each other. And then, of course, that debt will also grow over time due to compound interest.
If you earn more or spend less, you’ll be able to pay down debt, save, and invest for Future-You. It’s all this lifetime income and consumption. It’s just that it happens at different times. But we can use money, and debt, and investing to move that economic value through time.
[0:05:54] MS: Yeah. We do deal with this using something that’s called mental accounting. We have these distinct mental accounts when we think about our money. And we often do this just to be able to cope with all the complexity of it. For example, one bucket or one account is our debt. Savings is another mental account inside of our heads. And they don’t actually interact with each other. They’re kind of separate. That’s what mental accounting means. It’s a way that we try to manage some of that information in our brains. But placing the money, which is fungible, to these different accounts despite the fact that it’s really one bucket can lead us astray with some illogical thinking.
There are some times where mental accounting can be useful. It does help us cope with information and it can help us with some of our behaviors. But it’s generally considered an error from a mathematical standpoint. Because we can make illogical decisions about spreading our consumption over time. If we can avoid that and be totally logical, we can use it like a time-traveling Vulcan. Kind of like Spock.
Consumption Smoothing
[0:06:49] BF: Yeah. And money, it really is this fascinating technology that it’s like a time machine. It’s an economic time machine. It lets us move economic value through time, which I think is such an important concept.
There’s a really important concept in economics called the life cycle hypothesis, which is like the pie analogy that you used earlier, Mark. It basically suggests that people want to avoid sharp changes in their spending over their lives. To do that, to accomplish that, they’ll borrow and save as needed. Typically, borrowing when they’re younger and saving when they’re older to eventually fund their retirement.
Keeping consumptions smooth throughout the life cycle typically means having a hump-shaped pattern of financial wealth over time with lower negative wealth when you’re younger, peak wealth at retirement and then declining financial wealth through retirement.
Now the specific hump shape that any individual is going to have of their financial wealth over their lifetime is going to be different. It’s going to depend on their lifetime earnings, saving and consumption. Some people borrow a lot early on to fund things like an education or a business, which hopefully pays off in the future. They’re kind of making an early investment to increase their lifetime wealth. But that requires borrowing more of their future wealth to fund their lifestyle early on with the intention again of increasing the overall size of the pie, I guess, in the long run.
Some people save extremely aggressively. We’ve talked about financial Independence early on and retire early. So, the shape of their financial wealth hump is going to be different. And then on the other end of the spectrum, some people work until an advanced age. The exact shape of this financial wealth hump is going to be different for everyone. But that general concept of wealth over the life cycle is broadly applicable.
[0:08:29] MS: Yeah. After blowing some of those mental accounts out of our minds and thinking about smoothing the consumption of our total lifetime wealth, let’s move forward in a human-friendly byte of information here one piece at a time about this lifetime wealth pie starting with debt.
Good Debt and Bad Debt
[0:08:45] BF: Debt gets a bad reputation for a lot of good reasons. And we’ll talk about some of those reasons. A lot of them are psychological. Whether that be errors or how people feel about debt. But as we’ve mentioned, it also plays a valid role in good financial decision-making. Good rational financial decision-making.
I do think that a distinction can be made between good and bad debt, which are terms that people may have heard. I think how we make that distinction is important. And I think it can be made both economically and psychologically.
In general, good debt plays that useful role of smoothing consumption through time that we’ve talked about. Practically, that, again, means that younger people with low savings and low incomes would rationally borrow or could rationally borrow against their future income to smooth their consumption. And then as their incomes rise, they’ll pay that debt off and start investing.
For some applications, like investing in large indivisible assets when young. That’s things like we’ve mentioned with an education, or a business, or a home. That’s often unavoidable. You can’t easily buy a fraction of a home. You can buy a fraction of a company. And that’s what you do when you buy a stock. But you can’t buy a single share in your own education, for example. Young people with little financial wealth are often going to make that type of investment using debt. And then homes and businesses are going to be similar ideas where those are large assets, but they’re indivisible. You can’t buy fractions of them.
And then debt can also play the role of smoothing consumption in the event of a job loss or a temporary inability to work for some other reason. And then the cost of that, the cost of being able to move economic value through time borrowing against your future income in the case of debt is interest. Interest is what you pay to a lender on money that you have borrowed.
[0:10:26] MS: The interest is kind of like the ticket to ride in the time machine basically.
[0:10:29] BF: That’s good. Yeah. Yeah.
Mental Checks For Debt
[0:10:32] MS: There’s a few practical ways to think about debt that it can be helpful using this. I have a few mental checks that I use thinking about this sort of time machine. And one of the things is logically spending while in debt is logic equivalent to taking out a loan. You’re choosing to consume now rather than repay debt for past consumption already. Since all these pots are the same, that’s logically what it is.
While you’re in debt, you can ask yourself whether you take out a loan for whatever expense it is that you’re considering. Because you’re deciding to spend it on that rather than pay down your debt. And that could be something like a luxury car, expensive vacation, expensive meal. It could be whatever.
And the answer may be yes. Because it may be something that even though you’re spending money on it, it’s going to align with your values and goals. And it’s likely to give you lasting satisfaction. We talked about that in the first few episodes, which is why that was really important to have that reference.
But if it’s not aligned with those things but it can still be very tempting in the moment and this is a way of framing it, that might give you a bit of pause to weigh the answer more carefully. Because I think people do psychologically think of that a little bit differently. And this can help you to avoid regret or buyer’s remorse after it’s happened.
Another mental check is to ask yourself whether future you would think it’s a good idea in retrospect that you spent the money on this and had the debt. Because it’s going to be them who eventually does have to work and pay for it with their after-tax income. They may certainly be grateful for it if it’s something that actually does improve their life. Student loans are a great example of this. Pulling forward consumption. Or it could be a once-in-a-lifetime opportunity for some memorable experience or some object that actually facilitates that.
[0:12:11] BF: We’re going to get to some cases later. But what you just talked about, Mark, I want to tie in a really quick example. Spending while in debt is logically equivalent to taking out a loan. I think where people get in trouble with that and where this check becomes important is when you’re spending cash that you have. Like, you got your paycheck, you have money in your bank account and you feel like you can spend that on something. But if you’re already in debt, even though you’re spending cash, it’s logically equivalent to taking out a loan.
If people borrow from their line of credit to spend, I think that that pain of borrowing is there. But if you’re spending cash while having a loan, that’s effectively doing the same thing, but it might feel different.
[0:12:48] MS: Yeah. That’s a great way of describing it. I think it’s so true. I know it is for me.
[0:12:53] BF: Oh, yeah. Totally.
[0:12:55] MS: Money burns a hole in my pocket.
Your Future Self
[0:12:57] BF: I think visualizing your future self is also a really good idea. There’s been quite a bit of interesting research. We’ve had one of the main guys that’s done that research, Hal Hershfield, on the Rational Reminder podcast twice actually. But his research suggests that people behave in ways that are detrimental to themselves, to their future selves, because they have this weak psychological connection with their future self.
The research is wild. They did – I think it was FMRI scans to see how people viewed themselves in the future versus how they viewed strangers and people view their future selves more similarly to a stranger than to their self, to their current self. It’s a crazy thing where people just don’t view their future selves as the same person. And therefore, they don’t treat them with as much compassion and empathy. And then people also make cognitive errors. Like, they discount rewards in the future more heavily than rewards today. Much more heavily. And again, that might be related to the weak future self-connection, but it might also just be a cognitive error.
Either way, I think finding ways to connect with your future self can help a lot. And it sounds kind of funny when you hear it. But, again, this has been researched. But just doing things like writing a letter to your future self, which is kind of related to what you’re doing when you’re doing financial planning. Even if it’s not a written letter, when you’re thinking about yourself in the future and imagining different scenarios, I think you probably get to a somewhat similar place.
Another interesting one is looking at aged pictures of yourself. I don’t know how practical that one is. Because I don’t have a picture aging machine. But I think, conceptually, the idea is if you deliberately think about yourself in the future and try and find ways to build that connection, it can help with more rational decision-making.
[0:14:32] BF: And what’s neat in that episode, they talked about using artificial intelligence to help you have a conversation with your future self too where it could kind of simulate – I mean, the aging picture is pretty easy for me. I see an aging picture of myself every time I watch one of our episodes. I probably just need to get a lower-resolution camera.
My wife and I actually have written down future goals. I actually found them when we’re moving houses a couple years ago that we had written down early when we were married. And it’s really interesting to do that not just to have this exercise or talking about making connection. But it’s a good way to look back later and reflect and read then readjust those goals as you move along, which is part of financial planning. Because you often do become someone different than you thought you would be. When you look back at those goals later, you realize that you probably actually changed.
[0:15:11] BF: Yeah. That’s like the end of history illusion stuff where people think that they have just become the person that they’ll be forever. Even though the person they currently are is different from the person they were, whatever, two years ago. But that concept is why I think the information and why we started with that information in the first few episodes. Because we can’t predict precisely what’s going to make us happy in the future, we can use that lens of positive ecology to help generally understand what to aim for. And then we can use that lens of regret to kind of generally understand what to avoid. And you can run spending decisions through those filters. How’s it going to affect how you spend your time? How’s it going to affect your relationships? Is it going to lead to feelings of accomplishment? Is it going to get you outside? We talked about how important being outside is.
And then to your point, Mark, if you’re currently in debt, you can ask those same questions but in the context of would you borrow money to do this thing? Would you borrow money to get outside? I mean, maybe I would. I’d borrow money for a kayak or something to get outside.
[0:16:07] MS: Oh, yeah. I totally would too. If I had to, for sure. I mean, it’s funny. Because now knowing what I know, I actually would do that. Earlier in my life, I was so debt averse. I just wouldn’t have. I would have just found some other way, which is okay. But using debt can actually help you if you’re careful with it.
The Emotional Weight of Debt
And the other reason that I like the future you debt test is that it helps us with some of that emotional baggage that I was just talking about. I mean, there is such a thing that probably is good debt. But even with that good debt, it can still make you feel bad. I mean, I wouldn’t have bought a mountain bike or something really nice with debt for sure, even though it may not have been a bad decision.
And this is actually really important for all the early career crowd because this is one of the most common things that I get when I speak with medical students or residents. Because a lot of them really are beating themselves up over the debt that they’ve got. Or they’re starting their business and they’ve got loans and it’s very stressful.
And that probably is hopefully good debt. In the case of physicians, it’s somewhat of a predictable career path at least. And as long as you live like a student, Future-You will be grateful that you spent that debt to build up your career even though Current-You is actually sweating it out.
Dealing with the emotional weight of debt is actually really important. And it actually should be part of your plans to eliminate it and feel more secure. Because in addition to this math around compounding interest and time investing, I mean, you’re going to find that, right through what this entire podcast series, most financial decisions are a combination of the math and the psychology that actually allows us to carry through. Because money is supposed to actually help us enjoy our lives. Both of those intertwine with each other.
[0:17:42] BF: Yep. Some of the interesting evidence of physician student loan debt being good debt is how willing financial institutions are to extend that credit to doctors. Because it is – like you said, it’s a relatively stable career path. And the financial institutions therefore feel like they’re not taking much risk. That’s a vote of confidence, I think, for physician early career debt being a good type of debt.
[0:18:04] MS: Yeah. I think one thing to remember, even though future you will likely have that income, you can’t spend and live like you are that well-established future physician yet. Because a lot can happen along the way. And you need to still have to be somewhat careful about it. It’s not really money to spend without making some decisions.
[0:18:22] BF: Yeah. It’s consuming future wealth, which is expected but not guaranteed. Lots of stuff can go wrong along the way. And if you get stuck with a big debt load and you don’t end up realizing the income that you expected to earn. Yeah, definitely it’s relatively low risk but certainly not risk-free.
From the perspective of psychology, debt can have a negative impact on subjective well-being. Even though we’re talking about all this stuff about some use of debt being rational in some cases or even in a lot of cases early on in life, it can have this negative impact on subjective well-being, especially when the debt is perceived as a debt. And there’s interesting research on this too. But some people seem to be less likely to mentally label debt like a mortgage as debt, but then more likely to assign that label to their student loans. That’s a US study. Maybe not directly applicable to Canada. But I think, conceptually, it’s interesting that some debts feel different from other debts even though, again, logically they’re all kind of the same thing.
Mortgages and vehicle loans have also been associated with increased life satisfaction while credit card debt and student loans negatively impact life satisfaction in one study. Being in debt is also associated with high levels of anxiety, depression, reduced marital satisfaction and reduce job satisfaction. Now that’s from a big study that was – those are all correlational relationships. But I think it’s just still worth considering. There can be these psychological factors with debt that are important.
[0:19:45] MS: That’s really interesting research. And I think we can see that translating in our lives with some practical issues too. Even though student debt is good debt, if it’s psychologically weighing more on us than a mortgage, that’s important.
And I wonder some of that may be because current me gets to enjoy my house, or my car, or whatever I have the loan for. Where’s future me, as you’ve mentioned, is a bit more difficult to relate to. It’s not quite in your face as much.
But being aware of this type of bias and some deliberate type of reflection could temper how we feel about it. That could be important. Because sometimes the math is really, really strongly favourable. In Canada, the student loan issue, federal student loans in many of the provinces now, loans are interest-free. Mathematically, that’s a really strong argument to stretch that out and even let inflation eat away at how hard it is to pay that debt back. There may even be some forgiveness. But you really have to be able to emotionally get on board with that.
[0:20:38] BF: Yeah. Yeah. That is a really important point. And the interesting thing is the emotional side. I have seen cases where I’ve been able to illustrate, like, “Look, leaving this debt in place is actually a really good thing for you.” Whether it’s a low after-tax interest rate or even interest-free. But some people just want to get rid of the debt even if the math says they shouldn’t.
[0:20:55] MS: Yeah. But at least taking that time to externally consider it in a rational way. That I think is really important. And so, doing that with yourself on a calculator online or an advisor or whatever I think at least helps you make an informed decision.
With a line of credit debt, whether labeled or not, I think that definitely would weigh on me mathematically and emotionally. Both the interest rates and just the baggage of that. And I bring that example explicitly because there’s always been this debate about whether to pay off your line of credit or use that money to invest. And it’s less so now that interest rates are normalizing. But I think there are some important lessons in the debate. And we’re going to circle back on that later.
Financial Resilience
Before you can really consider that though, you have to have some financial resilience. And that’s we’re going to speak a little bit about next. And as your financial situation improves and you’re in a position to start actually saving some money and maybe even investing, you first need to make sure you have cash flow security and some financial resilience before you can do that.
Cash Flow Security
And this is very common early in a career. I mean, from the doctor perspective, it may be transitioning from the employed resident where you get a steady paycheck to the self-employed professional where income usually, even in our fields, comes, and fits, and starts and may have some unexpected costs for starting up your practice. And all the fees and everything else that goes with it.
There’s also some predictable costs that still surprise people. The biggest one being paying taxes in these massive quarterly installments. And we’ll unpack that more in a future episode when we talk about tax. But that often catches people off guard. Because they see that cash hit their account and there’s no longer taxes deducted at source.
And as you mentioned earlier, Ben, when you got that money in your pocket, it’s easy to spend it and not remember all of the other accounts that are in there that you have to deal with. And other professionals starting a business have I think a very similar unstable cash flow when they’re starting out.
Having some access to liquidity when it’s needed, really, it’s kind of like a form of insurance against unexpected irregular and unpredictable expenses. Because that is predictably going to happen. And you can’t really start investing until you know that you can absorb that kind of cash flow shock. Because if you get one of those shocks and have to sell investments, it’s usually going to be at a bad time. That’s something you’ll need as a prerequisite. But it’s a common dilemma about how to build up that cash cushion.
Do you pay down your debt more to build more room there? Or do you put money in a separate high-interest savings account? Again, this is a balance between behaviour and math and how you can actually do that and manage all the risks.
[0:23:26] BF: Just to reiterate on that. I think financial resilience is like urgent access to money, to cash, or liquidity, or whatever you want to call it without it being detrimental to your long-term financial goals. If you have to sell all of your investments that you’ve made to make your mortgage payments in a market crash, that is not a path to resilience. That’s a path to financial destruction and disaster.
And I bet there’s an important point there though, that access to money, access to liquidity does not necessarily mean having cash stocked away in a savings account or even more so under your mattress. Although, I do also want to say that a lot of people in survey research do identify having cash available to them as being very important.
But what it takes to be financially resilient is going to be different for every household. I think households that have more what’s called economic slack, which is like the ability to cut back on expenses to meet an unexpected financial need, you might be less worried about keeping piles of cash around.
Credit Cards & Lines of Credit
Credit cards and lines of credit can, to an extent – and I want to be as particularly careful with credit cards here. But they can, to an extent, provide emergency access to money if they’re used properly. This means that access to credit and cash savings. Having money in a bank account or having access to credit, those are two different paths, two alternatives to building financial resilience.
And they’re not mutually exclusive. You could have both. And I think a combination probably does make a lot of sense. But whether you build this emergency buffer that we’re saying is important before starting to invest by building up savings or paying down debt. That is, for example, if you have a line of credit that has a $300,000 total credit limit and it has $100,000 that you’ve drawn from it, paying down that $100,000 gives you more room to borrow in the future. It’s kind of like saving.
Now I do just want to emphasize on credit cards, that while they are a source of liquidity, they’re only reasonable to use for very short-term solution. Because you can borrow on your credit card. And as long as you pay it off in that billing period, you’re not going to pay any interest. But as soon as you start carrying a balance on a credit card, it’s very expensive. Because the interest rates are so high.
If you do have a balance on a credit card, which is that like at 20% or whatever interest rate, paying that off is going to be pretty compelling no matter what. You can’t find a 20% guaranteed return anywhere else. If you have an unsecured line of credit, paying that down to create more room to borrow in the future is often still going to be compelling because the interest savings from paying down a line of credit are usually going to be higher than the interest rate that you’re going to earn with cash sitting in a savings account especially after taxes are considered.
It is important to be aware of the fact that lines of credit are typically callable loans, which means that the bank can change the terms of the loan. For example, the total available credit could be changed. Or the bank could ask you to start repaying the loan in a way similar to a mortgage payment. They can amortize the loan. While lines of credit can be sources of liquidity, they’re not quite as safe as cash. Roughly equivalent because they’re pretty safe sources of liquidity, but it’s not quite the same level of safety, but still very safe. I don’t want to scare people.
[0:26:36] MS: I think it’s a really important point though, it depends a lot on how cyclical your business is. And even physicians aren’t immune to that. I mean, when the pandemic came, OR shut down and there are a lot of doctors who are out of work for a period of time.
And if you have a callable loan, when do you think the bank is most likely going to change the terms and call the loan? Well, it’s going to be when they see some threat of not getting paid back. Callable loans, like a line of credit, the highest likelihood of them getting called back is when something bad economic is happening across the board and they’re afraid of getting their money. It’s usually going to happen the worst possible time. It’s kind of like investing with margin is the same idea. They’re going to want to call that margin back in when the stock market’s not doing well.
[0:27:18] BF: Yeah. And, again, we’ve never seen that happen with a physician client. But it is a risk that is there. I’m not sure if we’ve seen it happen with any client. But that doesn’t mean that it can’t happen. It doesn’t mean that it doesn’t happen.
[0:27:29] MS: No. There’s a lot of people having the terms of their lines of credits change though. Interest rates changing pretty dramatically. I don’t think so much with our group of borrowers. But I think, in general, I’ve heard a lot about it.
[0:27:40] BF: Yeah. Rates are changing, for sure. Because lines of credit are going to be typically floating-rate loans. I think the scarier consideration is if you have a $300,000 credit limit and you’re relying on that and then your banker tells you that they’re cutting that to $150,000. That’s a tough surprise.
And then, likewise, if you have a balance on the line of credit, which you’re making the revolving payments. Typically, with line of credit, you’re making interest-only payments. But the bank could decide to amortize the loan. They could say you’ve got to start paying back principal and interest. And we want this loan paid back in five years or something like that. That’s a hypothetical possibility with line of credit, which of course can’t happen with cash savings.
Again, relatively rare instances. But to your point, Mark, and it’s a very important point, if those things do go wrong with the line of credit, they’re going to go wrong at the worst possible time.
[0:28:28] MS: Yeah. I think the professional line of credits that we’ve been talking about are relatively safe. What would concern me is a home equity line of credit and if you’ve used that to take that home equity line of credit and invest in more real estate and more real estate, and then those are lines of credit that can easily be changed. And that changes your whole business model of what you’re trying to run.
[0:28:46] BF: Yeah. Anyway, we’ve got these different sources of liquidity. And in terms of levels of safety, I would say cash savings are kind of the king of safety and liquidity and lines of credit kind of after that. They’re still liquid. They’re still relatively safe. They’re still sources of funds when needed. But they’re not quite as safe as cash.
And then, I also think it’s important to touch on the psychological considerations with that that we’ve already mentioned a couple of times. Including discipline. Not to overspend. If you have a $300,000 line of credit limit, that can burn a hole in your pocket in much the same way that cash can. And then there’s also the psychological discomfort with debt, which can arise for cultural reasons or the way that you grew up. Some people just don’t like having debt. Plain and simple. And in that case, having cash savings for emergencies would probably be better than painfully drawing on debt or having to draw on debt.
Now, one argument for having a dedicated cash emergency savings account as opposed to a line of credit that you use for all sorts of different expenses is that designating an account specifically for unexpected expenses can protect those funds. And this is empirical study. Can protect those funds from being spent for other purposes. And similarly, may protect other savings like retirement savings from being spent to cover unexpected expenses when they arise. Because funds earmarked for certain purposes are less likely to be spent on other categories.
You mentioned briefly earlier, Mark, that mental accounting can sometimes be used advantageously. This is one of those examples. Access to liquidity is the main point. How you structure that does matter. I think cash savings is – from a few different perspectives, at least for a portion of potential liquidity needs, I think is a pretty attractive option.
[0:30:23] MS: That’s a great point. The other thing I was thinking about when we were talking about line of credits is one of the questions that commonly comes up is should I close off my personal line of credit and use it? Or should I use a corporate line of credit? What should I do for my lending needs?
And the reality is they’re both relatively theoretically equivalent. I mean, for us, we closed off our personal line of credit and we now use a corporate line of credit as our cash flow buffer. And part of that’s behavioral too. I think there’s a couple of advantages.
I mean, one is that who’s at our business income? On our operating expenses? Which is probably the biggest fluctuation in our lives. It’s not so much our personal spending. But when we do have big personal spends, we’re also a little bit more reluctant to just take this huge chunk of cash out of our corporation and put on the line of credit and trigger all the taxes with that than we would be if it was just a personal line of credit. It puts another layer of accessibility for us to think carefully about it. And it also allows us to not leave large chunks of uninvested cash sitting around in our corporation. Because once we do have that financial resilience, we need to move from saving to investing.
[0:31:23] BF: Yeah. And that’s exactly where we want to go next from the transition from saving to investing.
From Saving to Investing
Eliminating debt and building up cash savings, that’s going to create wiggle room for unexpected expenses. But you also want to direct savings toward major known and near-term expenses before committing money to an investment.
Savings in a bank account, as we’ve mentioned, are considered extremely safe in the short term. You know with a high degree of certainty, especially here in Canada where we tend to have pretty low unstable inflation and our banking system is pretty safe, you can be pretty sure that the money in your bank account will roughly be there and maintain its purchasing power in the near term.
An investment is going to be a different animal. Investing – and we’ll talk more about this in the next episode. But investing is putting money into something that you expect to deliver a positive return over time in exchange for taking risk.
Now risk is a very complex topic. And the word risk can mean a lot of different things in the context of investing. But for this discussion, it means that, in the near term, money that you invest could be worth a lot more or a lot less than what you started with.
Having an expense in three years doesn’t necessarily mean that you need to park all of the savings for it now if you plan to add to your savings between now and then. That’s an important point here, where there’s rules of thumb around how far in the future should you need money before it can be invested.
Some rules of thumb are like three or five years. If you have an expense, a need in three or five years, money should be saved, not invested. But that I think is driven more by your ability to build new savings over longer periods of time than it is by being a suitable period for a risky long-term investment.
If you told me I’ve got a five-year time horizon. Should I invest in stocks? Absolutely not. But if you haven’t expense in seven years, the point here I think is that you maybe don’t need to be sticking all of that money into a savings account now because you’ll be able to build that savings up over time.
Even longer out in the future, a major purchase in 10 years, you probably don’t need to save at least much for it now. You can maybe start saving for it. But you don’t need to take all that cash and put it in a savings account now. And I think this also highlights the problem with rules of thumb when we’re talking about personal finance. What’s the time horizon for a long-term investment is always a funny question to answer. I don’t think it’s a great answer. But that’s one of the important considerations in just thinking through when should you move from saving to investing.
[0:33:48] MS: Yeah. And I think this thinking really highlights the whole issue of trying to separate all of your accounts mentally out. Because how you tackle your investing can also influence how much of both you’re able to do at the same time. You mentioned being able to save some money over time to make up for the money if you invest it now. That’s one way that you can actually you could invest money as long as you’re able to save that up.
For example, you could also invest money that actually frees up some cash flow and invest a little bit at the same time. For example, I could use in my RRSP and invest some money in my RRSP now, I get a refund from that. That’s taxes I otherwise would have paid. Now I actually get some investment and some tax money back plus the tax-sheltered growth. I get that a little bit of both that’s got a bit of a boost by the fact that I used that instrument to invest with.
And the other part of it though is really you have to be able to access the money. The problem with an RRSP is that you can only take out money for specific purposes. If my reason for saving was for a house, with an RRSP, I could access some of that money with a home buyer’s plan potentially. But if it was for some other reason I was saving, I may not be able to access it. So, you’d have to be a bit careful about that.
Even though when you invest the money using an instrument like that, if you are planning to access it. Like, say, I want to take money out of my RRSP in a few years for a house. I still have to accept the fact that I’m investing it and that there’s a risk that the investments may be down in price at the time that I need the money.
I may need to either invest a little more conservatively or be flexible. And I think this is the other part in addition to just how much you were able to save over that period of time is how flexible it is. What it is that you’re planning to save and spend on? If I’m unwilling to compromise on how much I’m going to spend my looming house purchase or I’m unwilling to delay it by a year or two if the markets are bad. Then I really need to save more of that money or be very conservative with it rather than aggressively invest it. Because I can’t take that risk. And it doesn’t really matter the account that I use. You have to match your flexibility and your saving ability, all of that together when you’re weighing the two options.
Account Types and Products
[0:35:48] BF: Yeah. You started backing into some really important practical issues there. What does it actually mean to put money into savings? We need to both address the things you’re just touching on there, which is account types of which there are a ton in Canada and investment products.
Registered Savings Accounts (RRSP, FHSA, TFSA, RESP)
In Canada, just to name a few of them, we have accounts like the RRSP, the Registered Retirement Savings Plan. The FHSA, the First-Time Home Buyer Savings Account. The RESP, the Registered Education Savings Plan. And we have the TFSA, the Tax-Free Savings Account. These are referred to as registered accounts.
Now a common misconception, and I think that this can lead to a lot of mistakes, is that an account type like an RRSP or a TFSA is not itself a financial product. These are account types that have different tax attributes. When you make an RRSP contribution, you can deduct that contribution from your taxable income. Whereas with the TFSA, you’re making the contribution with after-tax dollars. But growth inside of both accounts is tax-free. And we’ll get more into that in a future episode. But these are the account types with different tax attributes, like the examples that I just talked about. But inside of those accounts, you can hold different types of financial products.
An RRSP is not itself an investment. And a TFSA is not itself an investment. You have to first pick the account type that you want to use based on its tax attributes and other rules around it. Like, how you can make withdrawals and all that kind of stuff. And then once you pick the right account type, then you have to deposit money into it. And then you’ve got to decide what financial product you want to put money in.
But an RRSP itself does not have a rate of return, for example. An RRSP is a type of account. And then what you invest inside of the account has a rate of return or expected rate of return.
As we’ve mentioned on savings, your savings need to be safe. Now safety in this context means that it’s going to be stable in value and accessible when you need it both really in the short term. We’ll go deeper on account types in a future episode as I mentioned. But I think just for now, very briefly, RRSPs, FHSAs, RESPs are generally – and I say generally because there are exceptions like purchasing a home in the near term, but are generally not well suited for short-term accessible savings. While TFSAs and non-registered accounts, non-registered is just an account that doesn’t have any of the special attributes that registered accounts do, those tend to be better suited for short-term savings.
All of the registered accounts do have limited contribution room. And contribution room is calculated different ways for all the types of accounts, which again is beyond the scope of this episode. But because they have limited room, with the TFSA, for example, which I said can make sense for short-term savings. While that is true, it’s probably actually ideal to prioritize the TFSA room, the limited TFSA room that you have for your long-term investments, which tend to have more income to shelter if you’d rather have more tax-free growth in the TFSA from your long-term Investments rather than parking cash in there.
If you have TFSA room that’s not being used though for long-term investments, then you can park savings in there. I know this gets kind of confusing, but it’s like you have this finite amount of TFSA room. Ideally, you use all of it for long-term investments. But if you’re not using it all for long-term investments, then it’s a good place to park short-term savings. Anyway, so that’s picking an account type. And then we need to pick the product.
[0:39:05] MS: Just to emphasize this. This is important because people – the accounts basically, like the grocery bag that you’ve got and the things that you buy to invest in are the groceries you put into it. And it’s important that you can know you can buy your bag and you can buy your groceries separately. Because if you go to an institution, they’re going to sell you a prepackaged bag calling it the RRSP or the TFSA, which is really their package that comes filled with a bunch of junk food that they put in there.
[0:39:31] BF: That’s such a good analogy. but you’re right. They will. They’ll sell you like their 3% TFSA. And that makes it seem like the TFSA is itself an investment. But they’re selling you a grocery bag full of, I don’t know, Cheesies, which can be very confusing for people if they don’t know that they’re buying the bag and the food together when they could be purchased separately. Or you can make decisions about them separately. Picking a product to go in there. Hopefully not the equivalent of Cheesies.
High Interest Bank Deposits & CDIC Coverage
High-interest bank deposits are kind of the gold standard of safety and liquidity while still earning. High-interest bank deposits are weird right now. Because if you go to an actual bank branch, the rates that they’re paying are pretty low. Much lower than what you can get elsewhere. And we’ll talk about some of the different products that are available. But it is worth looking around.
If you go to one of the big banks, for example, the savings accounts there are going to pay relatively little interest. Whereas if you go to maybe a smaller bank or if you look for some other types of high-interest savings products, which you can get through self-directed brokerage accounts sometimes, you can get through financial advisors most of the time. For large amounts of money, if you’re parking tens of thousands of dollars or hundreds of thousands of dollars in cash savings for a long period of time, it’s worth shopping around. High-interest savings account is like a common term. But the actual high-interest rate can be very, very different from product to product and institution to institution.
Now a common thread in bank deposits, which most but not all high-interest savings products are going to be. And we’ll talk a little bit more about high-interest ETFs later. But bank deposits in Canada are going to be covered by $100,000 of CDIC coverage, which ensures the deposits per account type.
That means, for example, you could have $100,000 of CDIC coverage in a personal account, and again in a joint account, and again in a TFSA all at one institution. And then, of course, you can multiply that coverage by using multiple banks. But that can start to get inconvenient. It depends how much you want to optimize.
I’ve seen people have accounts at five different banks to try and maximize their CDIC coverage. To me, that would seem like a little bit of a nightmare. But if you run the numbers, and it’s – if you can get a little bit more interest maybe and you feel safe having that coverage, then, hey, I guess if it works for you. It would drive me crazy personally.
[0:41:47] MS: Oh, yeah. Well, the time where I’ve seen it is as parents and people age, they really want to keep that money squirreled away. But the problem is if they pass away, their kids have to find it. And, yeah, I’ve seen a lot of people who actually forgotten they’ve had these accounts of money sitting places. And it’s just been sitting there wasting away when they could have used it.
[0:42:04] BF: Yeah. I’ve seen estates take years to process for that reason. Because you keep finding different accounts hidden away in different places. Now that risk of like should you worry about CDIC coverage, because CDIC is going to cover you in the event that a bank fails and cannot return your deposits to you. Should you worry about that in Canada with the big banks? Less so.
I mean, even while that’s true, I think a lot of people probably were a little bit stressed earlier this year when there was some pretty meaningful banking concerns in the United States. I think that made people a little bit nervous in Canada too. I know we got a lot of questions about it. Just from a piece of mind perspective, maybe staying within the CDIC limits makes sense.
But again, I guess the way that I would say it is that if you’re going to go over the CDIC limit because you don’t have a choice, doing so with one of the big Canadian Banks is probably safer than doing it with a smaller institution or maybe with a credit union. Worth staying in the CDIC limits if you can. If you can’t, then sticking with the big banks in my opinion at least is probably a smart way to do.
Yeah. The high-interest savings account is a good option for savings. And it’s going to provide flexibility. It’s usually going to have deposit insurance coverage. And then the downside is that it’s going to pay an interest rate. Even at current rates, which are high, it’s going to pay rate close to inflation. Current rates are high. But guess what? So is current inflation.
And that interest, if it’s in a taxable account, is going to be taxed. After-tax, the interest you’re going to earn on a high-interest savings account is maybe not going to be so high.
High Interest ETFs
[0:43:33] MS: Yeah. And those accounts that we were just talking about are basically ones that you open at an institution. But there’s also ways that let’s say you do have some money in one of your special accounts that you don’t want to invest too aggressively right now. Like, say, you have some money in your RRSP or your RESP and you’re going to need that money. There are different products that you can use that have some risks and restrictions. They’re not quite cash, but they can be very close to being cash equivalent. And you might hear that term cash equivalents.
One of those options would be a high-interest savings account, ETF. This is an ETF or a fund that you would buy and put inside one of these accounts. And it’s not the same as depositing the money directly into the bank like we just talked about. What these funds do is they take they have money and they actually deposit it into high-interest savings accounts across multiple institutions. They kind of spread out the money and collect the interest for you.
Now with that arrangement, you don’t get this CDIC insurance. But that already minuscule risk of a bank going under that we talked about is actually spread out amongst a bunch of different banks. It may be a little bit less of a concern. But it still is a risk that’s there.
And the other thing that does come with those ETFs is that they do have a small management fee. You’d be paying some money. It’s not a lot. But it’ll be a little bit off of the interest rate to have that money managed across all of these different accounts.
Now why would you do that? I mean, the main upside would be if you have that money sitting in an investment account and you don’t want to take it out of that tax shelter before you need to. And particularly, ones that you can’t put the money back into. Your RRSP or your RESP, take that money out, you’re not going to be able to just put it back in. But if you want to park it and let it sit for a bit, high-interests savings account, ETF, might be an option.
Money Market Funds
Another option would be money market funds. And they’re similar in that you can buy them inside your investment account. They have a small management fee. Usually kind of in the 0.2 to 0.3 percent range. And instead of using that money and putting it into a bunch of high-interest savings account, they take that money and they invest it in very short-term bonds. A nd by a very short term, I mean like one to three months.
Yeah, there is some risk of some change in the value over one to three months if there’s a dramatic interest rate change. But it’s pretty small over a one to three months period. It’s not going to affect it that much. And there’s also, of course, anytime you have a bond, you’re basically loaning someone your money. And if they go bankrupt, you may not get it back. There is that risk.
But most of these funds are really – they hold relatively safe government bonds. The risk of that is pretty low. If you’re parking money for a few months, a money market fund is another reasonable option that could pay a little bit more.
Another option that people often talk about is a GIC or a guaranteed investment certificate. And this is a product that you can buy at a bank or a credit union. And they usually pay slightly more interest than a high-interest savings account. They also have CDIC insurance like a high-interest savings account. But the trade-off for that is being able to access your money. There’s the safety, but it comes at the cost of locking your money up. It’s not as readily accessible. You should hope you get compensated by higher interest rate for doing that.
Duration Matching Savings
[0:46:36] BF: Yeah. That point introduces another concept. It’s funny how savings accounts seem like they should be such a simple thing. But I don’t know how long we’ve been talking about them now. We haven’t even got into the more complex topics like investing. You can see that –
[0:46:49] MS: It’s good though. People ask about all this stuff a lot though, because everyone’s looking trying to squeeze every little penny out that they can. Because this usually is happening at a time in their lives where every little penny really counts to them.
[0:47:00] BF: Yeah. Yeah. That’s a good point.
[0:47:01] MS: I think it’s a good time spent here.
[0:47:04] BF: Yeah. Definitely. Yeah. Another important concept on the many complexities of what seems like it should be simple in savings accounts is matching the financial instrument, the financial product that you use and the account type that you use to the time frame for when you need that money.
Guarantied Investment Certificates (GICs)
The economics term here would be duration matching your savings to your financial goals. For example, if I am going to need money in two years and not before, then I might buy a two-year guaranteed investment certificate. A GIC, like you mentioned. And that might give me a higher rate sometimes. You got to always compare rates. If you’re not going to get a better rate in the GIC and the high-interest savings account, maybe you wouldn’t do it.
But the other thing though, is that the GIC rate is locked in for two years. Whereas high-interest savings rates can drop tomorrow. Anyway, with a two-year GIC, you lock in the current rate and you maybe get a little bit of a better rate and you guarantee that rate for the full two years. And it’s going to be available in two years when you need it.
Now that sounds good. But I’ve seen this go wrong many times. The downside of doing that is that you may end up needing the money sooner because you think you have this two-year need. But if something comes up or if a need is brought forward in time for some reason, there can be penalties where you give up some of the interest that you’ve earned on the GIC.
Or if you look in the GIC contract, in many cases, or maybe even in all cases with a regular GIC, the GIC issuer is allowed to simply deny the withdrawal. Because you’ve entered into a contract to give them the money for a fixed period of time. It’s at the GIC issuer’s discretion. But I have seen them say, “Nope. You can’t have it back.” Which kind of sucks if you have a liquidity need that comes up in the interim.
Government Bonds
The other thing that you can look at if you have enough money to make it worth the effort. And you’ve got to be a little bit careful what the transaction costs here. But it’s buying government bonds that mature in line with your time horizon. That’s like one of the most risk-free ways to fund a known future liability is duration matching it with a safe bond.
The price of the bond will fluctuate over time. Say it’s over a two-year period. The bond price might fluctuate over the time, but you know what’s going to mature because of the way bonds work at its face value. If you put $100,000 into a two-year bond, you’re going to get your $100,000 in two years when the bond matures and you’re going to get the interest coupons along the way.
Bonds are liquid unlike a GIC. But in this case, the risk is the bond price fluctuating in the interim. If you need your money in one year and interest rates have gone up over that period of time, your bond is going to be less than its face value.
Now another important point there on bonds is that this is not the same thing as buying a bond fund, like a bond fund, or ETF, or a bond mutual fund. An individual bond is going to fluctuate in value over time like the example that I just talked through. But it does give you certainty around your principle at maturity. So you know you’re going to get the Facebook value back at maturity.
Bond funds own a whole bunch of different bonds and they’re constantly rebalancing the bond portfolio to a target duration. The duration of your individual bond is going to decrease with time to match need, your funding need. But the bond fund is going to be constantly rebalanced to a target duration. If the bond fund’s duration is eight years and you hold it over a two-year period, the bond fund duration is going to remain at eight years. Basically, it’s not going to guarantee that you get your principal back at maturity like an individual bond would. I would say as a generality, bond funds are more suitable for investing and they play a different role in your portfolio. Whereas you could use an individual bond to perfectly match a future liability.
[0:50:30] MS: Yeah. We have a really good reason why we’re spending all this time on differentiating between savings, and investing and duration matching your savings to the right instruments. And the answer is that when time is on your side, you can take some risks to earn higher expected returns. And over long time horizons, there’s actually risks to not taking that risk.
All these things are important for that time horizon to make the right decision about what you’re going to do with your money. The bank deposits and savings or vehicles that guarantee that nominal value. So, the money that you’ve got in there is going to be there worth that amount. But that’s without adjusting for inflation.
And if you’re going to be looking at longer periods of time, the buying power that you’ve got with your money, if it’s just nominal dollars, not adjusted for inflation, is going to erode over time. And over three years, that’s probably not a big deal. I know we’ve had a lot of inflation the last few years. But over long timeframes, it’s going to definitely be a big deal. For 30 years, historically, you are much more likely to lose purchasing power in safe short-term investments than in risky long-term Investments. And there’s data to show that that is historically what’s happened. And that makes sense with all the things we know about savings and investing.
Having a mix of stocks and bonds helps to balance that inflation risk with some of the investment risks. The shorter your time frame is, the more you’re going to lean towards cash. Maybe some bonds. And we’ll get into that more again when we talk about risks and asset allocation in a future episode.
But the basic idea of time horizons is what’s important. And that’s important when you’re weighing saving versus investing and all that kind of gray area in between. You really need to know what your time frame is.
Pay Down Debt or Invest?
And that brings us to the pay down debt versus invest debate. And we’ve covered a lot of the basics leading up to this point. And we’ve touched a little bit on the transition to investing. But before we extract the money scope, I want to touch just briefly on this is a major stressor for professionals and for business owners that sits at the intersection of these topics.
I mean, a lot of us have this big pile of debt when we graduate or start up our business. There’s also a lot of social pressure at that time to take on more debt like a mortgage. And we also struggle with how we’re going to pay that down. And we feel behind. Because we often start a lot of this later in life, we feel behind with our saving and investing part of it too. Everybody else seems to be doing all these things and we feel pressure to do all of them at the same time. And it’s hard to balance out with each other. We’re going to cover this in one of our cases. But this discussion we’re going to have right now just serves as a bit of background to that.
Risk & After-Tax Expected Return
[0:53:01] BF: Yeah. This is a situation that applies when you already have debt but you’re at the point where your income will allow you to pay it down. And the basic premise here is that you want to allocate your dollars toward the highest after-tax expected return. Paying off debt earns you, sort of, in the form of interest that you no longer have to pay a return. But that’s not necessarily going to be the best economic outcome.
If you could leave the debt unpaid and invest in an asset that pays more than your loan interest, you might be happy to do that. Although, that also increases your risk. That’s borrowing to invest, which is generally a pretty risky thing.
Now running these numbers, pay down debt versus invest, as it turns out, especially when we’re talking about things like corporations, is not super simple for a few reasons. One is that we have to consider taxes. We need to consider risk. Like I just mentioned, borrowing to invest is riskier than not doing so. And we need to consider the previously mentioned psychological factors, which that alone can result in even the best calculation, which I think is pretty hard to justify that it’s even possible to do the truly optimal calculation because of all the uncertainty. But even if we could, the calculation could be useless for each individual decision because of how important the psychology is.
Taxes also matter in assessing debt. There are two sides where taxes have an impact here. On one side, interest on money borrowed for the purpose of earning income from business or property is generally tax deductible. That’s going to cut your after-tax cost of interest relative to your pre-tax cost of interest. And I think that’s an important point.
Investment Loan Interest
[0:54:30] MS: Yeah. I think this is a really important distinction. And it’s one that often confuses people. For interest to be deductible, it needs to be clear. There needs to be a paper trail that the loan is used to invest. And it must be invested with the expectation that it’s going to earn income. By that, I mean not just capital gains, but actual some type of taxable income. And it has to be taxable income. It can’t be in a tax shelter like a TFSA or an RRSP.
If you take out a loan or put money on your line of credit to invest in your TFSA or your RRSP, that’s not a tax deduction. And with that paper trail, the sequence that you do things is actually really important. If I choose to invest instead of paying off my line of credit, well, that’s logically the same thing as taking out a loan to invest. But it’s not for tax purposes. That interest is not deductible because that’s just the line of credit I paid for all my other stuff with. It’s not specifically for an investment.
If you do pay it off though and then you take out a new loan, or line of credit, or whatever and then you try track its use for taxable income yielding investments, then that interest is deductible. If you’re in a 50% tax bracket, that 8% interest is functionally more like 4%. Because half of that is made up for by the fact you’re not paying tax on it. So, you don’t have to get as much of a return to get to the same spot.
If you’ve partially paid off your line of credit, then you explicitly took out money to invest, just the portion you took out to invest is deductible. Not the whole thing. And, yeah, you can do that. But that makes bookkeeping really a big pain in the butt. I mean, to try to track all of that.
[0:56:04] BF: Yeah, big pain and a risk of an error which CRA might not appreciate if they catch it before you do. On the interest cost side, the deductibility, whether the interest on the loan is deductible or not, that’s going to matter a lot on this invest versus pay down debt debate. On the expected investment return side, you may have to pay tax on investment income. If you’re investing in a taxable personal account or a corporate investment account, your after-tax cost of debt is going to have to be compared to the after-tax expected return on a potential investment.
In a non-taxable account like a TFSA, your pre and after-tax return are the same. But in a taxable account, your after-tax return is typically lower. I ran some estimates just based on PWLs current expected return assumptions. We do expected return assumption for like the total return. But we also break that down by return characteristics. Whether the return came from interest Canadian dividends, realized capital gains or unrealized capital gains. Because those are all taxed differently. It’s a bit of a complex calculation.
But anyway, I ran these numbers assuming just a 30% tax rate held in a personal account. And with those assumptions, a 6.91% pre-tax expected return falls to about 6% after-tax at a 30% personal tax rate. For bonds, the expected return for pre-tax is 4.15%. But at that same 30% tax rate, it falls to 3.19%. You can see there’s quite a big difference there between pre and after-tax returns.
[0:57:31] MS: Yeah. And I think just to sum up the section we’ve just gone through with all the numbers, just as a basic rule of thumb with that 30% tax rate, you really would have to have about 1% higher rate of return than the interest rate to break even with those assumptions if you’re investing that way. And if you’re in a higher tax rate, then it would have to be a bigger difference. And a lower tax rate could be a smaller difference. And you might have to be invested fairly aggressively to get those returns. Whereas paying off the debt and just not taking on new debt is a risk-free endeavor.
[0:58:03] BF: Yeah. Yeah. Definitely. That’s step one in thinking about this, is you’ve got to look at your after-tax interest cost and your after-tax expected investment return. And then you can make the first part of this comparison. But return importantly is only one part of the equation.
Weighing Risks of Debt vs Investing
You just mentioned, Mark, that paying down debt is going to be much less risky of a return stream than investing in something like stocks. Paying off debt is still not a guaranteed long-term savings. Because depending on the type of debt, the interest rate can change over time. If you pay off a high interest savings account that is at a 7% interest rate today and then rates drop to 2%, you might be kicking yourself. Although, I guess you could just re-borrow from it.
[0:58:44] MS: Yep. Exactly. Yeah.
[0:58:46] BF: But anyway, much less risky though to pay off debt in terms of the return stream that you’re going to get from that than it is to invest in a risky asset like stocks. Now even still, a portfolio of stocks is going to be – even though I mentioned that the high-interest savings account does not totally guaranteed return, investing in stocks is going to be much more volatile than changes in interest rates. Or at least typically it will be. And to be confident about earning the expected return on a portfolio of stocks, you’ve got to be able to hold it for a very long time.
And even then, it’s not a guaranteed return over longer periods of time. It’s still an expectation of return. And then another thing on risk I think that’s important is separate from investment risk. Debt has cash flow risk because you’ve got to make payments. We’ve talked about cash flow uncertainty earlier in this episode. If you’re in a situation with cash flow uncertainty, having meaningfully large, fixed payments related to debt, that can increase your household risk pretty substantially.
[0:59:41] MS: You mentioned those time frames and being able to stick to a good investing plan for many years. I think that’s really critical. To do that though, you really do have to have this financial reserve that we’ve talked about. This financial resilience. So, that you’re not forced to sell at a bad time. You have to be able to stay in that game. Investing in for a long period of time. You need more of that financial and psychological capacity. And you actually have more of that when you’re debt-free.
I mean, psychologically, you’re much more able to deal with the price of things going up and down when it’s not the price of things going up or down and you still owe a bunch of money on it. Because investing with that is called leveraged investing. And it’s called leveraged because it’s like a lever. It magnifies the gains, but it can also magnify the losses too. That magnifying of the prices going up and down really stokes our emotional beasts. And our emotionally-insighted investors can really force us to make those behavioural errors. The classic one is selling when the market drops. It’s very scary when the market drops. And your $100,000 on your investment that’s now worth $50,000, it’s not a good feeling.
[1:00:43] BF: Yeah. No. It’s no joke psychologically. And I’ve seen it happen. For some people, it’s fine. For some people, it’s extremely stressful. But I think it’s a really important point to bring up. And you mentioned earlier that spending while in debt is logically equivalent to taking out a loan. Investing in stocks while in debt is logically equivalent to borrowing money to invest, which again may not be sensible in all situations.
It is worth mentioning just because there is quite a bit of research on this and opinion from economists on this, some economists would suggest that younger people should borrow to invest in risky assets while they’re young and have low financial wealth. Some people hold that opinion. Some people hold it very strongly.
I think in reality, for most people, paying off debt, especially non-tax-deductible debt, which is going to be more expensive, is going to be pretty compelling both from the expected return perspective but also from the risk and psychology perspectives. It’s also important to consider that paying down debt earlier in your career gives you time to learn about investing.
If you get your first paycheck and invest it all in stocks while you’re also sitting on a big pile of debt, you’re not going to have any idea how you’re going to feel when stocks that you’ve actually invested in as opposed to some abstract idea of the stock market see a sharp decline. If you decide to invest with leverage later, the experience of watching the market while servicing alone I think is going to be valuable.
And then the other interesting piece of that from the tax perspective is that if you pay off your non-deductible debt first, like you mentioned, that sequence being important, Mark, you pay off your non-deductible debt first. And then later on if you decide that you do want a borrow to invest, when you take that loan out explicitly for investing with the intent of earning income, the interest is going to be tax deductible.
I do want to say something here though. I’ve seen many people do this, pay off their debt with the explicit intention of borrowing against whatever credit facility they had available to invest. Whether that’s paying off a mortgage and then planning to take out a new mortgage to invest. Or paying off a line of credit. Whatever it may be.
In, I would say, 95% of cases, people pay off the debt. And then when it’s time to proceed with the plan and then borrow to invest, they’re like, “Yeah. No. You know what? Being debt-free feels really good.”
[1:02:49] MS: Yeah. That’s the irony of the whole argument. I mean, you mentioned the people that are young and with no wealth are the ones that would benefit the most from the leverage. But by the time you actually get in a position to do it really well, you don’t really need to. And you don’t really want to either. I mean, that’s kind of the irony of the whole thing. Which is why I think in practice, the theory [inaudible 1:03:09] I think paying off, that usually wins out.
You do need to gain some experience with investing though. And that’s one of the ways that you’re going to be able to become financially literate, develop financial self-efficacy. And you want to do that the right way not just buying some random stocks with leveraged investing where the stakes are high and you don’t know what you’re doing. You want to do it in a well-thought-out way.
And most people do find a compromise between repaying debt and investing. And if you’re going to do that, I think using the registered accounts like an RRSP, or an RRSP, or TFSA, or this new FHSA, those are really kind of the attractive options for doing that.
And the reason why I say that one, tax sheltering makes the math of an unexpected return and debt a lot closer to each other. Because taxes don’t really figure into it as much. And the other thing that’s good about them, that there’s a bit of a limitation on the account size. It’s easier to learn to invest with smaller amounts of money than to have huge amounts of money when you’re starting off just from an intimidation standpoint.
And because, as you mentioned, that you can’t just go and take money out of these accounts on a whim. It’s a way of investing that you’re also not tempted to make it a short-term endeavour and take the money back out. When you put it in there, you’re making a commitment to leave it in there for a long period of time. And that long-term commitment is one of those behavioural things that we need to do when we’re investing. If you are going to make a compromise and start investing while in debt, those tax shelter accounts is probably where I’d do it.
And that brings us down to the third part of the financial duodenum here. We’ve gone on here for a long time. But I think we’ve gotten to the end of the procedure.
[1:04:41] BF: Yeah. And I think it’s a good thing. The sedation seems to be wearing off. And the bite block is getting pretty worn out. So, let’s go out and do a debrief and then we’ll go to our case review in the next episode.
[1:04:51] MS: Excellent.
Post-op Debrief
[1:04:51] Mark Soth: Excellent. So, in this episode, we hope to help you consider the trajectory of financial wealth over your life and how to build that strong financial platform to launch from when you can’t safely start investing when you need to sell investments at a bad time potentially because you need that money now So the first part is to ensure that your immediate financial security is in place By creating a cashflow buffer to absorb that ebb and flow of income and spending.
And that provides the financial security that you need to also feel financially secure because your behavior, which is going to be critical to your actual outcome is really driven by that.
[1:04:51] Benjamin Felix: Yeah. And then I think it’s important for people to understand how debt fits into their financial life along with their spending. their income, their savings, and investing. It’s all one big system, one big pie, I guess, of lifetime wealth. And we have control over how and when it gets consumed. And even like we talked earlier about education, increasing the overall value of the pie and the overall size of the pie. So, the things we have control over, but thinking about it as a big system, I think it’s important that can help us make more logical decisions about investing and saving, but also about debt and how we can use it.
Debt is a way for us to pull consumption into the present from future income from future wealth. Now, that can help or hinder us in the long run, both economically and psychologically.
[1:06:10] Mark Soth: And once our debt, whether it’s good or bad debt, is at a level where we are secure, then we have some breathing room to decide what to do with that excess money as we bring it in. So, some may opt to spend more; some may work less or earn less. However, most people have some short-term and some long-term goals that they have to allocate money towards. And for those shorter-term goals, that means saving.
[1:06:30] Benjamin Felix: And then there are a ton of financial instruments that you could use like cash savings, high-interest savings accounts, high-interest savings ETFs, or GICs. And those products can be held inside different account types, but both the financial product and the type of account that it’s held in have to be matched to the goal for the savings.
[1:06:47] Mark Soth: And the goal for the savings is to guarantee that all that money is there when you need it, and that you’re able to access it.
And you need to make sure if you’re not doing that, that you have the flexibility to deal with it in a different way. If you don’t have that flexibility, you need to be saving it. But over long periods of time, that savings instrument is likely not to keep pace with inflation. So the amount of dollars that you save erodes over time, and that’s why, with longer timeframes, you need to consider taking progressively more risk by investing to preserve that value and grow it into more buying power.
And hopefully, we get the growth that we need to meet our long-term goals. And that’s where we’re going to go in the next few episodes.
[1:07:27] Benjamin Felix: Yeah, definitely. And in the meantime, we’ve also released a supplement to this episode. This main episode provided some foundational knowledge on these topics in the supplement.
We’re going to talk through some cases that illustrate common dilemmas related to these topics with numbers and context, including a mid career personal debt versus corporate investing dilemma, which was a lot of fun for us to work through. So we hope you’ll join us for that case conference once you’ve recovered from this procedure.
Footnotes
Related Resources
Rational Reminder Episodes
Basic Personal Finance Concepts: Cost of Living, Emergency Funds, Savings Capacity
The Role of Debt in Financial Planning
Morgan Housel: The Psychology of Money
Prof Hal Hershfield: Your Future Self
Loonie Doctor Blog Posts
The material in our first few episodes are strongly related to the first three modules of The Loonie Doctor Core Financial Curriculum. Here are a few articles closely related to this one.
Logically Get a Grip on Debt
Most professionals accrue debt at some point. Often a lot. Some become numb to it. Others overwhelmed by it. Some use debt wisely. Debt can have a major impact on our current and future financial and mental health. Humans are wired to think about debt illogically at times. Learn to think about debt logically to release your inner Vulcan boss. How you think about debt enables you to use it and deal with it more effectively.
Spending & Debt: A Chat With Future-You
Debt is actually spending your future income. Future-You will need to earn it. If used wisely, Future-You may benefit from how you spent their money. In that case, they will thank you. If your spending puts them into a bad position, then they will have something else to say. Best to chat before Current-You becomes Future-You.
Pay Off Debt or Invest More?
Most people face competing priorities for their income. One of the most common dilemmas is whether to more aggressively pay off debt vs invest more. Debt interest and missed time in the market can both result in compounding losses over time. You need to make a deliberate plan and then execute it.
Saving: High-Interest Savings Accounts & Beyond
Money that you need in the next 3-5 years, without flexibility, should be saved. Not invested. When you park that money, you want to earn as much interest as you can. That helps to ensure that not only will it be there when you need it, but that its purchasing power is less eroded by inflation. Learn about the differences between high-interest savings accounts, high-interest ETFs, money market funds, GICs, and short-term bonds.
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