Questions are still trickling in about the year-end Investor Clinic quiz, so today I’ll answer a couple of them. If you haven’t taken the quiz already, you can find it here.
Several readers were stumped by question No. 11:
Jane has a $200,000 fixed-rate mortgage at 3.5 per cent and her marginal tax rate is 43 per cent. She has $50,000 in cash that she wants to use to either pay down her mortgage or buy a guaranteed investment certificate (GIC) in a non-registered account. What interest rate would the GIC have to pay in order to have the same after-tax return as paying down the mortgage?
The purpose of this question was to demonstrate that, if you’re investing in a non-registered (i.e. taxable) account, you need to earn a very high yield on a GIC just to match the benefit of paying down your mortgage. Here’s why.
For every dollar Jane pays toward her mortgage, she saves 3.5 cents of interest. In effect, she earns an after-tax return of 3.5 per cent.
If she invested in a GIC instead, after paying 43 per cent in tax she’d get to keep just 57 per cent of the interest. So the question becomes: What interest rate, when multiplied by 0.57, equals 3.5 per cent? By moving some numbers around in the equation, the answer is 3.5 divided by 0.57, or 6.14 per cent.
Another question that tripped up some people was No. 7:
Ignoring taxes, if you invest $200 per month starting one month after your 18th birthday and earn an annualized return of 8 per cent in the stock market, how much money will you have when you turn 65?
The easiest way to find the answer is to use an online compound interest calculator such as the one here, which allows for monthly contributions. Enter zero for the initial balance, $200 for the monthly contribution, 564 (47 years times 12) for the months invested and 8 for the annual percentage return. The final sum is $1,242,475.
A reader asked the following question about reinvesting dividends in his son’s registered education savings plan:
I’m looking to buy my son some shares of TransCanada Corp., which pays an annual dividend of $1.76. I’m planning to buy 31 shares so that I’ll receive $54.56 in dividends, which is enough to purchase an additional share of TRP if I enroll in my broker’s dividend reinvestment plan (DRIP). Is this wise?
I’m all for reinvesting dividends. But there are two problems here.
First, TransCanada – like most companies – pays dividends quarterly, not annually. Instead of receiving a lump sum of $54.56 once a year, you’d receive $13.64 in dividends every quarter.
Second, most broker-operated “synthetic” DRIPs only permit purchases of whole shares, not fractions of shares. With TransCanada currently trading at about $48.77 , your quarterly dividend wouldn’t be enough to buy a full share, so the cash would sit in your account.
Unfortunately, it’s not an option to enroll the shares in a “true” DRIP operated by the company’s transfer agent. These plans permit fractional share purchases, but shares held in RESPs and other registered plans aren’t eligible.
You have other options, however. You could purchase a low-cost mutual fund and choose to reinvest all dividends. Mutual funds permit fractional share purchases, so every penny of your dividends would be reinvested.
Another option is to reinvest your accumulated dividends and Canada Education Savings Grants once a year when you make your RESP contribution. You’ll miss out on some compounding during the year, but you’ll have control over what you buy and when.