Why I don't like earning interest

joyfulguyJanuary 26, 2005

I said elsewhere that I'd told the reason elsewhere so wouldn't repeat, but to write me, which someone did and someone else asked on that thread and I forget where the original comment was, on a thread related partially to a different topic, so here goes.

Twenty years ago as I began work as a personal financial advisor, a number of people recounted to me with great satisfaction how they'd got 19% on their Canada Savings Bonds in 1981 (rates vary from year to year). Reported with a big smile, and even a bit of a chortle, one might say. An expression on their face sort of like, as Dad used to say, the face of the cat that swallowed the cream (but without any white residue, of course).

I said that, while the 19% shows up nicely in their savings account book when they deposit the cheque, so makes a substantial impact on their memory, that's not the end of the story.

The Income Tax people want to talk to us every year about all of our earnings in the previous year. If the owners of the Canada Savings Bonds were in a 25% income tax bracket, that would reduce the 19% to under 15% after-tax return.

The Canadian Income Tax rate is highest on our income as employees, or interest that we earn on our investments. And at an equal rate, with a small tax credit, on our income as retirees from our private pension plan. The types of income that most Canadians have.

We don't have tax-free municipal bonds in Canada. Every type of interest earning that I know of is taxable here. So, as the disclaimer always says on ads about mutual funds, " ... your experience may differ".

If I own Canadian stocks, which pay me dividends, those dividend rates are often somewhat lower than the rates of interest that an equal amount invested might produce - so I have a smaller amount of current income to report to the income tax people, this year.

If I, a Canadian resident, own U.S. or other foreign stocks which pay me dividends, I must pay income tax at the same rate as though I earned interest, here or elsewhere. So if that dividend rate is lower than the rate of interest that I might earn, I pay less tax now, though at an equal rate to that which I'd pay on interest income.

Also, the income tax rate on some other types of income is much lower - the types more commonly owned by more wealthy people.

Those dividends paid by Canadian stocks are taxed at a much lower rate.

If I have been skillful enough to have purchased some quality stocks, as the value of those stocks increased, the amount of dividends that they pay annually usually increases, as well. If a stock priced at $10.00 pays 2%, that's 20 cents, but if the value increases to $20., 2% of that is 40 cents.

Some stocks, especially in fairly new companies which have a good product or service and want to expand, pay no dividends at all. I own several like that. Some have not done well, so the price of their stock has not advanced as much as though I'd put that amount out to earn interest. I have lost on such stocks, of course.

But a number of them have grown, some quite substantially, so that the value of the shares is several times the amount that I paid.

That's fine with me - and I haven't had to pay the income tax people a cent related to my investment in that stock, so far.

As I've said to a number of people over the years, I don't have to answer to the Canadian Revenue Agency until I either sell those stocks ... or die ... and I don't plan to do either, this week or next.

Suppose I hold the stock for twenty years, its value increased, then decreased, then increased some more, then slipped some more, went up again, etc. and I sell it for three times what I paid for it.

I don't have to talk to the income tax people about the increased value throughout the time that I own it. When I sell it, I deduct the amount that I paid to find the capital gain.

Only then, at the end of the twenty years of fluctuating prices, must I report the growth in value of that asset over those twenty years to the income tax people.

Instead of facing all of my tax liability as I go, I like to defer it when I can.

Not only that - after I've calculated the capital gain on that stock at the end of that twenty year holding period, I am required to pay tax on half of it, but can keep the other half free of tax.

I prefer tax-free income when I can get it.

Furthermore - I have a choice as to when I sell a stock, so need to report the income - which I may choose to do in a year when my income from other sources is lower (and when, as a matter of fact, I might like to have the money).

When I lend my money to a financial institution (or an individual, for that matter), they guarantee that they'll return every dollar that they borrowed at the end of the agreed period (but the guarantee is a little less solid on loans to individuals).

There's another guarantee that they never mention - they won't pay one dollar more than they borrowed, either. So, apart from the rent on the money, that's the only return which you'll ever receive on that chunk of money for that period of time.

So, the only income that that asset will ever develop related to that year is ... right then. So, all of your return on that asset for that period will always be fully tax-liable at the time that you earned it.

You would agree, I'm sure, that $10,000. won't buy as much now as it would 10 years ago.

So, if the asset that you rented out to earn interest can't grow, you'd better take part of the annual income that it produces to increase the amount of the asset, so that you can now afford the the car that cost $10,000. ten years ago and now costs $16,000.

If the $10,000. that you had 10 years ago hasn't grown by the rate of inflation, more or less, you may have the same number of dollars - but you're losing ground.

Did they know what the rate of inflation was in 1981, I asked them and most had only a vague idea.

It was running at 12% - so when they deducted that amount from the better than 14% after-tax return on their vaunted Canada Savings Bonds, they had a real rate of return of somewhat over 2%. If their top marginal rate of incometax was 25% - if it was higher, their net amount left in hand after allowing for tax and inflation would have been even less.

How would you like to have a real rate of return for a year of just over $2,000.00 on an investment of $100,000.00?

Sometimes in recent years it has ben negative.

If you choose not to add part of your interest earnings to the basic asset annually, or at least from time to time, at the beginning your $100,000. stays $100,000. through the first period ... then the second ... then the third, etc.

So your interest earnings will be based on the same amount of asset, at the going rate each time when you invest the asset.

That seems to be enough for now - should get a good discussion going.

Hope you'll come back later, for I have some more to add that may be of interest.

Good wishes to all for conducting an examination of the way that you live, your habits, etc. from time to time.

Sort of stretches the mind, so to speak.

joyful guy

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Thanks, I was one of the ones that asked. I'll be waiting to hear the next you have to offer. I felt that anything that is tax deferred makes sense so am glad to hear you say the same thing.

    Bookmark   January 26, 2005 at 5:36PM
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Go to the London Public Library, check magazines, read an article by David Stanley in the current issue - I think it's related to Dividend Renvestment Plans (DRIPs).

If you go to Westmont, Byron, Central and some others you can read it there.

If you go to one of the branches that have it, you can borrow back issues, but you can't from Central.

Davis Stanley has been commenting on an investment system that is Canadian that's similar to the "Dogs of the Dow" plan in the U.S. I think that there was an update of it in the July/Aug issue.

Good wishes for effective management of your money - including tax avoidance.

ole joyful

    Bookmark   January 27, 2005 at 1:00PM
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Hi all,

I'm sorry about the repitition in the original message. I have no idea what caused it - it wasn't like that in the composition.

I was almost out of my allotted time at tthe computer in the library when I composed it, so did not read it when it went on the board. Once it's there, I couldn't have amended it, anyhow.

I await your comments.

The magazine, "Canadian MoneySaver" carries no ads and has few pictures - mostly text.

As they say, they are totally subscriber-driven, so asked the subscribers what they wanted as additional service.

Seminars with the writers of the articles - so they've put them on in various areas of Canada for several years, at $20.00 ($30.00 for two) to hear eight 45-minute messages.

Meetings of subscribers in various localities - so each issue carries a list of about 40 places in Canada where subscribers may choose to gather, with phone number of a contact person.

Our monthly 2-hour meeting in London has carried on for nearly ten years, with usual attendance of about 15 - 20. Last night we had a record, I think, at 25 - including my daughter, who recently developed increased reason to be interested in how to handle money.

A good many interesting ideas get an airing in our meetings, with questioning back and forth.

Total cost to attend - is the price of the gas to get there (and several, especially out-of-towners), travel together.

Some planned last night to travel together to the Financial Foreum in Toronto, about 120 miles away, going on from today till Sunday, with many exhibitors and a number of interesting seminars.

Some of us gather in a coffee shop for another hour after the meeting.

Good wishes for effective use of your money - learn to make it serve you more than the other guy.

As I've said many times (ad nauseam, perhaps?), "Learning how money works is an interesting hobby - that pays well".

ole joyful

P.S. Drat! More of the same problem - and I can't fix it. Sorry.

oj (not on the juice, today, despite appearances)

    Bookmark   January 27, 2005 at 1:39PM
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I'll try to check that out when I get a chance. I'm not far from the White Oaks or the Wesmount library.

    Bookmark   January 27, 2005 at 3:12PM
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I agree with your point that earning interest alone is sometimes not a sufficient hedge against inflation. But here in the U.S., we do have some tax-deferred options such as U.S. Savings Bonds, so they grow tax-free. But even given that, a person can indeed get a better return with some research and luck.

The problem, though, with a lot of investment options is that many people really do not have the time to properly research them, and even if they do some research, it's hard to separate legitimate advice from pitches designed to sell things. My sister and her husband bought into a variety of high-load funds on the advice of a "reputable financial advisor" several years ago. Not only did they pay big money to get in, but all the funds pretty much went into the tank.

This is why if anyone ever asks me for any advice on the subject, I always say to look into fairly conservative investments where you're not going to lose your money. The thing most people need to do is start some type of savings plan. If they're scratching and scrimping to come up with money to save, it's pretty disheartening to find out that their efforts have come to nothing because the stock or fund keeps dropping faster than they can put money into it.

I know that many people find that approach simplistic, and maybe it is. The only thing is, without a single exception, the people I know who bragged about being rich "on paper" in the 1990s and laughed at me for keeping my IRA in safe investments now wish they'd done the same. I'm certainly no smarter than they are, but it's just a different approach. Maybe their funds will recover and they'll wind up ahead again, but maybe not.

I tend to believe that it's hard for the average person like me to know how the financial markets really operate. By the time various trends are reported in the mass media, it's probably far too late to take advantage of them. That being the case, sometimes it's better not to compete in a contest where you're out-gunned.

    Bookmark   January 27, 2005 at 11:59PM
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If you invest $1.00 at 5% and let it run for 50 years, it would have grown to $11.00+, without allowing for the erosion of your income, whether annually or after a period of years, several times, by income tax, or the ongoing erosion in value of your asset by inflation.

If, however, you could invest it at 10%, after that same 50 year period it would have grown to $117.00+.

Your investment could lose 3/4 of its value and still come out ahead of having invested it at 5%.

Actually, more than that - for it's the value after taxes and inflation that really counts.

Do you expect that companies like Exxon, Gillette, Coca Cola, and such, or other major petroleum, pipeline companies, etc. may go out of business? Or even suffer serious losses.

A person who invests a major portion of his (probably less likely "her", cause women generally are more risk-averse and less likely to plunge; [some would say, "smarter"]) total invested asset into highly speculative issues seems to me to have cheese for brains.

The stock markets as a whole have average growth of 7 - 8% or so, over the long term. Few mutual fund managers' holdings have grown faster.

And they charge fees for their expertise - somewhere between 1 - 2% in the U.S. for equity (i.e. stock market based) funds, most of them over 2% annually in Canada.

If they match the long-term average growth of the market ... they're reaping about a fifth to a quarter of the growth, a larger proportion in Canada.

Unfortunately, if there is no growth - they still get their percentage.

Many persons calling themselves financial planners/advisors are actually mutual fund sales people: that's all the equity-related financial issues that they're licensed to sell. They don't want to talk to you about individual stocks, for they can't sell them and it's illegal for them to recommend them unless they've taken the courses that stockbrokers take (which few have - their courses are much less complex).

There are a few who sell no financial products, but many of them stop doing that because often their income levels are much lower, despite many people who want to invest saying that they'd really love independent advice.

One should investigate what kind of training a prospective personal financial advisor has taken and whether s/he has advanced courses above the minimum requirements. Also what kind and length of experience the prospective advisor has. Also what lifestle experience the prospect has: some have seen a great deal more of life than others - and have learned much more per year than many who have lived as many years.

Finally - you need a person whose personality and ideas are compatible with yours. You will trust that person with a very important part of your life.

Some years ago, when I had a display at a county fall fair, someone asked me what right I had to call myself a financial planner.

I said that we could get rid of unemployment tomorrow - we need only have every unemployed person put out a shingle on his front lawn calling himself a financial planner, as it was unregulated - any darn fool could do it.

Stock brokers were regulated, as were mutual fund salespeople, but in our area at that time financial planners were not, as there were few of them operating outside of stockbrokerage and mutual fund sales agencies. That's not the case now - but it would be a good idea to ask several of them what kind of regulations there are governing them.

I took the course that stockbrokers take, over 20 years ago and worked for a mutual fund sales brokerage (i.e. they could offer mutual funds managed by a large number of managers, rather than only funds managed by their own company). I didn't produce enough sales to suit them, so was there for only one year.

I'm more tuned into the idea of helping people set their financial goals, look at some concepts that they might not have thought of, and work toward achieving them.

I am totally devoted to helping my clients decide what they want to achieve and start out on a plan of how to achieve that/those goals. They don't have to be concerned that my advice or recommendations may be slanted toward various financial products that I just happen to sell, for I don't sell any.

One local person that I met a few years ago said that he'd done well in business and managing his investments, so some friends asked him to manage some money for them.

He asked for a minimum investment of $10,000., asked the client to sign a power of attorney for that account only, and when he made decisions about investments, a copy of the confirmation went to the client and one to him.

He charged 10% of the growth (exclusive of dividends, if I remember correctly). Rather a good idea, for if he doesn't produce, he doesn't get paid. There is a fairly major proviso, though - that he might choose some fairly risky investments where there could well be a possibility of major gain. He being a person of integrity, I think that he was quite strongly guided by the level of risk that his clients were willing to tolerate.

When I asked what happened if there were no gain - he said that there hadn't been a year yet that he hadn't been able to send a request for payment to every client. I'm not sure how many years the concept had been in operation.

This has been rather off topic - sorry about that.

As for many people lacking time to manage their investments ...

... many people spend more time on consideration of where they'll go for a two week vacation than they do on an investment system that may well be in place for forty years (or more).

Good wishes for making your money work well for you - rather than better for someone else.

joyful guy

    Bookmark   January 28, 2005 at 4:02PM
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I really enjoy your posts.

    Bookmark   January 28, 2005 at 5:44PM
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Thank you.

Years ago when I was a practising clergyperson, some asked me how I could subscribe to the "Financial Post" and be interested in financial issues.

I told them that bread cost me the same price that it cost them.

I was taught that my body is the temple of God, so I should take care of it. And I feel that I should do what I can to enhance the power of my brain, to acquire some possessions and use them responsibly, not just for myself but share them with others, as well.

And that I should do what I can to take care of this precious world, including not only my local environment but that in other parts of the world, as well.

We have had it brought home to us in recent years that it's not only the environmental conditions in other parts of the world that affect us - but the values, opinions and life choices of many in other parts of the world can have a strong affect on us, as well - right here at home.

I feel also that I should be interested in the best "interest" of my fellow inhabitants on the earth. So my feeling about money management is that I want my clients (and others as well) to learn as much as they want to about how to manage money effectively - so that it works for them as well as for others.

Good wishes as you seek to achieve that, all.

joyful guy

P.S. Iva Mae, I'm not enthused about using RRSPs as a system to prepare for one's retirement, either - but that's a topic for another day that may interest some Canadians on here.


    Bookmark   January 29, 2005 at 3:16PM
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As I mentioned earlier, if you invest to earn interest, while most carriers guarantee that they'll return every dollar that they borrowed, there's another guarantee that they don't mention. Apart from the rent on the use of your money (interest), they won't pay one dollar more, either.

So all of the growth that those dollars will ever produce relative to this year is developed - right now. And (almost always) taxed right now. At top rate.

So, apart from being required to pay income tax on (usually) all of the return produced by those dollars this year - you must add some of those dollars to the original asset, in order to maintain its value undiminished.

For example, if you had used your $10,000. to buy a new car 10 years ago, it would have paid the full cost of a relatively decent car. If you went out to buy the same model car now - the cost would be probably about $15,000., so your $10,000. would pay for only about 2/3 of the full cost.

As I've said before - there are two rats that eat your cheese.

The income tax people want part of (almost) all of your current income, which reduces your annual income. Here in Canada, I don't know of any investment vehicle available to the average investor that's equivalent to tax-free municipal bonds in the U.S., which is the reason that I said "almost".

The inflation rat eats part of your asset's value each year, for each dollar will buy less at the end of the year than it would at the beginning.

After those two rats gnaw away at both ends of your interest income - you can keep what's left. Which, at interest rates the way they've been in recent years, isn't much (if anything).

Know what?

The rats eat first!

Good wishes for learning the various aspects of effective management of your money.

joyful guy

    Bookmark   February 22, 2005 at 8:47PM
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Hi all,

Suppose you invested $10,000. 30 years or so ago.

The bank or whatever financial institution agreed to pay you whatever rate of interest on your loan to them

Then loaned about eight times as much to several others.

They paid you the rate of interest that they'd agreed upon.

At the end of the period - they gave you back ... $10,000. Not a dollar less ... but not a dollar more, either. Which would buy less than it would when they borrowed it.

You continued to do that throughout the 30 year period. The annual income from interest would have remained substantially the same, allowing for differing rates from year to year.

So now you have $10,000. Which would buy less than half what it would have, 30 years ago.

So, as I said before, you need not only to pay the Income Tax people annually, but you need to add some of the current interest received to the principal in order to maintain its original value, after losing some of it annually to inflation.

I bought a stock 38 years ago, for about $16.66 per share. It has split twice (perhaps three times) 2 for one of the earlier shares. Which means that my cost per current share went from $16. to $8. then to $4. (and if it split 3 times, to $2. or so).

A few years ago the value was at $56. Then to $24. (after one of the splits?), later in the 30s, then 40s, 50s, and 60s. Recent price was $75., about $69. now.

As I mentioned in the earlier message, usually the rate of dividend payment is lower than that on interest - often about 2 - 3%, sometimes 4%, occasionally higher. So I have a smaller annual amount on which I ower tax liability. On non-Canadian stocks.

But if I own shares in Canadian companies, I pay a much lower rate of tax per dollar earned than on interest earnings.

Not only that - my dividend earnings have increased most years throughout that over 30 years that I've owned the stock. As mentioned earlier - 3% of $4.00 is 12 cents, but 3% of $70.00 is $2.10!

Some years ago the rate was 80 cents per share, then 90 cents, then $1.00, $1.20, $1.32, $1.48, $1.60, etc. Now I get paid about $2.40 for each share that I own.

And, as I mentioned - at much lower rate of tax per dollar than I'd pay on interest earnings.

Furthermore - I haven't had to talk to the Income Tax people throughout those 30 years and more about the increased value of the shares ... and won't, until I either sell them (or die). Neither of which I plan to do, this week or next.

When liquidation day comes, I deduct the amount that I invested originally to learn the amount of capital gain.

I pay tax on half of it, at regular rates. So I have some choice as to when I liquidate, one may plan to do so in a year when one has a lower income. But as most of my income is now pensions, which stay about the same, some allowing for part of the value of inflation, that is not of great value to me.

But ... I get half of the increased value free of tax.

I like them apples.

Better than becoming tax-liable now ... is to defer the liability.

Best of all - avoid the tax entirely. On at least part of the increased value of your asset.

I await your comments.

o j (ole joyful) (and that ain't orange juice)

    Bookmark   March 24, 2005 at 3:18PM
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Hi again, all,

That stock that I bought nearly 40 years ago for about $4.00 per share (actually $16.00+, but it split 2 for 1 twice, maybe three times).

Originally it paid about a nickel or a dime per share annual dividend. A few years ago that annual dividend had grown to 80 cents, then several further increases. A year or so it became $2.40 annually - just now it went to $2.60 annually.

At a lower than average rate of income tax.

Actually, I'm just finishing my income tax now - figured the other day that tax rate would be about 7.2%, but later found about $1,500. more income - but no further deduction, so the tax rate will be 7.5 - 8.0% or so, I expect.

Actually, higher than that, for I got paid for my daily trip to oversee Uncle's house and farm after his death, last year, and won't have a lot of expenses that I can claim.

Accomplished the rather low rate of tax mainly by making substantial charitable contributions.

Good wishes to all for effective use of your (and God's, if you look at it that way) money.

ole joyful

    Bookmark   May 1, 2005 at 2:12PM
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Cowboy!!! Tax deferred in the US (as in Savings Bonds) sucks! I've got some heavy duty taxes to pay on some old bonds that 'ancestors' have had to pay estate taxes on, ---three times now - aunt, father, mother, and now that I'm going to cah them in, I've got to pay more taxes on the interest.

Tax Free Munis are the only way to go.
Why don't you ever mention them?

    Bookmark   July 5, 2005 at 12:17AM
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