Where to Start with Your Money: Current Financial Situation
Last week we started answering the question ‘Where do I start?’ when it comes to money. There are many ways to answer this question, and so we’ll break it up into three posts:
Your current financial situation (this post)
While high-level checklists are helpful, I wanted to provide additional ideas for your unique circumstances. By combining relevant life events, your current financial situation and your financial behaviours, I hope this series helps address the question of ‘Where do I start?’ If you’re not sure whether an idea applies to your unique situation, you can always speak with a financial planner to get a more tailored list of recommendations.
Your financial situation
When considering your financial situation, we’ll look at four primary numbers:
What you earn (income)
What you spend (expenses)
What you own (assets)
What you owe (liabilities)
Combining what you earn and what you spend provides your ongoing cash flow. This represents how much money is coming into or going out of your bank account regularly. The amount you keep after all expenses are accounted for is one of the most important factors in determining your financial health.
Taking the total of what you owe and subtracting it from what you own provides your net worth. This represents the total cash you’d have if you sold everything and paid off all your debts. While your net worth will likely fluctuate, the goal is to gradually build what you own while minimizing what you owe.
What you earn (income)
There are different opportunities for your money, depending on how much you earn. For instance, there are specific tax benefits for individuals and families with lower incomes. Also, some financial planning strategies only apply if your income is above a certain threshold. As a result, we’ll look at three income levels and what to consider for each:
1. Low-income (<$40,000)
While income inequality in Canada has recently started to improve, there’s still a wide divide. Once your income is higher than your ongoing expenses, you can invest the excess and gradually grow your net worth and investment income. This is much more difficult if your income is just covering your expenses. In Canada, we’re fortunate to have several government-supported systems in place to help reduce the strain on low-income individuals and families. The awareness of these programs must increase to ensure people can take advantage of them.
If you have children, they may be eligible to receive the Canada Learning Bond (CLB). This is a government program to provide up to $2,000 to help pay for post-secondary schooling, without any need for you to deposit money. To take advantage of the program, you’ll need to open a Registered Education Savings Plan (RESP). Families with 1 to 3 children earning $47,630 or less in income qualify as of 2020. If you have additional children, the income threshold increases gradually.
If you’re approaching retirement, the Government of Canada offers additional payments, called the Guaranteed Income Supplement (GIS). It’s available to those who meet the following criteria:
receiving the basic Old Age Security (OAS)
resident in Canada
income below $18,600 to $44,592 depending on your situation
There are additional tax benefits for low-income individuals and households, including:
The Working Income Tax Benefit (WITB), now called the Canada Workers Benefit (CWB)
The GST/HST tax credit
Provincial and territorial credits
To help increase your income, it may be an option to expand your skillset through training programs or to offer your existing skills as a freelance worker. With platforms like Coursera and Udemy you can complete courses and earn certifications to expand your skillset for your current job or a new career. Another option is to sell an existing skillset as a service on platforms like TaskRabbit or Fiverr.
2. Middle-income (~$70,000)
As a middle-income earner, you face some of the more challenging trade-off decisions. Whereas, it’s often easy for a high-income earner to invest using a Registered Retirement Savings Plan (RRSP) account, or a low-income earner to use a Tax-Free Savings Account (TFSA), there’s not necessarily a clear answer in your case. That said, I find the most common challenge for middle-income earners is getting overwhelmed by the choices and deciding not to do anything. It’s often better to get started with one option and to learn over time. Either choice is likely better than doing nothing.
At your income level, it’s important to find the right balance between enjoying life and increasing your income. There’s a growing movement of creating side hustles to increase the amount you earn each month. However, there’s only so much time in the day, and downtime can be a critical component of a healthy and fulfilling life.
Next week’s post on goals and behaviours should help you decide between many of the options available to you. In addition, as a middle-income earner, you’re the target individual for the majority of best practices and rules of thumb. It’s often in the extreme cases on either side of your income level where some of these ideas break down.
3. High-income (>$100,000)
One of the most prevalent challenges for high-income earners is the temptation to keep up with those around them, commonly referred to as ‘keeping up with the Joneses.’ Those who earn a higher income often work with and associate with others who earn high incomes. The challenge is when you make $100,000 and try to keep up with people earning $200,000 or $300,000. It’s important to be spending on experiences and items that bring you the most happiness, not spending because you must in order to fit in. As with any income level, it’s important to spend less than you earn, since the amount you keep is what matters.
To help minimize your income tax today, you can deposit money into a Registered Retirement Savings Plan (RRSP). Any deposit into an RRSP can be used to reduce your income by that amount in the current or a future year. For instance, if you earn $120,000 and deposit $20,000 into an RRSP, your taxable income for the year is only $100,000. This will help limit your taxes today, and you’ll instead pay taxes when you withdraw the money in retirement.
If you run out of RRSP contribution room, or you’re saving for a shorter-term goal, you can use a Tax-Free Savings Account (TFSA) to invest your money. Any growth in the TFSA is tax-free, allowing your money to grow much faster than in a traditional account.
If you have a partner or dependents, insurance is a critically important consideration for your financial plan. If your lifestyle (e.g., mortgage, car expenses, extracurricular activities) depends on a high income, you would need to make material changes if you were to lose your income due to a disability or death.
What you spend (expenses)
As we covered in an earlier post, you likely spend money on things that bring you happiness and help you live a fulfilling life. It’s important to balance your spending today against spending in the future. Sacrificing your quality of life today in pursuit of the largest possible nest egg can be just as bad as spending everything today and forcing your future self to deal with it. It’s about providing yourself with a consistent lifestyle that makes sense for your priorities.
1. You earn more than you spend (positive cash flow)
Congratulations on keeping your costs in check in an ever more expensive world. With positive cash flow, you can improve your financial situation by following these steps:
If you have high-interest debt, often considered above 10%, this is likely the best place to start. By paying an additional portion of your income each month towards the highest interest loans, you’ll reduce future interest costs and allow yourself to save even more later.
If your employer provides a group retirement account or pension plan it’s worth every minute of your time to learn more about it. Some employers will provide deposits to your account that equal 50% or even 100% of what you set aside, up to a limit.
The next step is to establish a savings account that can be used in the case of an emergency. Depending on how secure your income is and how flexible your expenses are, it’s common to save three to six months of mandatory expenses. This includes housing, food, contracts and other major commitments. It’s important that the account is accessible and earning interest to help it grow over time.
Once you’ve reached this stage, there’s a decision to be made between paying down any remaining debt (e.g., student loans, mortgage) or investing for future goals, such as retirement. This is one of the trickier decisions that we’ll help tackle in our next post as we look at goals and behaviours. For a sneak peek, if you prefer certainty, then paying down debt may be ideal. However, if your primary goal for your money is to allow you to travel, then setting aside savings for current and future trips may be the best approach.
2. You earn less than you spend (negative cash flow)
I recently wrote a post for Boomer & Echo that outlined ways to lower your expenses and increase your income. As the cost of living in Canada increases (e.g., education, housing, food, childcare) and wages remain fairly flat, it becomes more difficult to save for the future.
One of the most important steps for spending less than you earn is to pay yourself first. By setting up an automatic transfer to move your money into a savings account right as it’s received, you’ll put the money out of sight and out of mind. People often believe they can’t do this because they need the cash today. However, it’s often the case that your spending habits have increased over time to be precisely the amount you earn. It’s unlikely a coincidence that so many Canadians spend exactly their income each year on an ongoing basis. We’re either very good at finding careers that match our mandatory spending level, or else we increase our spending over time to match what we earn.
To help achieve the highest standard of living with your remaining spending, I recommend creating a budget. This involves three steps:
Calculate how much money you earn after taxes and savings
List your most important expenses (the ones that bring you the most value) in order of priority
Take your money from step 1 and move down the list created in step 2 assigning your money to the highest priority items
Many people fall into subconscious routines of spending their money on experiences and items that don’t bring them as much happiness as other purchases could. It’s important to ask if you’re spending money on dinners out, trips or other items because it’s your priority, or because you feel obligated out of routine or social pressure.
What you own (assets)
The value of what you own could be real estate you live in, savings accounts, investments for retirement and much more. The level of assets and whether it would be considered developing, established or significant depends a lot on your age. However, I’ve done my best to identify general thresholds and things to consider at each, regardless of your age.
Developing asset level (<$50,000)
In the early years of building savings, people often focus on investing and trying to maximize their returns. They see graphs of how starting early and earning a high return can set them up for success and focus on their investments. While it’s important to start early and invest in your early years, your focus should be on increasing your income and the amount you’re saving.
Established asset level (~$200,000)
As you build your assets, it’s important to consider the fees you’re paying. This may include fees on your investment account or commissions on property transactions. People often look at getting rid of small expenses when trying to save money. While this helps, you can usually have the same impact by saving on one or two major expenses. Sites like Purplebricks can help you save on commission costs when selling a home. In addition, new offerings like robo-advisors make it easy to manage your investments while paying lower fees.
In addition to monitoring your fees, it’s important that you’re investing appropriately for your goals. If you don’t need your money for the foreseeable future, there’s the opportunity to grow your savings faster by purchasing higher risk investments. If, however, you need your money soon, then you may be better off in safer investments like a high-interest savings account (HISA) or guaranteed investment certificate (GIC).
Having property insurance that removes unmanageable risks of damage or theft is important. In addition, there’s insurance for your savings and investing accounts in case the company you’re doing business with runs into financial challenges. The Canada Deposit Insurance Corporation (CDIC) offers insurance up to a maximum of $100,000 for certain deposits. There is also the Canadian Investor Protection Fund (CIPF) that covers up to $1,000,000 for investment accounts held at member firms. You can speak with your financial institution, CDIC or CIPF to learn more about the coverage given your situation. It’s important to save and invest with credible and registered institutions to minimize the chance of losses due to insolvency.
Another reason to ensure you’re doing business with credible and registered companies is to avoid fraud. The Ontario Securities Commission (OSC) provides four ways to avoid investment scams:
Get a second opinion
Check registration
Take the time you need
Research the investment
Significant asset level (>$750,000)
At this level, there’s considerable value in learning more about your money or working with a professional. Reading about different investment options, taxes, and psychology will provide excellent returns on time invested. Or, working with a quality accountant, financial planner or investment advisor may help you lower your taxes, invest your money appropriately and manage your money behaviours.
Spreading your money across a broad range of investments, including owning shares in companies, lending to businesses, lending to governments and more, minimizes the risk of losses. Diversifying your investments is important at any level of assets. However, it becomes even more relevant as the potential loss grows.
In the worst-case scenario, if you were to pass away, your estate becomes more complicated and costly the more you own. To minimize the impact on your heirs, you can set up a will and name beneficiaries for your accounts.
In addition, the topics of investment risk, insurance and fraud mentioned above remain relevant.
What you owe (liabilities)
Borrowing money can be very useful in certain situations. If you’re going to school or purchasing a home, borrowing money can help you benefit from the purchase earlier in your life and for a longer period. Regardless of why you’re borrowing, it’s important to remember that you’re spending today in exchange for spending less in the future as you repay the loan. To balance your quality of life over time, you may need to borrow occasionally. However, the more you borrow, the higher the chance you’ll significantly lower your future lifestyle.
Debt-free
Congratulations! By not paying interest into someone else’s bank account, you’ll have more money available for your goals.
Manageable debt level
‘Good debt’ allows you to invest in something that is expected to pay off in the long term, allowing you to build your assets and net worth. It should ideally charge a reasonable interest rate (2% to 7% currently) to ensure your payments are going mostly towards paying off the loan rather than paying interest.
High-interest debt
If you’re currently borrowing money on a credit card or through a payday loan, paying off the balance is one of the best investments you can make. If you can minimize your expenses or find side income until you’ve paid it off, you’ll be in a much better financial situation. On a $3,000 credit card balance at an interest rate of 20% (a standard rate in Canada), you’re paying $600 a year just in interest. Once you’ve paid off the loan, the savings on interest can be used to pay down other debt or to start saving towards future goals.
Significant debt level
It’s easier said than done to avoid debt. The reality is that household borrowing in Canada continues to hit all-time highs. Student loans, mortgages and personal loans are all being used to help pay for purchases. Sometimes this is out of necessity, due to higher education costs and housing prices. And sometimes it’s out of convenience, due to historically low interest rates. Whatever the source of any debt you may have, if you’re looking to pay it off, there are two common approaches.
Depending on whether you’re motivated by paying the least amount of interest or by lowering the number of loans you have, there are two primary ways to pay off debt.
The first approach is to focus on your high-interest loans first
The second approach is to focus on your small balance loans first
Either way, the key is to pay at least the minimum required to all your loans and make extra payments as often as you can to the highest interest rate or lowest balance loan.
Regardless of which approach you take above, another option is to refinance some or all of your debt. This involves finding a loan that charges a lower interest rate than what you’re currently paying. If you have credit card debt charging 20% interest, it’s worth seeing if you can find another loan. You may be able to get a personal loan from a bank or digital lender at a lower rate. If you borrow and pay off your credit card, you’ll have an easier time paying back the new loan. It’s important to ensure the rate of the new loan is lower and not a temporary offer that could increase later.
If you’re in a position where you owe money that you can’t pay back, do everything in your power to address the situation. Contact your lender directly to work out a repayment plan that works for everyone or contact an alternate company to see about refinancing the debt. If needed, you can speak with a licensed trustee to discuss your situation and options in greater detail.
Closing remarks
This post can be combined with last week’s post on major life events and next week’s post on goals and behaviours to help you decide where to start with your money. While we’ve covered quite a few topics in this post, they all fall into one of three buckets:
Save money for the future
Put your savings to work
Protect yourself from the unexpected
While you may have skimmed this post for the sections relevant to you (the main intention of breaking up the content), I’d encourage you to return and read through the remainder of the material later. By having an idea of the personal finance topics out there, you’ll be ready as your life situation changes, and you’ll be able to help others in different circumstances.