Millionaire on the Prairie - Personal finance for singles looking to finance their dreams.

A little something about mortgages

I love talking about money…and the word is spreading at the office. I have two very close friends at work and they have patiently listened to me talk about money for years. One of them has a young assistant who was looking to buy her first house with her fiance. My friend told the assistant to come and see me. I was more than happy to talk to her about mortgages, prepayment options, insurance options, and ways to minimize the amount of interest owing on her mortgage.

So I spent about 40 minutes talking to my friend’s assistant. I found out that she was using a mortgage broker. I tried not to ask for too many details about salary and savings, but I wanted to find out if she had considered pre-payment options (she hadn’t), the difference between mortgage insurance vs life insurance (nope!), rates offered by banks vs mortgage companies (yes), and whether they had considered paying bi-weekly rather than monthly (nope). I was also encouraging her to wait until after her probationary period at the office had expired, but I lost that battle.

a) Prepayment Options Matter

If ridding yourself of your mortgage is a priority, then you’ll want to ensure that you get the best prepayment options that you can.

In Canada, borrowers can increase their mortgage payments one of two ways. Firstly, they can increase their mortgage payment by a fixed percentage amount every calendar year. When I first obtained my mortgage, I was able to increase my bi-weekly payment by up to 20% once each calendar year. Some banks allow borrowers to increase their payment by a maximum of 10% or 15%. There is no need to increase the payment by the maximum, but I encourage people to go with a lender who allows for up to 20%. The higher the payment, the faster the mortgage balance disappears and the less interest that is paid overall. Paying less interest to the bank on a debt as huge as a mortgage is a goal worth striving towards.

Generally, once a payment is increased, that increase is in place for the remainder of the term of the mortgage. A bank does not allow a person to decrease the mortgage payment later on down the line.

Here’s an example. The original mortgage balance is $100,000. The annual maximum mortgage payment increase is 20% of the original mortgage payment. The bi-weekly mortgage payment amount is $500. The mortgage term is 5 years.

Year 1: $500 x 20% = $100; new bi-weekly mortgage payment = $600 ($500 + $100)

Year 2: $600 x 20% = $120; new bi-weekly mortgage payment = $720 ($600 + $120)

Year 3: $720 x 20% = $144; new bi-weekly mortgage payment = $864 ($720 + $144)

Year 4: $864 x 20% = $172.80; new bi-weekly mortgage payment = $1,036.80 ($864 + $1,036.80)

Year 5: $1,036.80 x 20%= $207.36; new bi-weekly mortgage payment = $1,244.16 ($1,036,80 + $207.36)

Of course, there is no requirement on the borrower to increase the mortgage payment by 20% every year. The bank would far prefer it if you simply paid the minimum required amount because doing so insures that they squeeze as much interest out of you as possible over the life of the mortgage! A borrower might only be able to increase her payment by 5% each year, or only be able to increase it in years 2, 3 and 5, or might only be able to increase it by the maximum amount at the very start of her mortgage, or any other combination.

It’s a decision that cannot be taken lightly. While making the higher payment as soon as possible is good for minimizing the interest paid the bank, the fact of the matter is that the borrower is going to have to come up with the new higher payment amount every two weeks. As you can see from our example, coming up with $1,244 every two weeks is going to be approximately 2.5 times harder than coming up with $500 every two weeks!

The other prepayment option available to borrowers is to make annual lump-sum payments against the outstanding mortgage balance up to a fixed amount. Lump sum payments are in addition to the regular mortgage payment. They are applied directly the mortgage balance. The larger the lump sum, the more effective it is in decreasing the amount of interest paid on the mortgage.

In my case, my bank allowed me to make a lump-sum payment of up to 20% of the original balance. Again, there is no obligation to make a huge lump-sum payment. Most banks require a minimum lump-sum of atleast $100. Further, lump sum payments can be made throughout the year so long as they cumulatively do not exceed the maximum amount.

Let’s go back to our earlier example. The original mortgage balance is $100,000. The annual maximum lump sum mortgage prepayment is 20% of the original mortgage balance. The mortgage term is 5 years.

$100,000 x 20% = $20,000;

The amount of $20,000 is the maximum annual lump sum mortgage prepayment that can be applied to the mortgage during the term of the mortgage. This means that the borrower can apply lump-sum amounts up to $20,000 to her mortgage in each of the 5 years of the mortgage term.

Full disclosure – I never took advantage of the lump-sum payment option. Instead, I chose to increase my bi-weekly mortgage payment by the full 20% every calendar year. I committed myself to higher payments to avoid the temptation of “forgetting” to set aside money for a lump sum payment. A dear friend of mine made the opposite decision. She made lump sum payments every two weeks. She and her husband had a young family and she wanted the option of not paying extra money to her mortgage in case those funds, which would have gone towards the mortgage as a lump sum payment, were required elsewhere in the family budget.

b) Bi-Weekly Payments

You’ll note that throughout my example, I’ve referred to “bi-weekly” payments. This is because I personally hold the opinion that bi-weekly payments are best for paying off a mortgage. Monthly mortgage payments mean that you, the borrower, are paying the maximum amount of interest on your mortgage loan. While this is good for the banks, this is terrible for the borrower. One of the few ways to pay less interest on your mortgage debt is to repay it as fast as possible. Paying your mortgage bi-weekly will allow you to do that.

There are other payment cycles. I’ve already mentioned monthly payments, but there are also weekly mortgage repayment plans. For my part, I’ve always paid bi-weekly on my personal residence. On my rental properties, the mortgage is paid monthly for two reasons. First, rent from my tenant pays down the mortgage. Second, the interest on the mortgage balance is tax-deductible, so it’s to my advantage that the mortgage balance is not paid down as fast as possible.

I’m not a fan of weekly mortgage payment schedules. This is because the amount of interest saved on a weekly payment schedule is only marginally less than the amount of interest saved on a bi-weekly payment schedule. To my mind, it’s hardly worth the added stress of insuring that the money is in the bank every 7 days. Play around with a few mortgage calculators on the web and come to your own conclusion. If you’re headset on paying as little interest as possible, then a weekly mortgage payment schedule might be for you.

c) Get Life Insurance instead of Mortgage Insurance

Most people don’t realize this but mortgage insurance is a rip-off. The insurance pays the bank the amount of the outstanding mortgage balance in case the borrower dies. However, the premium for mortgage insurance stays the same every single month. This is a problem because it means that the borrower is paying the same amount of money for a lower amount of coverage each month as the mortgage balance decreases.

Assume that the mortgage balance starts at $100,000, that the beneficiary of the mortgage insurance is the bank, and that the monthly premium on that mortgage is $5. Every month, the borrower will pay $5 to the bank to insure that the mortgage balance gets paid if the borrower dies before the mortgage is paid off. If the borrower dies the day after taking out the mortgage and the insurance, the policy will pay out $100,000 an the mortgage gets paid off. Ten years into the mortgage, the mortgage balance is now down to $81,000. The borrower is still paying $5 per month in premiums on that mortgage. If the borrower dies ten years into the mortgage, the insurance policy will only pay out $81,000 to the bank.

Do you see the problem? The premium stays the same but purchases less and less coverage each month. This is not a good deal for the borrower. The monthly mortgage insurance premium remains the same even though the remaining mortgage balance is decreasing as each mortgage payment is made.

Instead of taking out mortgage insurance through the bank, get a life insurance policy on the life of the borrower that is equivalent to the starting balance of the mortgage. If the borrower dies before the mortgage is paid off, the full amount of the life insurance policy is paid to the beneficiary. After paying the mortgage in full, the beneficiary can keep the rest of the life insurance proceeds. This is a much better deal all around and the mortgage balance still gets paid.

While I was on holidays, I received a very excited email from my friend. Her assistant and the fiance had put in an offer on a house! And a week after I got back to my office, the assistant came to me and told me that she was only a few days away from taking possession. Of course, I couldn’t resist giving her even more advice – get a locksmith to meet her at the house on the day of possession to have the locks changed immediately – but I was deeply happy that my words had helped them in making one of the biggest purchases of their lives.

Automation is beautiful!

I got my first part-time job in grade 11. Every two weeks, roughly $137 was plopped into my bank account via electronic deposit. And every two weeks, I would go to the bank machine and manually transfer $50 from my chequing account to my savings account without fail. It was simple and easy.

When I got older, I learned about automatic money transfers that can be set up once and left to run indefinitely. My money would be transferred on the schedule I set and in the amount I wanted so that I could meet whatever specific goal I chose. I set up an automatic money transfer as fast as I could!

When I started my first, real grown-up job with my own office and everything, I opened up several bank accounts and designated them for various goals: travel, utilities, insurance, property taxes, charitable donations, Christmas gifts, RRSP/TFSA contributions, home renovations, etc. Every two weeks, the following process took place: my paycheque hit my bank account, my automatic transfers went into action, and the money leftover could be spent on whatever I wanted for the next 2 weeks.

Thanks to automatic transfers, I’ve fully funded my registered retirement savings plan (RRSP) every year. When the tax free savings account (TFSA) was created in 2009, I was able to fully fund that account as well. My automatic transfers mean that I always take a vacation every year, in addition to short road-trips. Automatic transfers mean that I don’t have to scramble to find money to pay for my annual home and vehicle insurance premiums, nor do I panic when it’s time to pay for my annual property taxes. When it is time for me to buy my next vehicle, I will have the funds in place to simply pay cash because I have an automatic transfer in place to set aside money to replace my current vehicle.

When one goal is fully funded, the automatic transfer stays in place. I don’t suddenly add those funds back to my day-to-day spending to be frittered away on things that won’t last. Nope! Instead, those monies continue to accumulate for the next priority of my list. Next year’s annual insurance premiums are paid off? Great! The monies can now go towards hitting the RRSP goal a bit sooner. Oh? I’ve already met my RRSP goal for next year? Then the monies go towards the TFSA! Really, that goal is funded too? Then it’s time to seriously start planning that vacation…

You see what I mean? Having the automatic transfer in place means that I’ve made the conscious choice to take some of my today money and to turn it into tomorrow money. Part of my paycheque is allotted to deferred gratification so that I can meet my future goals and satisfy my priorities. The leftover money is to be used for immediate guilt-free gratification. I don’t need to worry that I’m spending too much on an item today because I already know that my future expenses are being paid. When the time comes to pay for the non-sexy elements of life (did I mention car insurance?), the money will already be in place for me.

Automatic transfers are one of the best tools available for meeting financial goals. Once you’ve determined the priorities for your money, automatic transfers ensure that those priorities are met. I can’t think of a single better method for ensuring that money is set aside to meet your goals.

Even if you’re in debt, you can use automatic transfers to meet your goals. Simply set up a recurring payment to a particular debt so that the debt is paid down every single time you get a paycheque. The benefits of this are two-fold. First, you’re meeting your priority of getting out of debt. Second, you’re paying the least amount of interest on your debt because you are ensuring that the principal is being paid down as fast as possible which minimizes the time period over which the interest can compound.

As an example, if you have a credit card balance then you need to get rid of it. The credit card company will tell you that you only need to pay a minimum amount every month and the balance can ride until next month. For the privilege of paying less than the full amount you owe, the bank will charge you interest on the outstanding balance. It’s a recipe for riches for the bank. It’s a recipe for disaster for you.

So here’s what you do to avoid disaster. You STOP using your credit card. You go to your online bank account. You add your credit card as an online payee. You set up an automatic transfer of atleast $100 to your credit card that matches your paycheque schedule. This system means that your credit card balance is paid down on a steady schedule, at an amount that is (hopefully!) higher than your monthly minimum payment. You do this until the credit card balance is paid in full.

Make sure that automatic transfers are working in your favour, not your creditors’ favour. It astonishes me that people are so willing to give their money away when they work so hard for it. Trust me – it only takes a little bit of patience to keep it for yourself!!!

How many bank accounts do you need?

One of the smartest things I’ve ever done with my money was to learn how to separate today-money from tomorrow-money. Today-money is the stuff that gets you from one day to the next – it’s the money for groceries, for your shelter, for your transportation, for your charitable donations. Tomorrow-money is the money that you will need to buy those very same things when you’re no longer earning a paycheque.

If you’re going to retire at some point in time, you’ll need to save some of your today-money so that it becomes tomorrow-money. I know that sounds simplistic but it’s one of the most fundamental tenets of personal finance – if you spend all of your money today, then you won’t have any money tomorrow.

So, let’s avoid that eventuality – no one should ever strive to be old and poor. It’s not charming. The first step to avoiding impecuniosity is to figure out the answer to the following question: How do we accumulate tomorrow’s money?

It starts with an income and a bank account. You need to have money coming in and you need a place to keep it. If you’re getting paid, you need a bank account to receive money from your employer. I’m going to assume that you have a chequing account and that from your chequing account, you pay your rent/mortgage, your utilities, your vehicle payment, your student loan payment, your credit card payment, and any other payment that you’ve agreed to pay. Chequing accounts are great for day-to-day living expenses. They are perfect for today-money, which is the money that you need to spend today in order to live the life you want.

You know what chequing accounts are not good for?

They’re not good for tomorrow-money. It’s a very rare person who can keep a nice float of money in their chequing account without finding some way to spend it on a day-to-day purchase. Maybe family’s visiting on the weekend, or a road trip with friends is in the works. Whatever the temptation, tomorrow-money doesn’t have a shot in hell of surviving and thriving in your chequing account.

Enter the savings account. You’ve heard of living below your means. That phrase means that if you’re earning $1000 each week, then you’re only living on $900 each week. Your means is the $1000, and you’re living below your means by only spending $900. The difference between your earnings and your spending is your savings, which in this case would be $100. So where to put the $100 of savings that is going to eventually burn a hole in your pocket? Where do you put the money that isn’t spent?

The $100 is sent to your savings account. It goes into your savings account and is not spent on the day-to-day expenses of running your life. The $100 is your seed money to fund your retirement. The $100 is tomorrow-money and your sole goal for this money is to make it grow.

So how do you make it grow? That’s simple too! Every time you get paid, you transfer money from your chequing account, where the today-money lives, into your savings account, where the tomorrow-money lives. And then you do not withdraw the money from your savings account. You must commit to not using this money. It is savings, which means it is sancrosanct – it is not to be touched!

I can already hear your next objection – what if I have an emergency and I need to use the money in my savings account?

Again, the answer is simple. You’ll have a second savings account that’s for emergencies. You will continue to live below your means while you build up your savings account to a pre-determined amount of money. Let’s say you will feel best if you have $7500 set aside in your emergency fund. Over time, you will live below your means and you will make transfers from your chequing account to your emergency fund until you have $7500 set aside.

See? It’s a simple process. You get money from your employer deposited into your chequing account. Then you transfer money from your chequing account into your two savings accounts, some money goes into your tomorrow-money savings account and some money goes into your emergency fund savings account. And you don’t ever spend money from your savings accounts. Instead, you live on the money in your chequing account.

The trick to funding your savings accounts is to set up automatic transfers. Trust me when I tell you that 99.9% of the population does not have the discipline to manually transfer money to their savings accounts every time they are paid. You might be one the very few who possesses this divine power, but what if you’re not? Why take the risk? Why not simply set up an automatic transfer and get on with your life?

Automatic transfers always work. Putting automatic transfers in place results in one less chore for you to have to remember to do every two weeks. They ensure that you’re meeting your twin goals of one, creating a pool of tomorrow-money to live on when your paycheque-money stops coming in, and two, setting aside money for those instances when an emergency rears its head.

Retirement planning starts today!

On February 22, 2018, the Atlantic put out the following article about elderly people living in poverty because they had insufficient retirement savings. It’s one of the saddest articles I’ve ever read.

https://www.theatlantic.com/business/archive/2018/02/pensions-safety-net-california/553970/

The reason why I found this article so sad is because I think it’s terrible that people can work so hard for their whole lives and not have some respite in their final years. Back in the day, employers provided pensions. A pension is a fancy term for retirement monies paid to you by your employer. A pension is a promise from an employer to an employee whereby the employer holds back some of the employee’s earned wages today and agrees to pay those wages to the employee when the employee retires at a pre-determined age. Under a pension agreement, the employer is legally obligated to pay the pension. The employee retires and waits for the monthly pension cheque to come to her for the rest of her life.

For the past few decades, employers have been moving away from the defined-contribution pension system. Instead, there are now two employer camps. In the first camp, employers are giving their employees the option of having a defined-contribution pension. This means that employers are giving employees control over how their pension money is invested. If the investments do well, the employees will have enough money in retirement. If the investment do poorly, then the employees will not.

Do you see the problem with the defined-contribution pension plan system? If not, here it is. Under the defined-contribution system, all of the risk of making good investment decisions over the decades of an employee’s working life rests with the employee. If employees do not know how to make investment decisions that will provide them with a steady stream of pension income in retirement, then the employees may be facing an impoverished old age. The weight of making properly investment decisions used to be the employer’s problem – today, that problem rests entirely on the shoulders of the employees who participate in a defined contribution pension plan.

The second employer camp is comprised of employers who do not offer their employees any kind of pension plan. These employers simply pay their employees their salary. It is entirely on the employee to invest their money in registered plans, such as the RRSP and the TFSA, or to invest in investment account, or to find some other way of investing their money to ensure a comfortable retirement. Other such investments could include rental properties, a small business, Bitcoins, gold, royalties, futures trading, or any other endeavour with the end purpose of earning money. Employers in the second camp take no responsibility for the retirement income needs of their employees.

Today, most people are responsible for creating their own streams of income for retirement, whether through define-contribution pension plans or through other investments. This means that people have to start saving for their retirements as soon as they start working!!! Not only do they have to start saving, they have to start investing their money for growth because money is always under attack from inflation. Money sitting in a bank account at less than 1% interest is not going to be sufficient in retirement when inflation is eroding that money’s purchasing power every single year. Finally, employees are responsible for ensuring that they have the proper asset allocation of their retirement funds so that their investment grows big enough to support them in old age.

Failing to do any one of these things means that a person runs a very real risk of being destitute in old age. Surviving on inadequate social services/benefits from the state is not an appropriate reward after a lifetime of work. Going hungry or refraining from life’s small luxuries isn’t a suitable way for the elders of our society to spend their remaining years. Watching every penny every single day and feeling despondent when those pennies are not enough is a horrible way to live, particularly when time to grow an investment portfolio has long since passed.

It takes years and years to build a retirement portfolio. However, there is no comprehensive system in place to teach people how to do it. Some people will learn on their own. Some people will inherit money. A few lucky souls will have pensions that will be sufficient to satisfy their needs. For everyone else, financial hardship of varying degrees is the reality that they will face sooner or later.

I never spend my $5-bills

That’s right – I don’t spend my $5-bills.

Many years ago, I heard a story on Oprah about how one of her guests never spent the change in his pocket and would empty it into a little jar by the side of his bed each night. The coins added up to rough $700 in a year, so he invested them. When it was time for his child to attend university eighteen years later, the investment account was worth $73,000!

Now, I don’t know what he invested in nor do I have any idea of his rates of return. What I do know is that the lesson I took was that a person can live without their small change and that it can grow to a decent sum if left alone to do its job. So I stopped spending my coins in 2012 or thereabouts. Every time my purse gets extraordinarily heavy and I start to feel shoulder pain, I know that it’s time to empty the coin from my wallet. In Canada, we have $1-loonies and $2-twonies so the coin adds up quickly. I’ve removed anywhere from $7 – $30 from my wallet in at any one time. Unlike the fellow on Oprah, I use my coin to pay for the expenses that come along with Christmas. In my world, $700 can go a long way!

In 2017, I started a new little savings strategy. I decided to stop spending my $5-bills. I figured that not spending $5-bills wouldn’t have an impact on my life in any significant way. The sacrifice was hardly worth my attention. I resolved that $5-bills would not go into my wallet and that I wouldn’t spend them if at all possible. And I told myself that if I honestly and truly couldn’t live the life I wanted without those $5-bills, then I would simply go back to spending them and my experiment would be over. This is what happened – in one year, I saved $885 which is enough to cover 80% of an out-of-town wedding for a dear friend.

I made the mistake of telling one of my friends what I was doing. He scoffed and rolled his eyes, but he was suitably impressed when I told him how much I’d managed to save. The other little lesson I learned from this experiment was that I cannot always count on the people who love me best to agree with every financial decision that I make. C’est la vie! I have to make my own decisions and I have to live with their consequences.

I try to spend cash whenever I can, partly because the odds are good that I’ll get a $5-bill in my change. In the world of online payments and credit card transactions, cash is becoming less and less common. Still, I do buy coffees and snacks at work. The idea of using my credit card for such small purchases does not appeal to me, although I recognize that others don’t share my view. To my mind, smaller purchases warrant the use of cash. And when I get back $5-bills, I’m very happy. Those bills don’t even make it into my wallet. They go to the bottom of my purse then they are transferred to a secret spot in my house once I get home.

Even though I don’t have a particular use for these bills, I like knowing that they give me an option. The 2017 stash wasn’t saved expressly for the wedding. However, I immediately said yes to the wedding invitation and I didn’t have to worry about how I was going to pay for the unplanned trip. I knew that I had just under $1000 that didn’t have a job yet. This $885 was separate and apart from the rest of the monies that I need to run my life. It was bonus money, if you will, and it was accumulated slowly over the space of 365 days. There was no particular purpose for this money other than allowing me to spend it guilt-free on whatever I wanted.

I’ve no idea how big the 2018 stash will be, nor do I know how it will be spent. What I do know is that on January 1, 2019, I will open up my secret spot, count my money and be very happy knowing that small sacrifices over the previous year have provided me money to do something fun and frivolous!