Companion Advisor: Techniques
Saving 10 - 15 per cent of your gross annual income is called "paying yourself first". Unfortunately, other demands like mortgages, cars, and orthodontic braces muscle themselves into the head of the line. One solution is to make an annual budget of all income and expenses.
One line of that budget, equaling 15 per cent of gross family income, is the savings line. This is divided into two parts: annual RRSP contributions and paying down your after-tax debts such as mortgages and car loans. First, make the maximum RRSP contributions every year for you and your spouse. Use your tax refund, and any money left over from your 15 per cent savings line, to repay after-tax debt such as mortgages, consumer loans and car loans.
Debt is much more costly that it appears. Since you have to pay your debts with after-tax dollars you must consider the dollar amount you actually have to earn before tax to provide the funds to make the debt repayment. If you are in a 42 per cent tax bracket you only retain 58% of every next dollar you earn. In this case you have to earn $1.72 before tax to have $1.00 after tax. Extending this reasoning to debt interest rates means that a 10 per cent loan actually costs you over 17 per cent in pre-tax dollars (10 divided by 58%). Determine your marginal tax rate and then calculate the actual percentage costs in pre-tax dollars on any debts that you have. It may encourage you to pay them off faster.
Getting back to paying yourself first , where will that 15 per cent savings come from? From spending less! This usually means fewer meals out, fewer impulsive purchases, and fewer adult toys such as VCR's, microwaves, mobile phones, and several dozen other automatic gadgets.
It will be difficult at first to cut back on expenses, but every year it will get easier as after-tax debts are paid off and more money becomes available to spend as you like: not as your creditors demand. One easy way to "pay yourself first" is to "fool yourself first". This means having your RRSP contributions and other investment savings deducted from your bank account monthly. If you don't see the money, you won't miss it as much.
After your RRSP, your mortgage is the best place to put your money. Remember, as discussed earlier, depending on your tax bracket, your mortgage is costing you much more than the stated rate, in pre-tax dollars. If you have a 10 per cent mortgage, and you are in a 42 per cent tax bracket your mortgage is actually costing you 17 per cent of the money you earn before any tax is deducted. This also means that any investment would have to earn more than the 17% before tax to be a better alternative than pre-paying a 10% mortgage. Think of every dollar paid against that mortgage as "earning" you a 17 per cent return.
Developing a budget is the best way to make sure you save for the future while paying off your creditors today. Remember, though, a budget is a plan, and plans can change. If there are unexpected sources of income or expenses, don't just abandon your budget in discouragement, rework your budget to account for them.
There are times when borrowing can be advantageous: when making RRSP contributions or when the cost of the loan is tax-deductible.
Borrowing to make an annual RRSP contribution, although not tax deductible, can be a sound idea providing you pay off the loan prior to the next RRSP contribution deadline in case you have to borrow again. Use your tax refund to pay down the loan and when it's paid off, continue making the payments but this time into your RRSP rather than towards the loan. This way you'll get a head start towards the next contribution deadline and will be able to reduce the amount you have to borrow at that time.
If your entire 15 per cent savings line is contributed
to RRSPs and you don't have any debts to pay off, borrowing to invest
outside an RRSP may make sense. Since interest on loans with a purpose
of earning investment income is tax deductible, you will be ahead providing
your investment earns a greater return than the cost of the loan.
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