Friday, February 26, 2010

Let's talk Interest(ing)

Now that we have bought a home, first we set our financial future on a more solid footing by paying off the mortgage as soon as possible. There is the eternal conundrum about what to do first: paying off the mortgage or contributing to the RRSP?

Why not do both? Make your maximum contribution to your RRSP and use the tax refund to make your maximum allowable or affordable annual mortgage lump sum payment (often 20% of the original mortgage principal). Ah... but what to do with the money inside the RRSP?

Cash gives no return on investment these days. So let’s look at GIC’s or Guaranteed Investment Certificates. Many GIC accounts are insured through the Canadian Deposit Insurance Corporation (CDIC) up to a maximum of $100,000 per account. Make sure yours is! Guaranteed Investment Certificates do not guarantee that you will get your money back (as usual, I found that out the hard way). It only guarantees a certain interest rate over the life of the GIC. Today many GICs don’t pay interest equal to inflation (currently around 1.5% per year). Even within a RRSP the most you can expect is to break even or slightly better in terms of purchasing power.

If you park cash in a GIC outside a RRSP you are nearly guaranteed to lose money. Say you get this very good interest rate on your GIC (5 year rate at Scotia in Feb 2010 is... 2.6%). Also let’s assume you have the top marginal tax rate in Alberta: 38%, what is your after tax and after inflation return?

2.6% x (1-38%) – 1.5%= 0.12% real rate of return (If you lived in most other provinces you would lose money). You may say, “Yeah but at higher inflation I get higher rates and then I should make money”. Try the same exercise on your own: GIC rate 12.5%, inflation 10%, and tax rate 38%. And if you think inflation will stay as low as 1.5% over the coming years, think again. In 2008, Canada’s inflation rate was 3.5%. What would happen if you were locked in for 5 years at an interest rate of 2.6% and inflation rises? So are you still keen on investing in GICs?

Eh, before you sign off, cash and GICs are low risk, not like stocks. At least I preserve my capital!” is your cheap shot at the departing author of this blog. From the distance I yell back: “We’ll discuss risk after we went through various investment types later on. B.T.W. discussing ‘risk’ will take me at least another 5 blog postings! So brace yourself”

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