The Time Value of Money

I sometimes think that one of the most important lessons a young person can learn is that $1 today is worth more than $1 tomorrow. It is amazing to observe that many young adults don’t learn this, one of the most critical principles of finance, until they reach university. My goal with this post is to make it easy to understand why money today, this month, or this year is worth more than money in the future.

Why is money today worth more than money tomorrow?

Simply put, because money can earn interest (and have less purchasing power due to inflation).  If I receive $100 today and can earn 5% interest annually, my money is worth $105 is one year. $105 a year from now is worth exactly the same as $100 right now for me as an investor. That being said $100 today is worth more than $104.99 in a year from now.

Why is this important? 

Making personal financial decisions is something that we have to do every day. If we know that it is better to pay in the future (because money is worth less at that time) then we would surely take advantage of times where people let us pay later rather than now. My favorite example of this is a car loan. Many car dealerships will offer you 0% or a very low interest rate to incentivize you to buy a vehicle from them. If you had $10,000 to pay for the car outright, is it still better to finance it? Yes! Simple math can show you that if you have no borrowing cost, but can earn interest that your $10,000 car could cost you much less!

You could pay $10,000 today for that vehicle, or you could pay $275 a month (for example) for 3 years and pay off the car. If you take time to pay off the car, your cash that would have been used to pay the whole balance can be in an investment earning you 5%. After one year, you will have paid $3,300, and used the remaining $6,700 to earn you $340 in interest, making the care effectively cheaper.

This principle is one of the fundamentals of financial theory and will affect the way that we calculate the value of things today versus in the future. There is a formula which can be used to describe the relationship between dollars today and dollars tomorrow. It is shown below.

PV = Present Value (value today)

FV = Future Value (value after one period)

r = The discount rate for the period (interest rate with or without inflation included)

 

Why Use A Mortgage Broker

I passed my mortgage agent’s license in December of last year and have been talking with my friends and family about what I do and it surprised me to learn that not a lot of people actually know what a mortgage broker does or why they should use one. If there is one thing you can take from this post it is this. If you are seeking out real-estate backed credit (e.g. mortgage for any reason) you MUST talk to a mortgage broker. But why?

  • We ask the right questions

Arranging mortgages all day can be a tough job, but it hardens us mortgage agents into financial fighters, credit combatants, money mercenaries, you get the point. We have extensive knowledge of the many different mortgage solutions that exist for folks in all types of situations, and can provide well informed guidance toward the products which best suit your unique needs.

  • We shop around

When you are looking to buy something that costs more than $1,000, do you go to one store, hear their pitch and then buy whatever product they offer you? Wouldn’t it be smart to consider looking at other stores? A mortgage broker is like a personal shopping assistant who can bring you the best from over 45 mortgage lenders. This is the best way to get to know what products are offered across the industry. You could call all the lenders in Canada or the GTA, it wouldn’t be THAT hard, but you could also let a broker point you in the right direction.

  • We negotiate on your behalf

Not surprisingly, many clients I have dealt with have issues negotiating with the bank or asking for a better rate. As brokers we demand a better rate. The banks and lenders know us, and know we are fully informed negotiators who know what price it will take to get our clients’ business. This negotiating power and experience combined with our volume as partners of the lenders make us the most suitable champion of your interests.

  • We provide service for life

Many lenders will let your mortgage roll over every term and automatically renew you until you re-actively check into your options. Good brokers have a duty to follow up with you every few months to ensure your product is still working for you, and to investigate whether you might benefits from a change in your mortgage. We follow you every step of the way until you are mortgage-free.

Essentially, a mortgage broker is an expert shopper who is paid by the lender to provide you with a mortgage. You have absolutely nothing to lose, and everything to gain by dealing with a mortgage broker. Now that we have cleared that up, happy home buying!

Full disclosure: I am a net-present-value ninja and mortgage agent at Northwood Mortgage. Call me anytime at 416-371-2077.

The Relationship of Risk and Return Part 2

Last week I posed a question to you at the end of my post asking:

Would you exercise the option of betting $1000 on a game in which you had a 51% chance of receiving $2000 back (+$1000) and a 49% chance of getting $0 back (-$1000). I would allow you to repeat the bet as many times as you could pay for it. Would you make the bet? Why or why not? Would your answer change if the bet was $100, $1?

One respondent’s first answer to this question was that he would not take the bet. He told me that even though there was a 51% chance of winning $1,000, there was also a significant chance, 49%, of losing your $1,000. When I explained to him that you could repeat the bet as many times as you like, he was still weary of losing $1,000 every time, and going broke. Truth be told this is a possibility but the more times you can repeat the bet, the more likely you are to reach the expected average of 51% success. This example brings to light a very important fact – risk can be mathematically calculated, and if you can find something that returns more money than the risk level would usually return, you will be a winner more often than not, and what else can we hope for?

When there is a 49% chance of losing your money, the odds of losing 10 times in a row are less than 0.09% which is just less than 1 in 1000. The expected value of your bet given these chances is expressed as $2,000*51% + $0*49% = $1,020. To make this bet costs you $1,000, and your expected value according to some solid math is $1,020. Every time you make this bet, you are theoretically buying something worth $1,020, for only $1,000.

In essence, after you made this bet 100 times, you should have made $2000. Now, not all of us have a cash reserve large enough to support making this bet with enough repetition to reap serious rewards, which is why I suggested using $100 or $10 instead. If you have $20,000 and can make a $100 bet 200 times before going broke, the odds are heavily in your favour to earn on average $2 every time you make a bet.

Buying something for less than its market value

Robert Kiyosaki, author of Rich Dad Poor Dad showed us that your profit is actually gained when you buy something that is undervalued.

Every time you have the opportunity to buy something that is worth $1,020, for a cost of $1,000, after all things are considered you will be ahead $20.

The Relationship Between Risk and Return

At different points in your life you have a different appetite for risk. Personally, as a late twenty-something I feel like I am a little less risky than my early 20’s (down about $23K in stock market trading) but I still have a hunger to grow aggressively because I am simply not comfortable living the middle class lifestyle. I want big things in my life, not just to have big things, but to do big things.

It’s easier to do big things with money, but how can you get it. With some discipline and a comfort with risk it’s not impossible to build a fortune earlier in your life. I know a successful entrepreneur by the name of Dan Demsky who told me that one of his best motivators is necessity. Dan faced a looming tax bill in his early years as an entrepreneur and frankly told his team “we need to sell X dollars to survive” and they did. I believe that to be successful, you need to create a sense of necessity through goals, and you need to take calculated risks.

This perspective helps me lead into a discussion of risk and expected return. There is a simple principle in finance which states that there is a relationship between risk and return which is; the more return you expect to get, the higher the amount of risk you need to bear. Let’s dive a little deeper into a technical explanation.

The Risk Free Rate

There is a return in the market which you can expect to earn without taking any risk. This is called the risk free rate. An investment that is risk free is one that is considered to have no risk of default or loss and a prime example of this kind of investment is a Government bond (in Canada). Speaking truthfully, the government can default on a bond but it is highly improbable, so in the finance industry we often use this as a risk free rate. If you take no risk you should be able to earn this return on your money which right now is about 1% per year in Canada.

Your Reward for Bearing Risk

After you’ve decided that you’d like to earn a little more than the inflation rate, you may ask yourself “how am I rewarded for bearing risk?” There is also a standard unit of risk called ‘beta’ that earns you a “market risk premium” which is a return. In simple terms when beta is 1 you are taking the average amount of risk for the entire stock market.

 

Your expected return can be expressed as:

The risk free rate + the level of risk of beta (1 is average) * the market risk premium  = Expected return

 ⇓                                                     ⇓                                                                  ⇓

Return without risk    +     How risky your investment is      *       The reward you get for average risk

 

What does this mean to me?

This relationship can show you that you are in fact rewarded for bearing risk. When you plan for your future you need to consider if you can tolerate the possibility of loss for the mathematically greater likelihood of making more money in the long run. If I gave you the option of betting $1000 on a game in which you had a 51% chance of receiving $2000 back (+$1000) and a 49% chance of getting $0 back (-$1000). I would allow you to repeat the bet as many times as you could pay for it. Would you make the bet? Why or why not? Would your answer change if the bet was $100? Stay tuned for my next post to explain which decision I would make and why.

The Not So Savings Account

When I was 16 I had $5,000 in my bank account which I’d earned working full time in the summers at a property management company reporting repairs that tenants required. At the time interest rates were about 2% on a savings account. Frankly speaking, a savings account is just a storage space for your money, when you need it fairly quickly. Had I understood a little bit more about finance, I may have sat down and thought of where my money could work harder for me.

When you should lock your savings into an investment

Like most 16 year old, I didn’t have many expenses. I was living at home and spending my money primarily on entertainment, and eating out. Now that I think of it not much has changed, but that’s beside side the point. I had $5,000 of liquid funds that I likely would not need in the near term, having money coming in from a job each summer. It was at that time that I should have evaluated how much of my saving account I might need over a reasonable time horizon. I could have easily put away $3,000 toward an investment for a few years.

When will you buy your next big ticket item? A car, a down payment on a home, and a capital investment for your business are just some examples of times when you might need cash quickly. The first step in your personal investing strategy is deciding when you will need your money and how much of it you can set aside for different purposes. You may quickly find that you have too much money in one source or another, and can earn more investment income by allocating your wealth more strategically.

Types of investments and their time horizons

Type of Investment Annual Expected Return % (Mar 2014) Time Horizon What my $3000 is worth after 3 years
Bank Savings Account 0.1% to 0.5% Liquid assets $3,022.55
Treasury Bills Around 1% 3-6-12 months $3,090.90
Short Term GIC 0.5% to 0.8% 30 days to 1 year $3,072.58
Long Term GIC 0.9% to 2% 1 to 7 years $3,100.09
Mutual Fund 10 Year Average 5.85% (BMO NA Equity) Liquid assets $3,557.90
Lend for Mortgage Transaction 5% – 10% 1 – 5 years typically $3,573.05
Stock Market Index Fund 14.6% (Last 12 months) Liquid assets $4,515.18

There are many types of investments which can earn you all different types of returns and force you to bear different levels of risk. Be careful to take your time in deciding what is best for you, but as you can see, you can do a lot better than a savings account at the bank!

Debt is Good

I often hear clients, friends, and the general public tell me about how they are in debt and miserable about it. This post was written for the purpose of dispelling the myth that it is bad to have debt. In fact, I hope that by the end of this article you think about how you can use debt to your advantage. The truth is:  you can use other people’s money to help build your financial future.

Types and costs of debt

There are many types of debt in today’s world and they all have different borrowing costs associated with them. Based on the effective annual interest rates you need to pay a creditor, you can classify debt as either cheap or expensive. Cheap debt is an amount borrowed at a very low interest rate, and expensive debt is the opposite, money borrowed at a high interest rate. Have a look at some of the types of debt and their costs below.

Type of Debt Typical Cost of Debt in 2014
Credit Card debt Between 15% and 20% per year effectively
Unsecured Line of Credit debt Between 5% and 10%
Secured Line of Credit Between 3% and 5%
Government and Student Loans Between 4% and 6% (after grace period)
Mortgage debt Between 2.5% and 10%

 

The table should illustrate the fact that borrowing money from some sources is much more expensive than others, and that you can strategically use your borrowing credit to try to pay the least amount of interest possible. An example of this is borrowing money from a line of credit, to pay off your credit card bills. Instead of paying close to 20% interest, you could pay between 5% and 10%, which will equal huge savings over a few years.

Investing with debt

Once you have realized that debt can be borrowed at low interest rates if you have good credit, you may want to borrow money and invest it. Some readers might say that that is much too risky for them but the truth is; most people around the world borrow money and invest it, IN THEIR HOME! A mortgage is a prime example of an investment using borrowed money. Generally speaking, the value of a property should increase in value over time and a home is a capital expenditure that most of us need, making it a good investment. What if you borrowed money and invested it in the stock market? In the past year, the Dow Jones Industrial Average has increased in value by 14.6%**. If you borrowed $50,000 from the bank using an unsecured line of credit with an interest rate of 6% you would have made a nice profit. To be exact:

You would have had to pay $50,000 x 6% = $3,000 in interest, and your investment gain be worth $50,000 x 14.6%  = $7300. After paying off your interest to the bank, you would be left with $7,300 – $3,000 =  $4,300 in profit.

Now, I am not suggesting you max out your lines of credit and roll the dice in the stock market, but the lesson is that if you can borrow at a low cost and earn a higher rate of return in an investment, you can make your debt work for you.

 

Stay tuned for more finance!

**On March 7th 2013, the Dow Jones Industrial Average closed at a price of $14,329. On March 6th 2014, the average closed at $16,421, an increase of 14.6%.

 

 

How to Improve Your Credit Score in Canada

There are a few simple reasons why you might have a bad credit score. You haven’t paid in full or on time, or you have borrowed lots of money without having a lot of assets or income to use as security.

Once your credit is in the danger zone (less than 550 Beacon), there are a few things you can do to improve it effectively. In the mortgage industry we say “Two trades for two years” helps build you back up. Below are some examples of trade lines of credit

Types of Credit Which are Good Building Blocks for Credit

Getting a Secured Credit Card

The best way to improve your credit score is to have credit and deal with it properly, i.e. PAY YOUR LOANS! A secured credit card is a credit instrument whereby you put down a deposit and borrow against it using your credit card. This is a sure way to show future creditors that you have the intent and capacity to pay your debt.

Taking out an RRSP Loan

An RRSP loan is borrowed from the bank and used to make a deposit into your RRSP account which is later invested for tax-sheltered profits. The loan is one of the easier types of credit to qualify for, and can also help you establish a positive credit history.

Using a Car or Furniture Loan

A car or furniture loan will be a monthly payable which as mentioned before helps your credit score. Car and furniture sellers are also motivated to grant you financing to buy their products, so it is a relatively easy way to get diverse credit.

You Also Need to:

Pay all Your Loans Credit Instruments in a Timely Manner

If you can qualify for 2 of these credit facilities and pay your bills on time, you should be in a much better credit situation in as little as 1-2 years. This will ensure that you don’t have to pay those high rates forever!

Avoid Having too Many Credit Checks

Be careful with which types of credit you apply for and often consider going through a broker who can share your credit information without having other parties inquire about you separately. The less people who check into your credit, the better.

Avoid Borrowing more than 75% of your credit limit for each credit facility

Utilization of credit is a heavily weighted factor used to determine your score. If you borrow a high % of your limit, you are penalized and your score may go down.

 

It’s tough but doable!

If you follow the steps I mentioned above you should be well on your way toward being able to borrow the money you need once more.