Misunderstandings About Personal Finance

Meet John and Jane

Jane and John are a couple in their early thirties. They own a townhouse in a suburb outside of Toronto. Although the commute is a bit of a burden, their jobs as an architect and software developer, respectively, allow them to work from home between two to four days a week. They would like to have a child, but they wonder about the long-term financial impact: the reduced income for Jane, since she intends to take the majority of the parental leave, daycare for the first few years, saving in an RESP, etc. Even though they feel they are well-educated, they don’t have a sense of how to manage their household finances beyond what they are currently doing, which involves little more than paying their mortgage, utilities, and other household maintenance costs, leasing a new vehicle every few years, spending on other personal effects like clothing, the occasional vacation, and supplementing their mandatory participation in their respective employers’ pension plans with contributions to their TFSAs. Even then, they don’t know if they are doing these things in a responsible manner.

 

They Aren’t Alone

I think it is fair to say that many Canadians are like John and Jane. They tend to muddle along. They are responsible with their finances and do what they think most other Canadians do. Muddling along will be adequate for many Canadians, but many households are making mistakes of either omission (neglecting to do something) or commission (doing the wrong thing). For this blog post, I will look at some of the financial mistakes that are common among Canadians.

 

Top Personal Finance Mistakes

Neglecting to Budget

There are some people out there who make a budget and keep it up to date, I’m sure. Frankly, my wife and I are not among them. Instead, we keep track of our income and expenses, our “cash flow,” as it is known, and I pay particular attention when a month ends in the red, i.e., when we spend more than we bring in. This happens periodically due to fluctuations on both the income and expense sides of our household cash flow. However, as long as we end the year in a positive situation, which includes setting aside money for retirement, we feel we are doing okay.

 

The following solutions are ways to accomplish much the same result as budgeting by taking a few different approaches.

 

Solutions
Use Budgeting Apps

I will just note that a spreadsheet is a good option, as are spreadsheet-based solutions.

 

  • Spreadsheet: These days just about everybody has some form of personal computer. You can easily set up a spreadsheet to track your monthly income and expenses. Unless you have multiple sources of income, the income side can be quite simple. Tracking your expenses can be quite a handful, though. You can start with broad categories like taxes, family needs (food, clothing, etc.), housing expenses (rent or mortgage, utilities, property insurance, property taxes, etc.), insurance (life, disability, etc.), flexible family needs (vacation, restaurants, gifts, etc.), Other (major appliances, charity, etc.), and Savings (pension plan contributions, RRSP, TFSA, non-registered, etc.).
  • Ready-made spreadsheet-based solutions: Kerry Taylor runs a website called Squawkfox. If you subscribe to her newsletter, you get a FREE Budget Bundle that can help you get going.
  • Budgeting apps: Wally and Wilbur are two that come to mind and are free. These are meant to be used on your smartphone.
  • You Need a Budget – YNAB: After a free trial, this platform (for both laptop/desktop and smartphone) has a fee associated with it, but it tends to be more sophisticated than others you will find.

 

Automate Savings and Investments
  • Set up automatic transfers to your savings and/or investment accounts (e.g., RRSP, TFSA). If you use mutual funds (many are available at low cost) for your investments, you can also set up automated systematic investment plans.

 

Pay Yourself First
  • View your savings and investments as of equal importance to your mortgage, utilities, and insurance, to name three categories. Treat your savings as a non-negotiable “expense.”

 

Set Financial Goals
  • Define specific financial goals like an emergency fund equal to six months of your living expenses, $6,000 to spend annually on family vacations, or $30,000 for a new car every 10 years.
  • Open separate savings accounts for each category and set up automatic transfers.

 

Accumulating High-Interest Debt

In the wake of the pandemic, credit card debt fell dramatically since much of the Canadian economy was shut down. That has all changed, of course. Canadian consumer debt grew over $80 billion from the third quarter of 2022 to the third quarter of 2023, reaching a total of $2.4 trillion.

 

Credit cards are among the easiest of revolving credit facilities available to Canadians but if you leave a balance beyond the due date, you are more than likely paying an annual interest rate of 20% or more. About the only thing more expensive is a payday loan. If you pay the loan back in time, you may only have to pay the fee, but if you need to continue borrowing, then interest is added to the fee.

 

Payday loans typically charge a fee per $100 borrowed. However, when these short-term loans are annualized, they work out to effective interest rates in the hundreds of percent range, if not more. According to the 2023 edition of the annual Joe Debtor survey by Licensed Insolvency Trustee firm, Hoyes, Michalos and Associates, the average unsecured debt insolvent debtor owes over $6,000 in “rapid loans” (a broader term that includes payday loans). Nevertheless, credit card debt is the real killer when it comes to financial insolvency. The 2023 Joe Debtor survey showed that 91% of insolvent debtors filed insolvency with an outstanding credit card balance compared to about 50% who held rapid loans.

 

Solutions

The statistics from the Joe Debtor survey are a reminder that credit cards are a more dangerous instrument than payday loans simply because of their ubiquity among Canadians. What can Canadians do to avoid this situation?

 

Pay Credit Card Balances in Full

This seems obvious but it is necessary. If you get paid every two weeks, look up your credit card balance and pay it in full on your payday. Two weeks later, do it again. You may wish to argue that you do not need to pay until the due date, but if you don’t have any money left from your paycheques, you won’t be able to pay it off. You may want to reduce the spending limit on your credit card, too. Credit cards are only a convenience if you can pay them off. Otherwise, they are a giant financial burden.

 

Consider Alternative Payment Methods

If credit card debt is a recurring problem, then consider getting rid of credit cards altogether. Use a debit card that will only let you spend the cash you have available. Better yet, because the use of debit cards still makes spending less “salient” (conspicuous or meaningful), consider using cash to pay for your in-person spending.

 

Build an Emergency Fund

Credit cards are useful because you can pay for something you need even if you don’t have the cash on hand. Their utility is precisely their danger, however, so to make sure you always have the cash available, build up an emergency fund. If you have minimal financial responsibilities and no outstanding debts, three months of living expenses is probably enough. Push it to six months if you have people dependent on you and have debts such as a mortgage or vehicle loan. If you have irregular income, you may want to accumulate even more savings. A high-interest savings account is a good place to keep this fund.

 

Overlooking Emergency Savings

This has already been mentioned as a solution for other personal finance problems, but it deserves its own place. As observed above, failing to establish such a fund can result in paying for unexpected expenses with a credit card or other forms of borrowing. If the amount borrowed cannot be paid off on time, a vicious cycle of increasing indebtedness can be established, undermining what would otherwise have been a path toward a financially contented lifestyle.

 

Solutions
Open a Dedicated Savings Account

As mentioned before, using one of these high-interest savings accounts can serve you well. You can also open an investment savings account in a non-registered or TFSA brokerage account to save this money. Although traded like a mutual fund, these are considered deposit products and have the same CDIC insurance coverage as a regular bank account.

 

Set a Realistic Savings Goal

Calculate your monthly living expenses. Target savings of at least three to six months or more if you have an irregular income.

 

Pay Yourself First

Automate a transfer to the account holding your emergency fund and treat it as a non-negotiable expense.

 

Review and Adjust as Necessary
  • Monitor your progress. If an unexpected expense emerges, you may have to take a step back before continuing but continue working toward your goal.
  • If your expenses change, adjust your goal accordingly.
  • When you have reached your goal, direct your savings elsewhere but continue to monitor and update your goal when your circumstances change.

 

Use Windfalls as an Opportunity
  • Direct bonuses, tax refunds, and gifts to your emergency fund.
  • It is okay to use a portion of a windfall as a “reward” but avoid permanent lifestyle inflation.

 

Avoid Relying on Credit Cards or Loans
  • Use your emergency fund when the time comes. That’s what it is there for. Some people get hung up over whether an unexpected expense truly is an “emergency” and use credit instead. In my view, a balance on a credit card that you cannot pay off at the end of the month is an emergency. Pay it off and rebuild your fund.

 

Ignoring Retirement Planning

The establishment of Old Age Security (OAS), and the Canada (Quebec) Pension Plan (CPP/QPP) are intended to help alleviate poverty among seniors as is the Guaranteed Income Supplement (GIS) for those seniors at the lower end of the income spectrum. Employer-based registered pension plans (RPPs) and Registered Retirement Savings Plans (RRSPs are a supplement to this. Fifteen years ago, the government also established the Tax-Free Savings Account (TFSA), which is a real boon to those earning a lower income since they receive little benefit from the tax deductibility of RRSP contributions while finding that the withdrawals in retirement eat away at their eligibility for GIS. With all these opportunities in place, I still hear that seniors in Canada are finding themselves living in poverty. This may be due to poor planning, bad luck, or other reasons, but they indicate that retirement planning cannot simply be ignored.

 

Solutions
Start Early and Automate Your Savings
  • Set up automatic contributions to your retirement accounts.
  • For those early in their careers and/or earning a lower income, it is often wiser to prioritize the TFSA over the RRSP, assuming you cannot afford to contribute to both.

 

Maximize Employer Matching Contributions

Contribute enough to your employer-sponsored retirement plan to receive the maximum match from your employer. Failure to do so is like turning down free income.

 

Overspending on Housing

This is easier said than done. Housing costs are high and so are mortgage interest rates, but there are practical strategies to manage housing costs.

 

Solutions
Set a Realistic Housing Budget

This depends on what is meant by “realistic.” One version of realistic is to pay what I must to have a realistic chance of buying the home that I want. The problem is that this is not financially realistic. At one point not that long ago, a handy rule of thumb was to limit your housing costs to 30% of your gross household income. I think it is still a worthy budgeting target.

 

Prioritize Needs Over Wants

The HGTV effect means that many would-be home buyers want a luxurious home when they can only afford a basic one.

 

Explore Affordable Housing Options

Renting is always an option. Although you are somewhat at the mercy of your property owner, the instability of renting may be minor when compared to the instability caused by financial insolvency.

 

Consider Location
  • Balance commuting and the location of your home. If you work near the city centre but can work remotely from home for part of the week, you may find it easier to manage an occasional longer commute. On the other hand, if you have convenient access to public transit, you may be able to buy closer to your work without needing to own a vehicle.
  • Relocate to another city or province. Prairie cities like Edmonton and Winnipeg are a lot more affordable than Vancouver or Toronto. My wife and I have lived in the same house in London, Ontario for the last 20+ years, but in our married lives we have lived in two different cities in Japan, and in Canada, we have lived in Chilliwack, BC and Winnipeg. Our four children live in three different cities in three different countries.

 

Neglecting Financial Literacy

I think that many people fear financial matters because it sounds too much like mathematics and they have come to believe that they are “bad at math.” It doesn’t take that much, though, to be sufficiently competent at numbers to improve your financial life significantly.

 

Solutions
Misunderstanding Compound Interest

Most people have a reasonable grasp of simple interest, i.e., 5% interest on a $100 principal is $5. But once you start multiplying interest on top of interest, things can get a bit confusing, and dangerous, because compound interest on a debt can snowball dramatically, especially when the interest rate is high. Conversely, compound interest on an investment can make that investment grow dramatically, too. This article from Investopedia may help to explain compound interest. Also, here is a compound interest calculator from the website Get Smarter About Money.

 

Failing to Diversify Investments

Too many Canadians view investing as little more than speculative gambling. They will invest in a single stock that will gyrate wildly in price and quite possibly lose all its value. And yet we see that year after year, the stock market indices grow by seven, nine, or eleven percent or more. Granted they will fall every few years, but the long-term trend is toward growth. However, since very few people can successfully and consistently pick a single winning stock or even a portfolio of stocks, the better choice is to diversify widely, typically by using broad-based index funds. And, if you feel a need for more stability in even a diversified stock portfolio, add some bond index funds to your portfolio. You can read more about diversification here.

 

Misjudging Risk Tolerance

Investment representatives who sell mutual funds and securities require their clients to go through a risk tolerance assessment. The intention is to recommend a suitable collection of investments that will meet their investment goals without adding more risk of financial loss than they can tolerate. If the client sells out at the first sign of a downturn, then they may be in an overly risky portfolio given their personality type, or they may be inadequately educated as to the nature of investment risk. This simple investor questionnaire, courtesy of Vanguard in the US (their Canadian version is being revised) may illustrate what it means to assess your tolerance for risk in investing and how that may relate to your investment portfolio.

 

Not Understanding Tax Implications

Canadians have a lot of government-paid social safety nets to rely on. This is at least part of the reason we pay a lot in taxes. Having said that, those at the lower end of the income scale may pay little in taxes at all if they understand how the tax system works. As mentioned before, lower-income households will want to put their savings in TFSAs because the tax deduction from an RRSP contribution now is less financially helpful when compared to the tax-free withdrawals from a TFSA in retirement.

 

On the other hand, a family with young children can increase the size of the Canada Child Benefit (CCB) by contributions to the parents’ RRSPs, resulting in a deduction, reduced taxable income, and therefore a larger benefit.

 

Canadians in general and Canadian seniors in particular seem to love Canadian dividend-paying stocks. They like the regular income, just like when they were working. They also like to put them into a non-registered account where the dividend tax credit can provide a significant offset of taxes owed. However, depending on their income, they may find the dividend gross-up causing a “clawback” of part of their OAS.

 

If you are inclined to donate to a registered charity, you can donate appreciated stock and get the fair market value as the value of the donation without having to pay capital gains on the donated shares.

 

One more point. These are all benefits built into the tax system, but they require households to file their taxes. This is one of the biggest elements of financial illiteracy. By not filing you are potentially missing out on thousands of dollars.

 

 

The Potential Outcome

By addressing these common financial misunderstandings and investigating the suggested solutions, Canadians like John and Jane can significantly improve their financial health. They can avoid the pitfalls of high-interest debt, ensure they have savings for emergencies, and secure their retirement. Moreover, by prioritizing financial literacy, they can make informed decisions that will benefit them in the long run. The consequences of following this advice are profound: greater financial security, less stress related to money matters, and the freedom to make choices that enhance their quality of life. Ultimately, these steps can transform “muddling along” into a strategic approach to personal finance, paving the way for a stable and secure financial future.

 

 

This is the 241st blog post for Russ Writes, first published on 2024-04-01

 

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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions