Financial future: 10 numbers you must know

26% equals the return on investment you’ll get by paying off your credit cards

If a friend tipped you off to a GIC that was paying 26% a year, risk-free, you would be on the phone screaming, “Buy! Buy! Buy!” But the odd thing is that you may be ignoring an investment that is guaranteed to put at least that much cash in your pocket.

The investment comes in the form of your credit card balance. Pay off your outstanding balance and you’ll earn the equivalent of a 26% annual return on your money. No other investment can promise such spectacular risk-free returns.

Talbot Stevens, a financial educator based in London, Ont., explains the math this way. Most bank credit cards charge 18.5% on outstanding balances. So for every dollar of your balance that you pay off, you save yourself 18.5% a year in interest charges. Saving that amount is equivalent to getting a hassle-free return of 18.5%.

But the reward you get is actually even better than that. Remember that the dollars you use to pay off your credit card bill are after-tax dollars. To generate an after-tax dollar that you can use to pay down your credit card balance, you need to earn more than a dollar before tax. Most of us have to earn something like $1.30 before tax to have a dollar left after giving the taxman his due.

Stevens estimates that most Canadians in a middling tax bracket would need to find a GIC paying 26% a year to generate as much money after tax as they would gain by simply paying down their credit card debt. If you’re in the top tax bracket the return from paying off your credit card debt is even larger.

As you may have noticed, GIC rates are paying nowhere near 26% — a 3% payoff is more realistic. So the lesson here is stunningly simple. “The best investment that most people can make,” says Stevens, “is to get rid of their credit card debt.”

50% of your working income equals how much you need to have coming in each year to enjoy a nice retirement

Some mutual fund companies insist that to provide yourself with a decent retirement you should save enough money to replace 80% of your working income. Working backward from that figure suggests that many middle-class couples must save upwards of $1.5 million to avoid eating dog food in their golden years.

No wonder so many of us feel stressed. But if you’re already dining on gruel to put away enough money to meet the experts’ �argets, we’ve got great news. You can ease off on the starvation diet. “It doesn’t take all that much money to finance a good standard of living when you’re retired,” says Malcolm Hamilton, an actuary and worldwide partner with Mercer, the human resources consulting group.

Hamilton estimates most retirees can live nicely after they finish working on 50% to 60% of what they made while they were still going into the office. Why do you need so little? Because by the time you hit 65, you’ve shed the killer expenses of your 30s, 40s and 50s. You’ve paid off the mortgage, bid farewell to day-care bills, watched your kids graduate from university. You no longer have to save for retirement because you already are retired. Even taxes are lower because you have less money coming in.

As your expenses fall, the amount of money you have left to spend on yourself shoots upward. Hamilton calculates that a senior couple with a $45,000 household income have about the same amount of cash to spend on themselves as a typical young couple in their 30s with a $90,000 household income. Half the young couple’s pay is chewed up by kids, mortgages, retirement savings and high taxes on their — supposedly — high income. But for the retired couple, those expenses are distant memories. Even though they appear to be making far less, they’re living just as well.

4% equals how much of your initial portfolio you can safely withdraw each year after you retire

Many of us are overoptimistic about how much money we can withdraw from our portfolios in retirement. We assume that our portfolios will produce 10%-a-year returns, so we figure we can count on a $100,000 portfolio to throw off about $10,000 a year in income.

Ah, if only that were so. William Bengen, a U.S. financial planner, conducted extensive research to figure out how much money cautious investors could count on withdrawing from their portfolios if they wanted to ensure that their money would last for at least three decades of retirement. Bengen looked back at stock market history to calculate the withdrawal rates that would have allowed retirees to weather the worst financial storms of the past.

He found that drawing down 4% of your initial portfolio, then adjusting that amount for inflation every year, gives your portfolio an excellent chance of lasting 30 years or more. Using Bengen’s method, if you have a $100,000 portfolio, you withdraw $4,000 in Year 1 of your retirement. If inflation is running at 2% a year, you boost that withdrawal to $4,080 in Year 2, $4,162 in Year 3, and so on.

What happens if you take out more? Increasing your withdrawals above an inflation-adjusted 4% rate, even by a fraction of a percentage point, results in a much bigger chance that you will run out of money in your retirement. You may get lucky, of course, but if you hit a market downturn early in retirement, withdrawing more than 4% a year can deplete your savings to such an extent that your portfolio never recovers. If you want to be sure that you don’t outlive your money, stick to an inflation-adjusted 4%.

$500,000 is plenty for most middle-class Canadian couples to save for retirement

If you want an ambitious but realistic target to shoot for in your retirement planning, we suggest $500,000. If you and your spouse can accumulate a half-a-million dollars in RRSPs and pensions, on top of a paid-off house, you will have all that you need for a comfortable middle-class retirement.

To understand why, consider the 4% withdrawal rate we mentioned earlier. It implies that a $500,000 portfolio should produce $20,000 a year in income for as long as you live. On top of that, you and your spouse will collect an average of $22,000 a year in Old Age Security and Canada Pension Plan (or its Quebec equivalent).

Put everything together and your combined income, from both your own savings and government pensions, will top $40,000. Since you’re no longer paying down a mortgage or putting kids through school, a $40,000-a-year income should be plenty to finance a comfortable retirement for you and your spouse.

Remember that the $500,000 target is for both you and your spouse. If you’re single, you can cut the target in half. Remember, too, that the target includes the value of any company pensions that you may have. (You can find out the current value of your pension by contacting your human resources department.) If you’ve been working for the same company for decades, you may be pleasantly surprised to discover that you need to save next to nothing on top of your pension to make the $500,000 goal. Not so fortunate? Then make a habit of contributing to your RRSP. While stashing away money may be difficult in your 20s and 30s, even a decade of dedicated saving in your 50s can put you in shape for a fine retirement.

32% if your gross income equals the maximum you should spend on housing costs

How much house can you afford? The best way to figure it out is to add up how much you will spend a month on the home, including mortgage payments, property taxes, insurance and utilities. Then divide by your monthly household income before taxes. If the number is over 32% — in other words, if your housing costs eat up more than a third of your gross income — you’re in danger. You probably won’t be able to afford repairs or unexpected expenses without borrowing even more money. If you lose your job or fall ill, there is no way that you’ll be able to make your mortgage payments.

It’s not just us saying so. The 32% figure is what the Canada Mortgage and Housing Corp. recommends as the absolute upper limit for home buyers. Unfortunately, the average couple buying a two-storey home today and putting down a 25% down payment will have to spend a whopping 50% of their gross income on their house every month, according to RBC’s housing affordability index.

As more and more families stretch to the limit to buy a home, the casualties are mounting, says Scott Hannah, CEO of the Credit Counselling Society in Vancouver. He’s seeing a growing number of clients who are having trouble making their mortgage payments. “They get in over their heads. To make up the shortfall on their house payments, they end up using other forms of credit and get into even more debt.”

If you want to ensure that you don’t get caught in your own personal credit crunch, resist the temptation to buy more house than you can afford. Even with today’s low interest rates, a couple putting down a 25% down payment should spend no more than three and a half times their annual household income on a house. If you’re using a smaller down payment, be even more conservative.

8% of your gross income equals the maximum amount of your income that should be eaten up by required payments on credit cards and other consumer loans

On top of your housing costs, you probably have other debt, such as credit cards, student loans and car loans. Your minimum required payments on those other debts should not come to more than 8% of your before-tax income.

Go over that number and you’re flirting with danger, warns the credit counsellor Hannah. If you lose your job or fall sick, you will not be able to make your payments. “Even at 10% you won’t be able to manage unforeseen expenses,” says Hannah.

It’s easy to fall deep into consumer debt without any conscious intention. Borrowers tempt you with credit card offers and promises of ultra-cheap car loans. Problem, the interest payments on these loans tend to be extremely high once the honeymoon period ends.

Credit card debt is particularly expensive — and what makes it even worse is that it’s typically used to buy depreciating assets, such as clothes or restaurant meals. These purchases quickly lose value. You’re left with nothing but pleasant memories — and a lot of expensive debt.

To make sure your debt is under control, total up the minimum monthly payments on your credit cards, car loans, student loans and other debts. Then divide by your monthly income before tax. If debt payments represent more than 8% of your income, cut back your spending. Better yet, start paying down those loans.

5% a year equals the maximum you can reasonably expect to earn from a balanced portfolio

Your mutual fund adviser may brag about his ability to attain whopping double-digit returns, but don’t bet your retirement savings on it. Instead, look at what different types of assets have produced over history.

Over the past half century, U.S. and Canadian stocks have provided returns of about 10% a year, while Canadian bonds have generated returns around 8% a year. So assuming you have a balanced portfolio composed of roughly half stocks and half bonds, you can count on your holdings to produce no more than 9% a year.

But that’s ignoring a few rather important practical matters. In the real world, transaction fees for buying and selling investments, as well as management fees if you invest through mutual funds, will eat up at least a percentage point of your return and more likely double that. Inflation will also take its toll. Over the past half century, inflation has cut the purchasing power of your return by 3.5 percentage points a year.

After removing the effect of fees and inflation, you’re left with about a 5%-a-year return in real terms — and don’t forget the taxman will take another bite out of your returns, either immediately or when you remove money from your RRSP.

As gloomy as all that sounds, it could get worse. Someone who was unlucky enough to invest in a balanced portfolio of Canadian stocks, U.S. stocks and Canadian bonds back in 1998 would have made just over 4% a year on their money over the next decade — before deducting fees, inflation or taxes. After deducting those items, they would barely have broken even.

Our advice? Build your long-term plans on the assumption your investments will produce an after-tax return of 5% a year before inflation (or 3% after inflation). Sure, your investments may surprise and do better than you think. But that’s a nice problem to have.

750 equals the credit score you should have if you want to get a loan

Baseball aficionados use batting averages to rank a player’s likelihood of hitting the ball. Banks and other lenders have their own three-digit number to calculate the likelihood that you will default on a loan. It’s called your credit score.

The best credit score you can get is 900; the worst is 300. You should aim for at least 750. If you can achieve that number you won’t have any trouble getting loans at a decent interest rate. But fall below 750 and banks will start charging you a higher interest rate for loans. If your credit score drops below 650, it’s time to worry. Many lenders will either reject your loan applications or charge you exorbitant rates to borrow money.

You can order your credit score by visiting either TransUnion.ca or Equifax.ca, the two credit bureaus that calculate consumer credit scores in Canada. If your credit score is below 750, don’t panic. You can take three steps to bring it back up.

First, start paying all your credit card bills and other loans on time. Next, keep your balance on credit cards below 35% of your limit, and maintain your balance on lines of credit below 50% of the maximum. Lastly, resist the urge to apply for even more credit. The more often you apply, the more desperate you appear to lenders, and that apparent desperation will drag down your credit score, says Tom Reid, director of consumer solutions at TransUnion. Follow all three of these tips, and your credit score should start rising in six to 12 months.

2 times the sticker price of your new car is what the vehicle will actually cost you to operate during the first five years of ownership

All those shiny deals on wheels aren’t such a steal when you add up the all-in costs of running your new car. The total five-year cost comes to double the sticker price, says Jesse Toprak, an analyst at Edmunds.com, a U.S. website that keeps tabs on car costs.

Consider a basic Toyota Camry, which in the U.S. sells for $20,691. Over five years it costs $43,144 to operate, says Toprak. Though that figure includes gas and maintenance, nearly half the amount–$17,000– is financing, depreciation and purchasing taxes. “People don’t realize that when they leave the car lot they’ve really only started to spend money on their car,” Toprak says.

Fortunately, there are ways to cut the all-in cost of car ownership. The smartest thing you can do is to buy used. Your best bet: a one-year-old car. It has already lost 30% of its value but still comes with all the factory warranties, says Toprak.

If you do buy new, hang on to your car for at least five years to avoid paying the new car premium twice in that time. But holding on for a decade is even better. It’s only in the last three or four years of a car’s life that it becomes truly cheap to own. From Year 1 to Year 5 you’re paying financing charges while the car plummets in resale value. Over the next couple of years, cars tend to need extra servicing and major repairs. It’s only after Year 8 that your clunker becomes a real bargain.

$10,000 is how much money you’ll need to earn each year on top of your student loans to pay them off in 10 years.

How much debt should a student take on? Consider the rule of tens. You should plan to pay off all your student loans within 10 years of your graduation. To make this possible, you should be in a position to earn at least $10,000 a year more than your total student debt after you graduate. Here’s an example. If you graduate with student loans of $30,000, you should be able to earn at least $30,000 a year plus $10,000, for a total of $40,000 annually, if you want to be able to pay off your loan in 10 years.

Tim Cestnick, an accountant and author of Winning the Education Savings Game, uses this number to show how important it is to borrow as little as possible to fund your education.

Cestnick warns that people who aren’t prepared to pay off their student loans within a decade are courting financial trouble. Odds are that by a decade after university you’re going to be taking on a host of new commitments, such as a mortgage and kids. If you’re still paying off your student debt at that point, your budget may not be able to take the strain.

The $10,000 rule is a helpful reality check for adults thinking of going back to school. Cestnick recalls one of his clients, a single mother who already had $60,000 in student loans. She wanted to get her master’s degree. “When I asked her what she hoped to do after finishing her degree, she said she thought she might teach public school. I pointed out that if she accumulated an additional $10,000 in debt, that would be $70,000 in total. She would need to earn $80,000 a year to be able to pay that off in 10 years. That’s not a likely salary for a teacher in her early years of teaching.”

Cestnick recommended that his client avoid piling up more debt. Instead of taking her master’s degree full-time, he encouraged her to find a job and take courses part-time.