How To Screw Yourself Out of Retirement
Posted by Stephen on
September 20, 2006
I must have gone through 10 revisions of this post! As I learned more, and as I started to understand what was going on, I realized that many people will not be able to retire the way they want, even if they saved for a long time. The difference between good debt and bad debt and investments outside of RRSP’s and Savings Bonds were never very popular with previous generations which is unfortunate. Here are some examples of how using the play it safe approach to investments will not work.
Inspired by John’s Post on Making Money With Your Mortgage, I thought it would be interesting on how this would work, if at all for someone who wants to play it safe.
To recap, Home Equity lines of credit allow you to borrow up to 75% of your equity, or if you already own the home, about 90% of the value. For most risk adverse people, paying off debt is one of the top things on the list, so assuming you’re doing that, you can have access to quite a lot of funds by borrowing against your house. So say you scrimped, saved, and threw everything into an unrewarding mortgage, and the bank says that based on what you paid in, you have access to $100,000 for your equity line at prime rate.
Most banks like ING Direct and even Presidents Choice Financial are doing accounts that give you at least 4% interest. A bit more if you lock into a GIC, but let’s stick with 4% to keep it simple and assume we locked into a GIC at 4% flat. Currently, prime rate is 6%, so we’ll use that in our example. We take the full $100,000, and invest it into a GIC for 25 years, and we pay the $100,000 equity loan off as if it was a mortgage, so our payments would be $639.81 a month.
At the end of 25 years, our GIC, compounded monthly, in a perfect world, would turn our $100,000 into $271,376.52 and we celebrate on our world cruise! Well actually, you’re not going very far. Unfortunately, that 4% is subject to tax, EVERY year. So you have to pay your taxes on the gains. If you are in the 40% tax bracket, you pay 40% on the interest at the end of the year. That means that every year, as long as your tax bracket remains the same, you are actually making 2.4% interest per year (4% interest - 40% tax). This slows our rate of compounding to the point where that 6% interest, even if you get to write off the amount against your personal taxes, still won’t bring you out of the 40% bracket, and is exceeding your rate of return. There is no way to pull off using the equity in your mortgage to make money while playing it safe. So instead of $271,376.52, you’ve made $182,102.73 and your cost of borrowing was $91,909. Ouch!
In this case, you can beat that by taking that $639.81 a month payment and put it into a RRSP GIC fund, and you would end up at $332,634 dollars at the end of 25 years, with an income write off of around $7000 a year. Unfortunately, at 4% interest, you aren’t going to be able to beat inflation at 3% per year. Screwed again!
Government Savings Bonds? Forget it! They offer an even lower rate of return, and worse yet, they are still Taxable at your tax bracket!
If you want to be less risky, and retire comfortably, not going to happen folks! Sorry! 
So… I’m kindof confused did you just discredit John’s post? Or is what he stated still possible?
Nope. We just looked at it using a different person with a different risk profile.
If someone can find the right investment and is willing to take some risk, John’s method WILL work. However, it is definitely a bit risky of a manoeveur. The stock market is fairly volatile, and an index fund reflects the volatility as well as the good times. I applied the thinking of someone who wants to only buy fairly SAFE investments to test this method of investment, to see if it would work for them. If you’re into safety, you won’t make a dime. You’ll lose money unfortunately.
The sweet spot is to have the rate of return, equal the rate of borrowing, after taxes. Then compound interest can really do its magic. So if our example person really got an effective, after tax 4%, he’d be OK, but he wouldn’t beat inflation on the investment which is currenlty 3% and rising.
Most people would forget about the tax rate and think that because the interest can be written off against the investment, you’re good to go. However you’re getting taxed upwards of 30 - 40% on your capital gain, and your interest write off against it is only 6% of the principal’s interest. Your investment has to have a higher effective, after tax rate to make the big gains, and if you’re making a rate less than borrowing, it just isn’t going to happen for you in the long run. It’s like those people that think AMWAY works when they write off all the product they buy towards their non existent income. You’re only fooling yourself.
Bottom line, in order for the method to work, the effective rate of return must be at least equal or greater than the rate of borrowing. For many who can only fathom the most pedestrian of investments, it won’t work for you.
Oh, and you need to be in Canada because in the US, you can’t write off the interest used to invest, but the funny thing is that you can write off improvements to your home, which you can’t do here.