Renting vs. Buying Calculator

I was going to create a spreadsheet to determine whether buying or renting makes more sense in different scenarios. But then I found this excellent buy vs. rent calculator from Vancity. Here’s how it works:

We calculated your breakeven point by examining how long it would take to create enough equity in your home to exceed the value of investing your cash on hand. We also accounted for differences in your monthly rent and house payments. If your rent payment is less than your net house payment, we add that monthly savings to your investment. If your house payment is less than your rent payment we subtract that amount from your investment. You may notice that on the schedule at the bottom of this report the investment value can be reported as negative. This happens if your house payment is significantly lower than your rent payment. It illustrates that if you continue to rent the extra cost of renting would, in effect, use up your cash on hand.

It can take into account all sorts of fees, mortgage fees, closing fees, annual property taxes, GST on a new home, maintenance/condo fees. The home appreciation rate can be varied as well as the future sales commission. For the investment used to compare with, one can vary the investment return and the inflation rate.

Just make sure that if you include utilities in the “maintenance/condo fees” field that you also include it in the “monthly rent payment” field. The only reason to put utilities in at all is if the amount is at all different in the rental property vs. the owned property.

Note also that there is a bug in their charting which causes the chart to not extend past the 10-year time frame. Scroll down to view the detailed numbers for all years.

Just plugged in some values using the rent that I am paying now ($1050) and the price of a comparable apartment in Vancouver. A quick scan on shows that I’d have to spend at minimum $280,000 for a place of comparable size, with around $200 in condo fees. I haven’t even factored in location (and the location we currently are renting in is hard to beat, so $280,000 is very conservative). I assumed a 0%-down mortgage and the default of 3% annual appreciation on the home. Most of the other things I left at their defaults (except inflation which I lowered to 3% from the default of 4%). For my case, the value of the investment (initial cash-on-hand + monthly contribution of (mortgage payment minus rent) invested at 7% after-tax return) was $830,407 after 25 years. The home equity after 25 years was only $556,903. This assumes a monthly investment of $1300 (mortgage payment minus rent). This is almost what we are contributing monthly right now (we should be up to this level in 2006). So right now, renting is clearly the best option for us.

Asset Allocation and Rebalancing

Interesting example of asset allocation and rebalancing in this article, “What the Heck is Asset Allocation.”

He illustrates two cases (over 2 years):

  • Case 1: Investing $100,000 in 4 different mutual funds (large-cap, mid-cap, small-cap, and bonds), 25% each. Sell the worst performer after the first year and buy the best performer. Hold for one more year. This leaves you with $96,535 after the 2 year period.
  • Case 2: Same as above, but rebalancing the funds after year 1, so that each fund was again 25% of the portfolio. This case leaves you with $103,170.

He also could have shown the case where you just buy & hold for the 2 years:

  • Case 3: Using the returns provided in the article, the final value for each fund would be FV=PV \times (1+i_1)(1+i_2) for each fund, where i_1 is the return of a fund in year 1 and i_2 is the return of a fund in year 2. You would end up with $102,660

It just happens to work out this way because of the data he used. Had he rigged his data so that the Bond fund continued to do poorly in year 2 and the small cap continued to outperform the others, then our results would be different. But in my opinion if you looked at past market data you would find that case 2 above is invariably the best thing to do.

Financial Service Charges Calculator

I just found this, Financial Service Charges Calculator, provided by the Government of Canada! It’s provided by the Office of Consumer Affairs. It looks like PC Financial is the cheapest by far for my needs. Using a grossly exaggerated estimate of my monthly financial transactions (I exaggerated it a lot because I expect to use Interac more now that I don’t use credit cards), I got the following results:

PC Financial – $1.50
BMO – $25
CIBC – $14.45
HSBC – $25
Scotiabank – $29
TD Canada Trust – $14.45

This assumed only 1 withdrawal from another bank’s INTERAC bank machine. This assumption may be incorrect for some of these banks which don’t have as many ABM’s available to use. Most of the plans above are unlimited plans. PC Financial is clearly the cheapest. I’ve also neglected the fact that cheques from PC Financial are free, and also, CIBC and PC Financial appear to have one of the largest ABM network’s in Canada according to this article (BMO is not listed) which means that I will need to use the other banks’ machine’s less often. I just did a search for CIBC/PC Financial ABMs in Vancouver and it sure turned up a lot.

Risk Premium for Stocks

This Fortune article, “Investors Are in for a Shock,” talks about some recent comments issued by Alan Greenspan: “Investors, the Fed chairman intoned, normally demand a substantial ‘risk premium’—a high return in exchange for taking a chance that they may lose money. Now, though, investors ‘accept increasingly low compensation for risk.'” The author goes on to explain:

Greenspan’s argument rests on the idea of the risk premium—the extra return (over a supersafe investment like Treasury bills) that investors have traditionally received for putting their money in peril. For stocks, the risk premium equals the expected real (inflation adjusted) return on a broad portfolio of shares, minus the real interest rate. To calculate the risk premium that stock investors are getting today, we turned to Asness. For expected return, Asness uses the earnings yield on the S&P 500—earnings per share divided by price—adjusted for cyclical swings in profits. Asness pegs today’s earnings yield at 4.3%.

To derive the real interest rate, Asness takes today’s ten-year Treasury yield of 4.6% and subtracts the average inflation rate over the past five years, 2.7%, to get a real rate of 1.9%. So today’s risk premium is the 4.3% expected return minus the 1.9% real interest rate, or 2.4%. That’s about half the 5% margin that stocks have delivered for the past 80 years. So investors aren’t getting the usual extra bang for holding equities.

This will lead to two possible outcomes. At best,

people who buy at today’s levels are in for a sustained period of subpar returns, perhaps 4% or 5% annually, after inflation. That’s because the best predictor of future gains is the price you pay. “High prices and low risk premiums today mean low returns tomorrow,” says Cliff Asness, an economist who runs AQR Capital, a $17 billion hedge fund.

and at worst, “the more dire alternative is a steep fall in prices that makes everything from the S&P 500 to homes what they aren’t today—that is, great investments.”

Paying Down Student Loans vs. Contributing to an RRSP

There are many people, me being one of them, who ask themselves “should I put money into my RRSP or pay down my debts?” For very high interest debt, such as credit cards and bank overdraft, this type of debt should always be paid down before anything else. For other debt such as student loans, bank loans, and mortgages, the answer is less obvious.

I have come up with a good, simple example, to answer the above question. Imagine you had at least $1000 room in your RRSP and you owed $10,000 at 7% as of January 2006. In January 2006, you have a choice of either putting your next paycheque (of $1000) towards an RRSP invested in a balanced portfolio of bonds and equities, or towards the $10000 loan. You can do nothing else with your loan or your RRSP until January of the following year.

  • Case 1: If, in January 2006, you put $1000 towards the $10,000 loan, you would be left with $9,000. Over the next year, you would be charged $630 in interest, a savings of $70 over what you would have paid had the loan principal still been $10,000. Your net worth based on the RRSP and the loan would be -$9,000 – $630 = -$9,630 at the end of the year.
  • Case 2: If, in January 2006, you put $1000 into the RRSP invested in a balanced portfolio of bonds and equities. To be conservative, we will assume that it will appreciate by 7%, however, it doesn’t really matter so much as we will not be realizing any value on this portfolio for years to come (until we retire, presumably). After one year, the RRSP portfolio will have appreciated by $70. In April 2005, you will receive a tax refund. Assuming a marginal tax rate of a modest 18%, you will receive $180 in refunded taxes in April. You can then apply this to your loan in April or put it in your RRSP. Let’s keep the calculation simple and just hold it as cash until the end of the year (not a smart thing to do in practice, as technically you owe that $180, more or less, to the government later on). During the year, our loan accumulates $700 in interest. At the end of the year our net worth will be -$10,000 – $700 + $1000 + $70 + $180 = -$9,450.

In Case 2, we are $180 richer than in Case 1. This came directly from the RRSP tax credit as the amount that the RRSP holdings grew by was exactly compensated by the extra amount we owed on the loan. This demonstrates the power of RRSPs. The $1000 + $180 is now pre-tax dollars. The government has refunded us the $180 in taxes on that $1000. The $180 is not free money, as we now owe the government some taxes when we take our money out of the RRSP when we retire. It is our hope, however, the when we retire we will be in a lower tax bracket and the $180 in taxes will actually be less (let’s say $150). So really we are $30 ahead, not $180, but still, thanks to tax deferral (deferring taxes on income until we retire), we are ahead.

One strategy is to contribute monthly to your maximum allowable limit, then to apply the tax credit in April to your loans. The tax deducted from your paychecks acts as a forced savings device for an annual loan principal payment.