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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
Contact
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2
July-28-15

Fundamentals of Debt

Why do People Borrow?

People borrow to bring forward expenditure. Conversely, people save to defer expenditure. Bringing forward expenditure comes at a cost, interest, while saving is rewarded by investment returns. How much debt costs depends on the risk that the borrower may default (i.e. not pay the loan back), which is called credit risk, and the borrowing period (also known as term risk). A borrower who can borrow against assets they own (e.g. a house), will be able to borrow at a cheaper rate, than if the loan was not secured by assets.

Debt can be both a good thing and a bad thing. Broadly, speaking, debt may be considered good if it enables you to increase your future income. A good example of this is taking on student debt to earn a degree that will result in a higher income in the future. Many people also view purchasing a house as good debt. The assumption is that the rise in value of the house, less the cost of ownership (including mortgage interest payments) will compare favourably with renting the same property. Whether it’s a post-secondary education, a house purchase, or something else, there is still risk (you may lose your job, house prices may fall, etc.). Bad debt typically involves immediate gratification but no increase in future income. Examples could include an expensive holiday, luxury cars, etc.

Types of Debt

There are many types of consumer debt available. Outlined below are a few of the most common for young professionals:

Credit Cards: as long as credit cards aren’t abused (buying things you can’t afford, maxing the limit and not paying it off monthly), credit cards can offer some great advantages over paying with cash. Some of these include travel insurance, purchase insurance, rewards or points, depending on the specific card. Unfortunately, if you don’t pay off the balance each month before the due date, they charge extremely high rates, upwards of 20% on the total balance outstanding plus any new borrowings.

Personal Lines of Credit (LOC): Lines of Credit are loans from banks that are typically revolving (i.e. any amounts paid off can be borrowed again). Some lines of credit are secured by assets, while others are simply backed by the borrower’s earning capacity. Secured LOC’s offer the benefit of preferential rates over unsecured LOC’s. For example, if one uses a LOC to pay for a car purchase, the bank has the option to repossess the car (if you don’t make your payments), sell it, and pay off the loan. Since it’s less risky than an unsecured LOC, you can get a lower rate.

Student Loans: this is a very common type of debt for young professionals. The most popular in Ontario is OSAP, followed by loans from banks. I will go into more detail on these in a separate post.

Mortgages: These are a type of secured loan to help pay for a house. You own the home, and use it as an asset to secure the loan (providing the opportunity for lower interest rates). The standard mortgage is offered by banks, independent mortgage brokers, etc. There are many specifics when it comes to mortgages, which I won’t go into detail here.

Reducing Debt

There are a few basic guidelines for paying off debt:

If you are tight on cash each month, pay off at least the minimum you owe for each debt. This will ensure you don’t default on any of the loans, which will negatively affect your credit rating.

Pay down debts with the highest interest rate first. For example, say you have a balance of $2,000 on your credit card, running at 18% interest and $10,000 in a Line of Credit with a 5% interest rate. If you have $3,000 to use to pay off debts, you should eliminate the credit card first, then the Line of Credit.

  Credit Card Paid First Line of Credit Paid First
  Balance Interest Balance Interest
Credit Card $0 $0 $2,000 $360
Line of Credit $9,000 $450 $7,000 $350
Total   $450   $710

 

If you have multiple loans, it might be beneficial to consolidate those loans into one with better terms (i.e. lower interest rates). Many banks offer debt consolidation options, including Lines of Credit. Say the above example was a real estate agent who knew they were receiving a big paycheck 2 months from now, but didn’t have any cash available to pay off the credit card balance. If the limit on the Line of Credit was $15,000, they could pay off their credit card by borrowing from the LOC and increasing the balance to $12,000. Two months from now, they could pay off some or all of the Line of Credit with their paycheck, and they would pay 5% interest on the $2,000 Credit Card balance rather than 18%.

Finally, the best way to eliminate debt is to pay down as much as possible as early as possible. A simple guideline I’ve explained in my post Saving and Budgeting, is to put 20% of your after-tax income towards saving and reducing debt. If you can trim your budget to get to that 20% or more, that will help rid your debt more quickly and save on interest.

How does Debt affect your Credit Rating?

Having a large amount of debt doesn’t necessarily mean you have a low credit rating. While your level of debt may affect how much you can borrow right now, your credit record/rating is a history of how well you repay debt. If you show that you pay back your debts on time and consistently, even if the balance is large, your credit rating should not be adversely affected. If you don’t currently have debt and have not had any debt in the past, credit cards can be a good way to build up some credit history, as long as you are paying them off in full each month.

Other helpful items

Debts are often quoted as “Prime + X%”. Prime, or the prime business rate, is set by Canadian financial institutions. It was just lowered to 2.7% (from 2.85%), as a result of the Bank of Canada’s decrease in the Target Overnight Rate. Most banks list what the prime rate is currently on their websites, or you can find it under “Interest Rates” on the Bank of Canada Website. Rates are shown as annual figures (unless stated). Almost everything is negotiable, and there are many options when it comes to borrowing. For mortgages, for example, get quotes from at least 2-3 sources, including independent mortgage brokers as well as your bank.

If you cannot afford your debt payments, the worst thing to do is simply not pay them. If you are struggling, contact the lender and ask for help. They would much rather reduce your payments to make them more manageable, than have you not pay them at all. If this sounds intimidating, consider talking to a not-for-profit credit counselling service in your area.

With respect to your credit rating, it is a good idea to review your credit report to make sure there are no errors. Equifax and TransUnion provide you with your credit report (not your rating) for free once per year. For an explanation of the difference between credit reports and credit scores, read Credit score vs. credit report: What’s what?

It’s not a bad thing to have debt, as long as you don’t abuse it and have a clear plan for paying it off.

By: Susan Daley | 0 comments
July-22-15

Retirement Savings? Spend It All.

To save money for retirement and then not spend it is a waste. There are better options than simple spending rules.

Several weeks ago I bought a very large tub of potato salad at a wholesale store. It was on special offer and the expiry date sufficiently distant that I thought it had to be a bargain (you might already surmise that I am not often trusted to go shopping). We discarded it on the weekend only two thirds empty. We started off with gusto but we got tired and our consumption declined.

We were fortunate: we outlived the potato salad. If we had pre-deceased the tub then the children would have been surprised at the inheritance (we had told them to expect nothing) and I would be in the afterlife regretting my poor planning. Forever.

The potato salad is an (imperfect) analogy for the retirement challenge of figuring out how much a retiree can draw out their retirement savings so it lasts just long enough. A common response is to reach for a spending rule and a popular example is the 4% rule. Suppose you have saved $500,000 for retirement then the 4% rule says that you can spend 4% of your savings (in this case, $20,000) indexed to inflation and your portfolio will last 30 years.

The 4% rule was devised by checking whether, going back to 1926, there was a 30 year period when the rule failed on a 50% bond, 50% equity portfolio. While it never failed in many cases there were considerable assets unspent. Saving for retirement and then not making full use of those savings is a waste unless you specifically wanted to leave an inheritance. As an illustration we imagine an investor 30 years ago who invested $1,000,000 in a balanced portfolio (40% Canadian Bonds, 60% Canadian equities) and withdrew according to the 4% rule. At the end of 30 years they had withdrawn $1.20 million (in real dollars) but were left with a surplus of $3.57 million (in real dollars)! The retirees had massively underspent.

Fixed spending rules lock us into a one dimensional construct: run out of money versus underspending. The way out of this is to allow spending to fluctuate as markets and interest rates change. One method, ARVA, is simple to implement and results in the last payout depleting the portfolio to zero (or a previously defined residual if you want to leave an inheritance). When applied to the example above, real spending rose to $2.27 million, a gain of 89%. In this instance on no occasion did the annual income fall below the 4% rule but there is no guarantee this would always occur. The spending profile from ARVA is compared with the 4% rule below.

In the example above our investor conveniently expires at the end of 30 years of retirement.  In reality we don’t how long we are going to live in retirement, an uncertainty known as longevity risk. Because the 4% rule often leaves a residual, it might seem this provides some protection for those who live longer than expected. To see why this might be plausible on average but risky for an individual imagine you are starting retirement today. It may be the case that market returns are favourable and after 30 years there are residual assets. It may also be the case that you are still going strong after 30 years but these two events are independent of each other and there is no reason why they should coincide or that any residual assets match your income needs.

An alternative approach to dealing with longevity risk is to use ARVA to compute a level of income assuming you live to, say, 100 (the probability is less than 1% for a male and 2.7% for a female), and to repeat the calculation assuming you have average life expectancy. For example, a 65 year old male can expect to live another 18.8 years until nearly 84 years old. Where you choose to be within these two withdrawal ranges becomes a matter of preference and can be updated every year.

As an illustration, based on current real interest rates, the ARVA estimated withdrawal rates for 2015 are specified in the table below for a single male.

Age 60 65 70
To Average Life Expectancy 4.97% 5.90% 7.18%
To Age 100 3.13% 3.47% 3.94%

Source: PWL calculations

Compared to the task of accumulating assets there has been comparatively little effort made by the financial industry to help investors deplete their portfolios efficiently. We can think of a couple of reasons for this. Most advisors get commission for your savings, not your spending. Secondly there are just too many variables for asset aggregators to deal with: designing effective and efficient depletion strategies has to be done at the individual level in conjunction with an understanding of clients spending needs and other resources. The tools exist.

By: Graham Westmacott | 0 comments