Debt & Frugality

As Didi says in the novel (Findependence Day), “There’s no point climbing the Tower of Wealth when you’re still mired in the basement of debt.” If you owe credit-card debt still charging an usurous 20% per annum, forget about building wealth: focus on eliminating that debt. And once done, focus on paying off your mortgage. As Theo says in the novel, “The foundation of financial independence is a paid-for house.”

How Real Return Bonds compare with regular Bonds, protecting against unexpected rises in Inflation

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Real Return Bonds (RRBs) pay you a rate of return that’s adjusted for inflation, but that’s not always as promising as it seems.

When a real-return bond is issued, the level of the consumer price index (CPI) on that date is applied to the bond. After that, both the principal and interest payments are typically adjusted every six months, upwards or downwards from that base level, to compensate for a rise or fall in the CPI.

In general, Government of Canada real-return bonds pay interest semi-annually, on June 1 and December 1.

How a real-return bond works: A theoretical example

The Bank of Canada issues $400 million of 30-year bonds maturing on December 1, 2049. The bonds have a coupon, or interest rate, of 2%.

If after six months from the date of issue, the new CPI level is, say, 1% above the level of the CPI on the issue date, then each $1,000 of bond principal is adjusted to $1,010 of bond principal ($1,000 x 1.01). The semi-annual interest payment is then $10.10 ($1,010 x 2% / 2).

If after 12 months, the level is 2% higher, then the bond principal is adjusted to $1,020 ($1,000 x 1.02), and the interest payment rises to $10.20 ($1,020 x 2% / 2).

Three important considerations to recognize with real-return bonds

1.) The price you pay for real-return bonds reflects the anticipated rate of inflation. In other words, if investors feel that inflation will rise 2% over the long term, the price of the bond will reflect that future inflation increase and its effect on the bond’s principal and interest payments. So, when you buy a real-return bond, you are only protecting yourself against unanticipated rises in inflation.

2.) When the inflation rate falls over a six-month period, the principal and interest payments of a real-return bond fall. In times of deflation, the inflation rate turns negative. In a prolonged period of deflation, the principal of a real-return bond could fall below the purchase price. Interest payments would fall, as well.

3.) As with regular bonds, holders of real-return bonds must pay tax on interest payments at the same rate as ordinary income. That income gets taxed at the investor’s marginal rate. In addition, holders of real-return bonds must also report the amount by which the inflation-adjusted principal rises each year, as interest income, even though you won’t receive that amount until the bond matures. That amount is added to the bond’s adjusted cost base.

If the CPI level falls, that reduces the inflation-adjusted principal. You deduct the amount of that reduction from your taxable interest income that year, and also subtract it from the adjusted cost base.

Real-return bonds in comparison to regular bonds

In simple terms, a bond is a form of lending whereby you lend money to a corporation or government. In return, a bond pays a fixed rate of interest during its life. Eventually, a bond matures, and holders get the bond’s face value—but nothing more. Receiving the fixed interest and face value at maturity is the best that can happen. Note, though, that in some cases, corporate bonds can go into default. As well, inflation can devastate the purchasing power of bonds and other fixed-return investments. Continue Reading…

Mental Accounting and how we spend money

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We all have quirky behaviours when it comes to managing money. One trick we fall victim to is called mental accounting. We separate our money into different types of mental accounts, with different rules, depending upon how we get it, how we spend it, and how it makes us feel.

An easy example is when you have a fund set aside for something like a vacation or house down payment while at the same time carrying high-interest credit-card debt. Or how you decide to spend a $1,200 tax refund versus what you’d do with $100 per month if you had the right amount of tax coming off your paycheque in the first place.

I’m guilty of mental accounting every month when I budget $1,000 for groceries, $200 for dining out, $125 for clothing, and $75 for alcohol. I manipulate those mental accounts all the time, like when I overspend in one category and just take it out of another (shifting a meal from ‘dining’ to ‘entertainment’ for example).

The Mental Accounting challenge

Why do we assign money to these mental categories? One answer is to control how we think about it. If we were perfectly rational and could figure out the opportunity costs and complex trade-offs of every single financial transaction then it wouldn’t matter how we label our money: it would just come from a big pool called ‘our money.’ It’s just money, after all; totally fungible and interchangeable.

But because we’re human with cognitive limitations and emotions we need help with our money decisions. That’s where mental accounting comes in and acts as a useful shortcut for what decisions to make.

Another interesting way we classify our financial decisions has to do with the length of time between when we bought an item and when we consumed it.

Nobel Prize winner Richard Thaler studied wine purchases and consumption and found that advance purchases of wine are often thought of as investments. Months or years later, when the bottle is opened and consumed, the consumption feels free, as if no money was spent on wine that evening. Continue Reading…

The best bank accounts for Students

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Photo by Dan Dimmock on Unsplash

By Zack Fenech, RateHub.ca

Special to the Financial Independence Hub

As a new or returning post-secondary student, finances probably lean on the less exciting side of this new or continuing life chapter.

Be that as it may, properly managing your finances is still something you’ll have to do at one point or another.

Finding the right student bank account can help you save some money. In some cases, you can earn unique student tailored benefits: if you choose the right chequing account or savings account, that is.

After all, would you rather spend money on school supplies and experiences or pay monthly account fees or transaction commissions?

That said, the best student bank accounts offer a wide variety of options and advantages tailored to student living, and provide students with more financial freedom.

The other side of the coin for student bank account options might be using a free bank account. Free bank accounts allow you to use the account beyond graduation, in exchange for student tailored perks.

This article will detail the difference between the two types of accounts and which account is best for each category. It’ll also help you get a clearer understanding of which type of account is best for you.

Student Bank Accounts vs. free Bank Accounts

Student bank accounts are regular bank accounts that offer unique advantages to students. Some of these advantages include no monthly or annual banking fees, unlimited transactions and e-transfers, and sign-up promotions or point programs.

Another option fitting for students is free bank accounts offered by digital banks. Though not student accounts by definition, free bank accounts are entirely free and limitless, making them ideal for anyone, whether you’re a student or not.

The only difference from paid accounts is that they do not include many of the student-tailored advantages previously mentioned. Continue Reading…

Can home buyers hope to use the First-Time Home Buyer’s incentive (FTHBI)?

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By Penelope Graham, Zoocasa

Special to the Financial Independence Hub

The brand-new First-Time Home Buyer’s Incentive will hit the real estate scene on September 2nd, but will it be useful in your local market?

The federal mortgage equity sharing program was initially announced in the March 2019 budget as a new Canada Mortgage and Housing Corporation (CMHC) initiative. Under the new program, qualifying first-time home buyers can receive an interest-free loan from the agency to go toward the purchase of a new home (5% for a resale property, and either 5% or 10% for a brand-new build).

In exchange, the CMHC retains the same percentage of equity in your property, which the homeowner must pay back as a lump sum when either the home is sold, or the 25-year mortgage amortizes.

Qualifying purchase price too low in some markets

However, the income and mortgage-to-income ratio (MTI) restrictions the FTHBI requires reduces its effectiveness in many markets, particularly where home prices are high and arguably where first-timers would need its help most. Under its criteria, home buyers cannot have a combined household income that exceeds $120,000, and their MTI cannot be more than four times their income. This means, for a home buyer earning the maximum and putting 5% down on a resale home, the largest home purchase they can make is limited to $505,000.

As well, it’s important to understand how the equity sharing portion of the FTHBI will work. Basically, the amount provided by the CMHC is added onto the home as a second mortgage, which won’t bear interest, and must be paid back all at once when the loan is due. However, as the CMHC retains 5% of the home’s equity, the amount they pay back will reflect how the property has appreciated or depreciated over that time frame.

For example, let’s say they receive a 5% loan of $25,000 through the FTHBI for a home purchase of $500,000. The homeowner sells the home several years later, and its value has increased to $550,000. The homeowner would then need to pay the CMHC back $27,500 to reflect 5% of the increased value of the home. However, if the home loses value over that time period, only the original amount of $25,000 would be due to the CMHC upon its sale. Continue Reading…

Flipping Homes: One way young adults can achieve Financial Freedom

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By Donna Johnson

Special to the Financial Independence Hub

One of the top ways to make money historically has involved investing in real estate. Buying distressed houses at a good price and then selling them for a profit, known as flipping, is a great option for making money in housing. For those who are young adults, there is time to take risks and recover if they don’t pan out. Flipping houses is one of those calculated risks that could help younger American or Canadian adults achieve financial freedom in relatively short order. Here is how the flipping process works.

Find a house

In order to flip a house, it’s necessary to first own the house. A house that’s ripe for flipping might be a very distressed house in a great neighborhood. With tens of thousands of dollars of work, flippers could theoretically earn a profit that equals or exceeds their initial investment. Even a home that’s merely a bit dated in its decor could provide a good opportunity in the right location.

It’s important to know the market before purchasing a house to flip. It will be difficult to sell a house for a profit in a bad neighborhood no matter how impressive the renovations are. Additionally, comps in the local market will need to be high enough to provide a gap between what the flip initially costs and what you can sell it for. Otherwise, it will be difficult to make a profit.

Have money available

It’s important to have quite a bit of cash on hand before beginning a house flip. Those 3.5% down payments associated with FHA loans [in the U.S.] are only available for homes that will be occupied by the owner. Banks consider flips investment properties. Therefore, a flipper can expect a bank to require a 20% down payment as security for a loan. Continue Reading…