Canada Student Loan vs. BMO Line of Credit

We have a BMO line of credit and a Canada Student Loan. The interest rate is prime (5.0%) on the former and prime + 2.5% on the latter (7.5%). You would think that it would make sense to put everything in the much cheaper line of credit, but this is the first year that we have started to pay down either, and I knew that we received a federal and provincial tax credit on interest payments for the more expensive prime + 2.5% student loan so I figured it probably worked out to be about even, and besides, our student loan is a lot smaller than the line of credit (although not significantly close to $0 yet to not worry about it). Without looking at the actual numbers, I had no idea. It’s one of things that no one can tell you the answer to (except maybe your accountant if you have one) and there is usually no universally true answer either. Anyways, I finally crunched the numbers and here’s what I got:

The annual interest owed in one year on the line of credit is Q(1+p), where Q is the amount drawn from the line of credit and p is the prime rate. The interest owned on the loan is Q(1+p+0.025), where Q is the amount owed of the student loan. But with the interest payment tax credit, the effective annual interest payment is reduced to Q(1+p+0.025) – Q(p+0.025)0.2105 = Q(1.0197+0.79p), where 21.05% is the tax credit rate, including the federal rate and provincial rate for BC.

So the loan is worse when Q(1.0197+0.79p) > Q(1+p). Re-arranging yields, p < 0.09 or "the loan is worse than the line of credit when p < 9%" Since the prime rate is currently at 5% at BMO, it looks like we are better off paying down the Canada Student Loan using funds from the line of credit. This will not only save us some money every year but will give us one less monthly payment to worry about and simplify our debt into one amortization plan. Simple is always better.

Goals for 2006

This is the time of year when everyone is setting their goals for 2006, and I am no exception. 2006 will be a year with a lot of change for us, completing the switchover to a new bank, a switch to a new full-service broker, and our first year filling out our tax return as a married couple. It’s also a year where I expect the value of our RRSPs to grow 69% from contributions alone, to make a small dent in our line of credit while still saving up for the things we want, like vacations.

  • Investing:
    • Contribute to our maximum allowable RRSP room (18% of income in 2005) by the end of 2006.
    • Transfer my RRSP from TD Canada Trust to Clearsight in February.
    • Invest in value-oriented investments or ETFs at lowest cost wherever possible.
    • Be invested in 25% fixed income and 75% equities by the end of 2006.
  • Personal finance-related:
    • Switch all our automatic deposits and withdrawals to PC Financial from BMO.
    • Limit our daily expense for food, dining, gifts, gas, bus, entertainment, recreation, etc . . . to $300-400/week (this will be regulated by having a second chequing account linked to our bank cards which only contains that much per week).
    • Contribute the rest to ING Direct Savings accounts for vacations and other “wants.”
    • Try to get at least one salary raise this year.
  • Debt:
    • Get rid of AMEX Gold and carry only one credit card (BMO Mastercard). Don’t get any additional cards in 2006.
    • Eliminate all credit card spending except for online purchases (only when necessary and which will be paid off immediately) and dental appointments (which I get reimbursed for later).
    • Pay down federal student loan using our lower-rate student line of credit.
    • Pay at least $700/month to student line of credit.
    • Apply all of our tax refund to student line of credit.
  • Blogging:
    • Try to publish at least one post daily.

Some of these goals are things that we’ve just started doing in 2005, but would like to continue doing in 2006. I have no doubt that we will achieve all of these goals, which is why I’ve called them goals and not “resolutions.”

HBC Credit Card – don’t bother

Just bought a Christmas gift for someone on Saturday at The Bay. The lady at the counter said that I could earn 50% more HBC Rewards points if I used my HBC Credit Card. I said something like “no, thanks anyways, but I’d prefer to pay with the cash I have in my wallet, rather than pay off a credit card bill a few months from now.” Even it it means getting a few measly rewards points. The item I was purchasing was $40 (50 rewards points per dollar means 2,000 rewards points). If I paid with the credit card, I would get an extra 1,000 points. A quick check on the HBC website reveals just how much these points are worth. Taking the average points value of the, Blockbuster, and Starbucks gift cards that are redeemable using HBC rewards points, we find that 1,000 points is worth about $0.10. That is comparable to about 1 Air Mile (through the Air Miles rewards program).

So basically what the lady was offering me was an opportunity to save $0.10. This was easy to refuse. But she was persistent. She said that I could charge it to my HBC Credit Card and then she could immediately pay off the balance on the credit card right then and there using cash. I threw up my hands; what the hell, sure, charge it. She charged it and then paid off the balance. It took about 30 more seconds to do these two steps rather than just one, but that was insignificant compared to amount of time it took her to “gift wrap” the item.

Today I saw a similar item at a different store. A little bit better product, for $5 more. I thought about returning the item to The Bay to get this new item, but would I be able to get my cash back? Since I made the purchase with my HBC Credit Card, if I returned the item I would probably be given a credit on my credit card rather than a cash refund. Probably the best I could do would be to get a gift card or store credti. I would owe them some future business one way or another.

I don’t even know why I have this stupid HBC credit card. I think I got it a few years ago because I was offered 10% off my purchase that day if I signed up for one. It was a $600 purchase, so I guess it made some sense as I saved $60. But how many people save that $60, then end up spending $60 more over the course of the next year than they would have, had they used cash.

Just tore up my HBC Credit Card right now. Ripped into four pieces. It was actually good timing because I just got a PC Financial account and I need an empty slot in my wallet.

Screwed on Bank Charges

We just got our first bank statement since attempting to stop using our credit cards completely. My plan to reduce our total spending by not using a credit card may have back-fired slightly, as there was a whopping $17 in extra charges charged to our bank account, in addition to the $11 we are already charged for our monthly plan “Everyday Banking Plan.” We were pushed over our transaction limit because we are such heavy Interac/Debit users, and we have many automatic deposits and withdrawals coming in and out of our account every month. To combat the problem, we will carry around more hard cash in our wallets in December and I hope this will help us stay under the transaction limit.

I am seriously considering using our BMO bank account for all our bill payments and direct-deposits, and using a separate ING Direct account (they allow you to create 4) for Interac charges, since as far as I know there is no limit to the number of Interac transactions you can make with ING Direct accounts, just as there is no limits or charges associated with transferring money from an ING Direct account and a big-bank account (except charges incurred from the big-bank). It will be nice when ING Direct one day provides bill payment and direct deposit service.

Doom and Gloom

There is an interesting chart here, “Asset Class Performance” (got the link from here) showing the performance of various asset classes since 2000 and giving several predictions. One comment said: “I believe all will fall, while bonds will soar. special thanks to debt deflation depression.” The poster leaves no website to track him down unfortunately.

While digging around in Google for the term “debt deflation depression,” I found found this article: “Will the Latest Oil Price Shock Lead to a U.S. and Global Recession?

Interesting article with some interesting comments as well. The comment that Google picked up was this prediction:

I don’t understand how you can face two decades of real wages lagging productivity world wide, and still not be 100% convinced that a major depression is guaranteed in the coming years. The only way for consumers to absorb higher oil prices would be to take on more debt. As long as debt can be piled on, growth can go on, but there is no doubt that debt growth is the one and only fuel of the present growth.

Take away the US and european overindebted consumers, meaning, take away housing boom asset wealth induced spending… And the world falls into 30’s like debt deflation depression.

And if there’s one way out, I’d like to see it. Apart from aggressive monetising of public deficit, and aggressive policies in favor of higher wages (and I see none of them coming in the coming years), I can’t think of any.

So ?
So is there a question ?
Of course higher oil prices and lower house prices, will force the world into depression. Higher oil prices may indeed speed up the top of the debt-housing boom.

Talk about doom & gloom. Also no website provided for that comment either. No one really knows exactly what will happen in the next few years, but I have certainly seen a lot of doom & gloom predictions popping up lately regarding the stock market, real estate, and the US economy. I try not to let any predictions I read dictate my behaviour. I am invested for the long term and realize that market fluctuations are a fact of life. I am prepared to stay invested no matter happens and to invest consistently in my RRSPs year after year (especially when markets are down).

Life without credit cards – 2 week update

I did not announce it on this blog, but the week of November 6th, my wife and I stopped using our 2 credit cards, AMEX Gold and BMO Mosaik Mastercard, altogether. We basically told ourselves to stop using them, and to start using cash or debit for everything. I had thought for a long time that we were overspending because we were buying on credit, much like a university student will spend more money if they have a student loan then if they didn’t. As long as we paid of our cards promptly, I thought, they were a pretty good deal. One month interest-free plus the convenience. Wrong, according to The Wealthy Barber:

For most people, they’re not a good deal. The convenience that you view as positive can combine with human nature to form a destructive force, especially in the hands of someone who loves to shop. How many times have you bought something with your credit card that you wouldn’t have bought if you’d had to pay cash? And isn’t it usually something that you know you could live without? Then how many times have you opened your credit-card bill, clutched your throat, and shrieked, ‘Five hundred dollars! What the heck did I spend it on?’ So the fact is that many people who pay off their balance each month are still hurt by their use of credit cards.”

This described us pretty much exactly, so it was after reading this that I decided to work towards not using credit cards EVER. I realize that I will have to use them for many online purchases. However, those will be few, and it will be easy to transfer some money from chequing to the credit card immediately after making the online purchase.

We have made good progress so far. The last charge on our AMEX was on November 6th. The last charge on our BMO Mastercard was on November 11th. There was one other $4.25 parking fee charged to our BMO which was then paid down immediately that day and I also charged almost $200 to our Mastercard for dental work but I expect to get reimbursed for that from my employer well before it comes due (unfortunately we have to pay our dental claims up front before getting reimbursed from my company). I find that I have spent far less in the past few weeks than I have in a long time. I almost made a $300 purchase on a new computer case and hard drive two weeks ago, but after looking at the balance in our chequing account, I hesitated. That is a typical expenditure that I would have treated as a need before, charging it to my credit card without thinking. Now I realize that it is a want, and that I can live without it. We have a savings account for these wants and I will reconsider that purchase once there is more saved up. I was also wooed in the past by the Air Miles scam (both our credit cards are Air Miles credit cards). After 8 years of collecting, and enough points for just one flight, I am completely turned off by them. Nothing more than a scam intended to get me to spend more on my credit cards.

Here’s more thoughts on cash vs. credit cards from “Free Money Finance: Eight Unusual Ways to Create Cash“:

It seems impossible to exclusively use cash in today’s credit-oriented world, but those who do “create” significant cash. How? By spending dramatically less. Ron Blue, author of Master Your Money, notes that the mere use of credit cards causes a family to spend 34 percent more even if the statement is paid off monthly. Author Nancy Dunnan agrees in Never Call Your Broker on Monday by noting, “People like your parents or grandparents actually went through life using checks or cash. It worked then and it works now. Do the same and you’ll wind up spending 20% to 45% less.”

Check out the first comment on that post, and also the comments on this post. Unbelivable how attached people can be to their credit cards and those “cash-back rewards.” I am still firmly of the opinion that the best credit card out there is no credit card.

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.