Question from R.G., a lawyer in Vancouver, age 29: I am single, debt-free and just started my professional career. Two months ago I landed a new position making $70,000 gross. I currently have $12,000 saved up, and I am putting away $2,200 a month with $500 going into a mutual fund investment in my TFSA and the rest into my savings account. I am able to afford this level of savings because I am living with my parents.
The housing market seems like a sure-fire way to make my money grow, however I am so far from entering the Vancouver housing market, it’s laughable. I also don’t have a pension plan through my employer, so saving for retirement is important. Then of course there are unknowns such as eventual marriage, kids, etc., that I might need to access my money for.
Ben Felix regularly provides one-on-one financial advice sessions about investing, insurance, financial planning, and anything else personal finance related.
Benjamin Felix is an investment adviser with PWL Capital in Ottawa.
Answer: Let’s start off with the housing market. There is no evidence to show that the housing market is a sure-fire way to make your money grow. In fact, the long-term returns on real estate have trailed those of the stock market. As millennials we tend to hear from our parents that housing is a great investment; many of our parents have had a great financial experience owning a home, so they are inclined to believe that we will, too. I don’t want to get away from your question, so let’s leave it as this: renting is not throwing your money away, and buying a home is not a guaranteed way to make your money grow. There is nothing wrong with buying a home as a lifestyle decision, but the motivation to buy should not be financial.
You have no debt, which is an excellent starting point. Paying down high-interest credit card debt would be a priority if you had it. Paying down lower-interest debt like student loans is not always as obvious and usually comes down to preference. For example, if your student loan interest rate is 5 per cent and you expect to earn 7 per cent in the financial markets, it might be optimal to follow your regular payment schedule on the student loan and invest remaining savings in the financial markets. However, the 7-per-cent financial market return is not guaranteed, and you might be uncomfortable with debt, so paying it down can also make sense.
Now, on to your question – you want to know the best way to make your money grow while trying to achieve multiple financial goals with varying time horizons. I like to break things down into three buckets: emergency fund, intermediate savings, and long-term savings.
1) Emergency fund: Your emergency fund should hold between three and six months of your living expenses. It could be smaller while you’re living at home, but you may want to take the opportunity now to build it up to what it will need to be when you eventually move out. It sounds like you already have a healthy emergency fund built up. Homeowners should usually keep larger emergency funds than renters because owners may need to cover the cost of a major repair at any time. Your emergency fund needs to be invested in a high-interest savings account that can be accessed quickly and easily.
2) Intermediate savings: Your intermediate savings is for a wedding, kids, travel, a down payment, a new car, education etc. Anything that you want to achieve in less than five years goes in this bucket. Due to the short time frame, the money in this bucket should not be invested in anything other than guaranteed investments. High-interest savings accounts are again useful here. GICs often come up as an option for intermediate-term goals, but I am wary of using them. A GIC will give you a higher interest rate than a high-interest savings account, but your money is locked in for a fixed term. I have seen too many instances of five-year goals becoming one-year goals while money is tied up in a five-year GIC.
3) Long-term savings: Your long-term savings is your pension. It is common for young people today to be without a pension through their employer, making this bucket very important. This is where you have a long enough time horizon to invest in the financial markets through mutual funds or exchange-traded funds. These investments are not guaranteed, and their value can change significantly from year to year, but it is expected that they will increase in value over the long term. In building up your long-term savings, it is important to be mindful of fees which can have a significantly negative impact over long periods of time. Investing in low-cost index funds is a good way to keep the fees low while maintaining sufficient diversification.
We have talked about what goes in the buckets, but where to keep them is equally important. The RRSP and TFSA are types of accounts that you can open at most financial institutions. They have special tax attributes that are designed to help you save.
The RRSP is primarily designed for long-term savings. When you put $1 into your RRSP, you are able to deduct $1 from your taxable income, deferring income tax on that amount. When you withdraw from your RRSP, you pay income tax on the withdrawal. You gain new RRSP room based on 18 per cent of your previous year’s earned income, up to an annual maximum. If you make a withdrawal from your RRSP, you will not get that room back. These attributes make RRSP withdrawals before retirement less than ideal. There are two special cases where the RRSP can hold intermediate savings. They are called the Home Buyer’s Plan (used when buying your first home) and the Life Long Learning Plan (used when pursuing your education).
The TFSA is able to facilitate short and mid-term savings, but it is ideally used for long-term savings. TFSA room builds every year that you are a Canadian resident over the age of 18. You contribute to your TFSA with after-tax dollars, so there is no deduction when you contribute, but there is also no income tax when you withdraw. When you withdraw from your TFSA, you get the amount of the withdrawal added to your contribution room the following year. It is okay to use your TFSA to hold your emergency fund and intermediate savings in some cases, but as soon as you have enough money to fill up your TFSA room with long-term investments, they take priority in the account. Mutual funds and exchange-traded funds usually produce more taxable income than a high-interest savings account or GIC.
Prioritizing the buckets is also important.
Your emergency fund is the first priority. If you do not have one and there is a financial emergency, it means that you are either borrowing money or selling your investments. Borrowing money can be costly (think about your credit card interest rate), and selling investments at the wrong time can be even more costly.
Intermediate savings tend to be more discretionary, and are in competition with long-term savings. Do you really need to go on that trip, or should you max out your RRSP? Do you need to spend $50,000 on your wedding, or is $10,000 enough? Of course these questions are extremely subjective, but they are important. Logically everyone should put all of their money in excess of their emergency fund and living expenses into long-term investments, but that might make life much less enjoyable. Balance is important in sticking to a financial plan.
In summary, buying a house is not guaranteed to be a good financial decision, maintaining an emergency fund should be a priority, major expenses should be planned for, and long-term savings should be invested in low-cost index funds held in your RRSP and TFSA.
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