All posts by Robb Engen

Debt avalanche vs. debt snowball: When math trumps behaviour

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John and Erica Mullen are in their mid-thirties and have two young children at home. Together they earn well over $100,000 per year, but a combination of poor choices and unlucky circumstances have left them buried in debt.

Their substantial income affords them the luxury of not having to turn their life upside down by selling their home and vehicles; however, they will need to make some tough sacrifices in order to dig themselves out of this hole.

Creditor Balance Rate Payment Interest-only
Store credit card $6,800.00 26.00% $200.00 $147.34
Consolidation loan $23,000.00 8.00% $430.00 $153.34
Line of credit #1 $20,000.00 6.34% $105.67 $105.67
Tax bill $1,700.00 5.00% $200.00 $7.09
Car loan #1 $36,000.00 3.90% $460.00 $117.00
Line of credit #2 $16,000.00 3.00% $40.00 $40.00
Car loan #2 $23,000.00 0.90% $317.00 $17.25
$126,500.00 $1,752.67

After a close look at their budget, the Mullens decide they can afford to put $2,000 per month toward their non-mortgage debt. They want to know how best to allocate the extra cash so they can be debt-free faster and pay the least amount of interest.

Two popular debt repayment strategies are the debt snowball and the debt avalanche. Let’s look at each method and apply it to the Mullen’s situation:

Debt Snowball

Dave Ramsey, American author of The Total Money Makeover, suggests an unusual strategy for getting out of debt by using something called the debt snowball method.

With the debt snowball, you’re throwing math out the window, focusing instead on the psychological advantage that comes from making progress with quick, successive wins.

Related: Should you pay off your partner’s debt?

Start by arranging your debts from lowest balance to highest. It feels better to rid yourself of your smallest debt, and the idea is that the snowball effect builds enough momentum so that you’ll be more inclined to stick with the strategy on your way toward debt freedom.

This chart shows how the Mullens would use a debt snowball approach to tackle their debt. Remember, they’re throwing an extra $2,000 per month over-and-above their minimum payments:

Creditors in Original Total Interest Months to Month Paid
Chosen Order Balance Paid Pay Off Off
Tax bill $1,700.00 $7.08 1 May-15
Store credit card $6,800.00 $405.61 4 Aug-15
Line of credit #2 $16,000.00 $301.35 11 Mar-16
Line of credit #1 $20,000.00 $1,572.90 19 Nov-16
Consolidation loan $23,000.00 $2,929.50 25 May-17
Car loan #2 $23,000.00 $390.39 30 Oct-17
Car loan #1 $36,000.00 $3,270.27 37 May-18
 Total Interest Paid: $8,877.10

You can see how the strategy works: the tax loan is killed off in the first month and from there the Mullens can focus on the department store credit card, which will be paid off three months later. Altogether it’ll take 37 months to pay off all their non-mortgage debt and the total interest paid over that time is $8,877.10.

Debt Avalanche

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Doing the math on investment fees: the math isn’t pretty

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A few weeks ago I invited readers to share their portfolio details with me so I could help ‘do the math’ on their investment fees. Many of you did, and the results weren’t pretty. From accounts loaded with deferred sales charges (DSCs), management expense ratios (MERs) in the high 2 per cent range, and funds overlapping the same sectors and regions, it was a predictable mess of over-priced products.

The worst of the bunch: the number of portfolios filled with segregated funds.

I’ve highlighted segregated funds as the biggest offender when it comes to fees for two reasons:

1.) The MER on segregated funds are higher than most mutual funds (which we know are already high enough). I looked at one portfolio that held a suite of segregated funds from Industrial Alliance called Ecoflex, with MERs of 2.99, 3.26, and 3.29 per cent;

2.) Segregated funds were exempt from CRM2 disclosure rules because they are considered insurance products. Investors receive the fund facts sheet, which still express fees in percentage terms rather than breaking them down and disclosing in dollar terms.

Doing the math on your investment fees

 

Keep in mind most readers were looking for me to do the math on their investment fees for portfolios valued at $250,000 or more. One reader, a soon-to-be retiree, had an average MER of 3.13 per cent for his $412,000 portfolio.

I told him he paid nearly $13,000 in investment fees last year and asked if he thought he was getting good value for his fees. He said he hadn’t met with his advisor in three years, despite repeated attempts to get together to discuss his retirement plan.

Another reader held $300,000 in high-fee mutual funds with Investors Group. She recognized the fees, but was on the fence about switching because she was in the middle of the deferred sales charge schedule:  a penalty that would cost her $10,000 if she sold the funds and transferred to a robo-advisor. Continue Reading…

Worst day ever for stocks?

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Will Monday February 5th go down as the worst day ever for stocks? On this day the Dow Jones industrial average lost more than 1,175 points:  the worst single-day point drop in its history. But was it really the worst day ever? Investors need some context.

The 1,175 point drop was indeed the biggest single-day point loss the Dow has ever sustained. But let’s remember the Dow has been soaring almost uninterrupted since March 2009 when it bottomed-out at 6,627 points during the global financial crisis. By the end of January 2018 it had reached a record 26,616 points.

Related: Have we reached peak stock market?

Better to forget about points and focus instead on percentage gains and losses. Taken in this context the headline reads a bit different. The Dow plunged 4.6 per cent: its worst day since August 2011. It doesn’t sound nearly as gloomy.

Another way to frame this day is that the stock market has erased its gains from the start of the year. But 2018 is just one month old.

Where does this day rank in terms of largest one-day percentage drops in history? Will it live on in infamy like Black Monday, Black Tuesday, the Flash Crash, or the aftermath of the September 11th attacks?

Nope, not even close.

If you were thinking Monday’s 4.6 percent drop was a bloodbath then how would you have reacted to one of the top 20 largest daily losses of all time? This wasn’t even a blip on the radar.

Related: What can you do about the upcoming stock market crash?

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Using annuities to create your own personal Pension In Retirement

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The reason why retirement planning is so difficult is because the one variable we need to know – how long we have to live – is impossible to predict. Sure, we have mortality tables and family history to help guide us, but statistically speaking, half the population will outlive their median life expectancy.

That makes longevity risk – the risk of running out of money before you die – a very real threat to your retirement. And yet many Canadians ignore this threat by not saving enough during their working years; retiring before they’re financially ready, taking Canada Pension Plan benefits too early, withdrawing too much from their RRSPs, and so on.

Nearly half of Canadians are worried they won’t have enough money to live a full lifestyle in retirement, according to a recent survey by RBC Insurance. They interviewed 1,000 Canadians aged 55 to 75 about their retirement readiness and came out with some interesting findings.

The retirees, or soon-to-be-retirees seem to want it all, according to the poll, yet many will lack the savings to do so:

  • 80 per cent want to live at home for as long as they can
  • 72 per cent said it’s important to own a car.
  • 68 per cent said it’s important for them to be able to travel at least once a year
  • 53 per cent want to go out for lunch or dinner a few times a week

Having enough money to support their desired lifestyle is a real concern, highlighted by the fact that 62 per cent of those surveyed are worried about outliving their retirement savings.

The one retirement income tool that didn’t appear on the radar was an annuity. Just 12 per cent said they are using or plan to use one in retirement.

How Annuities Can Help In Retirement

An annuity provides a predictable income stream for life – much like how a defined benefit pension, CPP, and OAS pays benefits for as long as you live. Nothing protects you from longevity risk quite like a guaranteed lifetime income.

It’s puzzling why more Canadians don’t choose to turn even a portion of their savings into an annuity – to pensionize their nest egg, to borrow a phrase coined by financial authors Moshe Milevsky and Alexandra Macqueen.

Lack of knowledge around annuities definitely plays a role. While nine in 10 Canadians polled by RBC know they don’t need to invest their entire retirement savings into an annuity, just 28 per cent know that an annuity doesn’t have to be managed once it has been purchased. Continue Reading…

10 financial lessons to share with friends

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The personal finance community can be a bit of an echo chamber, reinforcing and repeating the same ideas on how to save, invest, and spend our money. This sort of tribalism can be intimidating for outsiders who are eager to learn but afraid to ask questions or know where to start, especially when it comes to more complicated topics.

The truth is not all Canadians are financially savvy. In fact, a Tangerine survey last year found that only half of Canadians consider themselves knowledgeable when it comes to personal finances.

As personal finance enthusiasts it’s our duty to move beyond this little corner of the Internet and start talking to our friends and family about money.

It’s not easy to talk in real-life about what we do with money, how much we save, how much we spend, and the foolish mistakes we make. But these are crucial conversations to help each other deal with money and the complex decisions about it that we all face.

We can start by sharing the kinds of tips and tricks that helped us build lifelong financial habits and skills. It’s what financial literacy is all about, right?

That’s why I was excited to partner with Tangerine for Financial Literacy Month and list my top 10 financial lessons to share with friends:

1.) Avoid credit card debt like the plague

It’s impossible to go through life without incurring at least some debt. I’ve had student loans, credit card debt, a car loan, line of credit, and finally a mortgage.

Carrying a balance on my credit card was by far the most harmful to my finances. Making the minimum monthly payment hardly puts a dent into the balance, and 19 percent interest ensures that balance will continue to grow.

Tackle it with the debt avalanche or debt snowball method, and once it’s gone commit to never again paying one cent of credit card interest.

2.) Track your spending

To free up that additional cash flow you need to understand how much money comes in and how much goes out every month. There’s no other way around it – how else will you know what you can afford to save?

Whether you use a mobile app, budgeting tool, or good old-fashioned Excel spreadsheet, the point is to track every transaction until you can glean some insight into how you spend your money. Use this information to make informed decisions on which areas of your budget you can cut, and where you’d like to direct any additional savings.

Related: Track your habits, save money

3.) Automate your savings

The key to building a life-long habit of saving is to make your contributions automatic and as painless as possible. Pick a day that coincides with your paycheque and set up an automatic transfer into your RRSP, TFSA, savings account, or RESP.

It’s called paying yourself first. Start with as little as $25 and increase it annually, or as your budget allows. This powerful strategy works because it treats your savings goals as ‘mortgage-like’ fixed expenses that come out of your account on a specific day.

4.) Save a percentage of your income

One rule of thumb suggests saving 10 percent of your take home pay for retirement. I say save a percentage – any percentage – of your income as long as you start with something and make it automatic.

One cool trick I learned was to bump up that percentage in tandem with a salary increase each year. So, for example, let’s say you earn $50,000 and saved 5 percent of that amount ($2,500). Then you get a 4 percent raise in the New Year, so now you make $52,000. Well, don’t just continue saving $2,500 – bump that up to $2,600 to stay in-line with your 5 percent savings rate. Continue Reading…