Tax Refund Pros

It’s a savings plan that you already have. You don’t have to go to a new bank, or set up a new account online. It’s not something that you have to spend a lot of time thinking about or planning for. It’s just a box that you check on a single piece of paper, and you’re set. Once you tax returns comes in, bingo! It’s like a lottery that you know is coming once a year and you’re guaranteed to win.

It’s a decision you only have to make once a year. I remember as a kid getting my weekly allowance and having to struggle in agony as I had to take that already small amount of money and divide it further so that I could save some. It was a hard decision to make, and every time that I made it I felt physically and emotionally drained. With using your tax refund as a forced savings plan, you only have to make that decision once.

Tax Refund Cons

There’s no interest on your savings. Instead, the government is most likely reaping the benefit of your income tax refund sitting in a bank somewhere, earning interest. Your money could be doing that instead. While most bank account interest rates are fairly low, and while the amount of money that you could be earning throughout the year really won’t add up to a ton, it’s still your money that you’re leaving on the table.

There’s no access to your money. If you suddenly need it in case of emergency, it’s not like you can call up the Canadian government and ask for your tax refund to be processed in November this year. You’ll have to wait until March/April like everyone else before you can access your money.

All in all, it’s pretty hard to make a good argument as to why this particular savings plan is better than an automated bank account withdrawal. It does the same thing, except earns you money and makes your money accessible. The only reason I would suggested setting up a forced savings plan like this is if you lack the ability to sit on your cash as it grows. If accessibility means that you’ll end up spending that money, then by all means, let the tax man take your cash and hold onto it for you if you can’t hold onto it yourself. Just make sure you have a good plan for that money when you do get your tax refund, else your savings and patience will be wasted. Pay down debt, set up an emergency fund, buy a new car, or whatever you need to do, just don’t let that money disappear into your regular checking account.

Do you use your tax refund as a force savings plan? Why or why not?

Related Posts:

• What Is The Registered Disability Savings Plan? (RDSP)
• Alberta Centennial Education Savings (ACES) Plan
• What Will You Do with Your Tax Refund?

Tax Refund: A Good Forced Savings Plan? originally appeared on Canadian Finance Blog on March 14, 2012.

Before we begin, a caveat. I’m going to assume the million bucks is an inheritance, or lottery winnings, or something that isn’t taxed (at least in Canada). Because what fun is it fantasizing about a million dollars if you immediately lose a quarter or a third of it to taxes? Since I’m pretty sure nobody is planning on giving me some sort of 7 figure surprise, this exercise remains a fantasy.

But hey, if you have a million bucks just burning a hole in your pocket, call me.

First, The Boring Stuff

I have a mortgage. At this point, I’m making fairly aggressive mortgage payments for it to go away, but I’m not really in a hurry to pay it off, especially considering low interest rates look like they’re here to stay for a little while. But if had a million bucks, I’d make it go away. That’s about $135k, right off the top. Balance remaining, $865k.

That’s it for me and debt, so next would be investing for income. I’d take half of the remaining balance ($437,000) and put it into a combination of dividend paying stocks, bonds, GICs and preferred shares. If I could get a scant 5% yield, that would spin off an income of $21,800 per year, without touching the principle. I honestly think I could do a little better than 5%, but I’m trying to be conservative here. Plus, I’d be primarily investing in stuff with less than 5 years to maturity, since interest rates are so low.

Well, that was a quick use of $572,000. What should I do with my remaining $428,000?

Would I Quit My Job?

That’s the big question, isn’t it? I hate to be that guy, but I honestly don’t know if I’d quit or not.

I like my job. It’s physical, which helps me keep the pounds off. For the most part, I like the people I deal with everyday and I like the routine. Plus, I’d still get free chips. I’m cheap at heart, so that’s a perk. Yes, even with a million dollars.

Alternatively, what a great opportunity to start my own business. Making close to $22,000 per year without lifting a finger would take a lot of pressure off having to ramp up earnings right away, not to mention no longer having a mortgage. At this point, I’ve been blogging for 2 years now, and I understand quite a bit about the business of the whole thing. I could start up another blog or two in other subjects, or I could use some of my sudden windfall to buy up a couple of financial blogs. With the time to run them, I know enough about the business to make them profitable.

And now that I type this out, I figured it out. I’d quit my job. How much fun would it be to blog for a living?

The Fun Stuff

I’d stick $100k just in the bank. It would serve as both a travel and opportunity fund. I think I’d still be a frugal traveller, but it would be nice to see certain parts of the world without having to worry about the cost.

What’s left? $328,000. Well, as a millionaire, I couldn’t continue to drive my crappy Ford Focus, now could I? For $28k, I could buy a pretty decent new car, so let’s go with that. Besides, that leaves me with a convenient $300k left to spend.

Hmm… What to spend $300,000 on? I think Canadian real estate in general is overvalued, so I wouldn’t be putting a nickel into that. I’d also avoid any private mortgage lending, barring very promising certain situations.

I’d take $100k of that cash and use it for picking stocks primarily for capital gains. I’d buy beaten up companies, hopefully ones with decent potential for turnarounds. I’d spend all sorts of my new found free time analyzing balance sheets and doing research. Yes, this is what I’d do for fun.

As for the last $200,000, I honestly have no idea. I’d keep it relatively liquid, maybe in short term GICs or a money market account. I’d call it my opportunity fund, reserved for buying some sort of other asset, like perhaps American read estate.

So, in conclusion, I’d only spend $700,000 of my $1 million, and barely spend any of it frivolously. Why would I? I have everything I need, and material stuff doesn’t really motivate me. The best part of having a million bucks? It isn’t the ability to buy a bunch of stuff. It’s the freedom that only passive income can bring. Since none of you are actually going to give me a million bucks, I guess I’m outta luck.

Readers, what would you do with a million bucks? The comment section is all yours.

Related Posts:

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If I Had A Million Dollars originally appeared on Canadian Finance Blog on February 16, 2012.

Setting up automatic payments is probably the best financial decision I ever made. Back when I was in college I signed up for an online bank account with ING Direct (use an Orange Key for a free $25). I then set up an automatic withdrawal from my regular chequing account. It wasn’t a lot of money. I think it was about $25 a month. However, even that small amount helped sell me on the benefits of automatic transfers. At the end of the year my chequing account was empty but my ING account was far from it. From there, it grew. Post college I had a real job and upped my monthly transfer amount. I set up a secondary ING account and started an additional transfer. I applied a liberal amount of time, and eventually that money helped my wife and I get married, and later, buy a car.

Saving up that much money can be daunting and incredibly difficult, but for me it seemed easy because it was a decision I only made once. You too can do the same.

Set up an online bank account if you don’t already have one.  I prefer ING, but there are multiple options out there.  Most should require a link to your main bank account, so it may take a few days to get completely set up. Once you are, hop in and take a look at what you can and can’t do. Check, for example, how long it takes to transfer money from this account to your main account. A longer amount of time is often a a good thing, as it prevents one from making impulse purchases with the saved money, but if you are setting up an emergency and are concerned about the amount of time it takes, check into your various options.

Now, also look into their automatic withdrawal options. What you’ll want to do is set it up so that you are regularly putting money aside. It is completely up to you what you want to start saving for. Retirement, a car, emergency fund, whatever you’d like. How much you can afford is also up to you. I would suggest a smaller amount to start, something that will add up to a lot over time, but is not do much that your finances will be strained. $25 or $50 is a good place to start. I also suggest you have it set up so that it comes out on your payday. Money goes in, money goes out, you never notice it being gone. You will, however, notice your online bank account slowly grow. Even at $25 twice a month you will be saving about $600 a year. If you are 30, that means you’ll be saving about $22k before you retire.  In the grand scheme it may not seem like a ton, but at $25 a pop that sure adds up over time, especially if you consider the power of interest over time as well.

Do you have an automatic withdrawal for your savings? How much do you save with them?

Related Posts:

• Personal Finance Basics: Build an Emergency Fund
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Personal Finance Basics: Automatic Withdrawal For Your Savings originally appeared on Canadian Finance Blog on February 15, 2012.

The program profiles families that are preparing for certain doomsday scenarios. One family is prepping for an economic catastrophe, one that will see hyperinflation render their savings useless. Another family is preparing for a significant natural disaster, like a super volcano.

Their preparation methods are all pretty standard. They’re all stockpiling food, water, firewood, and most importantly, bullets. Hey, you gotta be prepared for the worst, right? When the unthinkable happens, these people will be prepared, and the rest of us will be regretting our lack of preparation.

But until this happens, these people are just a bunch of crazy extremists. We can all point and laugh at their crazy antics, content in knowing we’re all safe and sound, at least for now. As I watched the show, a personal finance related theme came to mind. Forget about the end of the world, or some major disaster, or anything else really bad happening. Let’s talk about needs, and what you really need.

We Can Live Without A Lot

Just 50 short years ago, we lived without smart phones, iPads, the internet, cable TV, satellite radio, Coke Zero, personal computers in general, calculators and reality TV. All of those things are pretty awesome except one, which I’ll leave up to you to decide.

It wasn’t that long ago we did without all these things, and we did just fine. Is it really so bad if our friends can’t text us every single minute of the day? Is listening to the radio with commercials really that bad?

Yet, when you make your budget, how many of these so-called necessities have you pencilled in there? If you’re anything like me, a whole bunch. I have cable TV, the internet, (obviously, since you’re reading this) an iPhone, along with probably a dozen other things I don’t need.

At the risk of sounding a little condescending, I’m quite okay with all the luxuries in my life. I don’t struggle with making ends meet every month. I save a comfortable percentage of my income. This post is being written in a hotel room a long ways from home, a trip I didn’t even have to budget for. I just dipped into my savings and was off. I’m in the position that I can afford a few luxuries.

What if you’re one of those people who struggle to make ends meet? Should you be cutting out some necessities.

You sure should be.

The Biggest Luxury of All

Okay, it’s not really the biggest luxury of all, but I needed a catchy title to get your attention. What is, at least in my opinion, the #1 thing you should be cutting out if you’re carrying any sort of consumer debt? No, it’s not your cell phone, or your cable TV, or even your Netflix subscription.

Nope, it’s travel.

It seems like everybody is touting the benefit of travelling these days. I’d agree with them for the most part. Going from cold, cold Canada to somewhere warmer in the winter is fantastic. Seeing the world is a pretty cool experience. I’m not here to bash travel.

I am here to bash travel when you can’t afford it. I know all sorts of people who are still paying off vacations they took years earlier, since they put them on their credit card. I also know all sorts of people who at least didn’t finance their holidays, but don’t have an emergency fund or any savings to speak of, because they’ve spent all of their excess cash on travelling.

Travelling is good. Putting yourself at financial risk to do it is bad. It’s the same thing with having a cell phone, or cable TV, or satellite radio. Travelling is hardly a necessity, just like any of those other luxuries.

Cutting Out Is Important

Take a good long look at some of the unnecessary luxuries in your life. Most of them are there for one purpose – to entertain. Just how entertained do you need to be?

The world is filled with free or almost free entertainment options. The library is filled with all sorts of stuff to keep you amused, basically for free. Going for a walk is free, assuming you don’t buy a pair of shoes just for walking.

How many of you actually use your Netflix subscription? Or your satellite radio subscription? Finding a substitute wouldn’t be that difficult, and can save you some money each month. Is cable no longer important? Then cut it. Don’t just keep it because it doesn’t seem like that much. These recurring costs have a way of adding up over time. What are you waiting for?

No related posts.

How Many Of Your Needs Are Actual Needs? originally appeared on Canadian Finance Blog on February 9, 2012.

What is an emergency fund?

At first, by far the best thing to do (other than making sure you’re not missing debt payments) is to build an emergency fund. What is an emergency fund? An emergency fund is simply a separate stash of money that is reserved exclusively for emergencies. Ideally, it is a separate bank account that is more difficult to access, so that you’re not tempted to use it – but accessible from anywhere, so that you can get it, in case of an emergency. Why not just use a credit card? When an emergency happens, and it will happen, it is obviously a lot better to simply have an interest free way of getting out of that situation. If you are forced to use a credit card, your emergency gets that much worse as now you have a deadline to get that money back, or else you’re paying interest on top of it. As a result, the best option for an emergency fund is an online bank account like ING Direct, or a separate bank account through your normal bank where you can stash the cash until you need it.

How big should your emergency fund be?

There’s plenty of advice out there about different formulas you can use to determine just how large your emergency fund should be. Dave Ramsey says it should be a thousand dollars, assuming you have debt to pay back. Get your emergency fund to 1k, then pay off debt, then make your emergency fund bigger. Others say the best thing to do is to figure out how 2 months worth of expenses, and save up that amount. That way, in case of emergency, you have 2 months to figure something out before you start going back into debt. In reality, it all just comes down to personal opinion. Do whatever makes you comfortable, but please save at least a minimum of a thousand dollars before you cut off saving for your emergency fund. You’ll thank me later.

How to save money in your emergency fund

What’s the best way of getting all that money into the emergency fund? Simple. Set up an automatic transfer (ING is really good with this, get a head start with an orange key) for the day that you normally get your paycheck. Set it for something easily manageable, like $30 or $50. Then, just wait. If you have a lump sum that you can set aside, then definitely put that in there straight away to get it going, but even with a modest regular deposit, you can grow your emergency fund in no time. Even at $50/paycheck, you can have your thousand dollar emergency fund in less than a year, and because you’re taking it out on the day that your paycheck goes into your account, you’ll never even notice the difference. Just make sure that you adjust your other spending accordingly so that you don’t start spending more than you make. Keep tracking your finances!

When should you use your emergency fund?

Finally, when should you use your emergency fund? Again, there’s plenty of rules and guidelines you can attempt to follow, but you simply should use your best judgment. If you think that buying a new TV is the best use of your hard earned money that you’ve been saving for an emergency, well then, go for it! Have fun! But when your car breaks down on the way home from the store, and suddenly you don’t have the cash for the mechanic to fix your only mode of transportation, well then, I guess you can’t blame me for not warning you. To best honest, my wife and I have dipped into our emergency fund for non-emergencies. When we purchased our car we drained it so that we could pay for the car outright, as opposed to getting a loan. We deemed it was worth the risk, even though it wasn’t an emergency. It worked out well in our favour, but we both were quite stressed about our finances until we built it back up again.

Do you have an emergency fund? Have you ever dipped into it? Why or why not?

Related Posts:

• How To Build An Emergency Fund
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Personal Finance Basics: Build an Emergency Fund originally appeared on Canadian Finance Blog on February 1, 2012.

Just think of these classic examples. The soccer mom who thinks she is her teenage daughter’s best friend. The elderly man who thinks his eyesight is just as good as it was 40 years ago. The driver who thinks everyone else on the road is a horrible driver. Your self perception will fail you, and it could cost you money when it comes to signing up for services.

When you sign up for your cell phone bill, the sales person will often ask you what types of services you will need. Do you want to access your email on your phone? Do you like always having your phone with you? How often do you send or receive text messages? These types of questions will help them determine just what level of package you might need.

The problem is, you are probably the last person they should ask to see how you are going to use your phone. Why? Because you will answer based on your self perception. “Oh, I call my mother all the time! I best get a long distance plan”. Even worse, you might answer based on what you are hoping you will use the service for. “I’m going to use this new cell phone to text message all my old college friends! It’s going to be so fun”! How do you stop the cycle? How do you prevent this from occurring? You have two options. You either let someone else pick your service plan for you, or you go with what you think/hope you will use, and re-evaluate after 6 months. Has it already been six months? Let’s look at your service level plans.

Cell Phones

How much of your cell phone do you actually use? Did you get a smart phone because your teenage kids thought it would be the best/coolest phone you can get? Do you ever actually use the data plan that you are paying so dearly for? Go take a look! Most cell phone providers will be happy to provide you with that information. Either give them a ring, or go to your service provider’s website. Most companies will now show you your historical usage.

For example, I have Bell as my cell phone provider. They actually provide me with a “6 month trend” of my usage. In my case, I have up to 350 talk time minutes per month that I can use. I use approximately 1/3 of that each month. There’s potential savings! As for data, I use between 250-750MB per month. I pay for 1GB, and the next lowest option is 500MB. So I am probably best off staying where I am, or dropping down a level and seeing if I can restrict my usage a little more.

Television

How many channels do you actually watch? I can’t tell you how many times as a kid I wished I had more channels to watch. I was so sick of there being nothing on the 20 channels that we had. Every so often, at a friend’s house, I would get to watch Satellite TV. There were hundreds of channels, and within an hour or two, I would be bored. I was spending more time trying to find something to watch than actually watching it, if I could even find anything good to watch. There’s plenty of options, but when your options are primarily infomercials, local news for places that aren’t local, and reruns for B-movies, there aren’t actually that many options.

So take a week and write down which channels you actually watch throughout the week. There’s a good chance you are not using all of your channels. Once you do, take a look at your provider’s website, or give them a call. You may be paying extra for channels that you don’t actually watch. It’s worth checking periodically as well, as channel lineups and provider packages seem to change on a regular basis.

Internet

How fast do you need your Internet to go? How large of a bandwidth cap will you use? Just like your cell phone bill, you may be paying more than you need to for your service. The speed of your Internet will rarely affect your user experience. As long as the YouTube video loads after a few seconds, you should be good. As long as the download from Microsoft takes minutes, and not hours, you will be fine. As long as your games don’t lag and you can Skype your grandmother, there’s no real reason to need a faster Internet.

Most provider’s regular package should be more than enough for you. Don’t get me wrong, I love having a fast Internet, but there are few occasions where I can justify the additional cost for a few seconds difference. As for bandwidth caps, your provider should again be able to provide you with how much you have been using, and whether or not it is worth going up or down in cost for your personal needs. It could save you money!

How do you select your service plan level? How do you justify the additional costs?

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Which Service Plan is Right For You? originally appeared on Canadian Finance Blog on October 26, 2011.

Schools don’t teach money management. They teach algebra, calculus, and geometry and although each of those is useful for developing abstract thinking, these skills have little practical purpose when it comes to everyday money management. (When was the last time you used a quadratic equation?)

If you want your children to someday become independent adults you have to teach your children these lessons. What should you teach your children about money? Here are a few ideas.

Saving

Teach your children that money isn’t meant to be spent, it’s meant to be saved so the person later has options. Those who save have little exposure to economic events because saving gives a person options. The nation’s richest people are often vilified but most are rich because they’ve managed their money well and that first starts with savings instead of spending.

Pay your Credit Cards off Each Month

Ideally, cash would be the ideal way to live but in a digitized world, cash is becoming less practical although still very possible. Teach them that if they’re going to use a credit card it must be paid off in full each month and if they find that they can’t do that, get rid of the credit card and only use their bank card or cash.

Where Does Money Come From?

Money comes from work. It doesn’t come from government assistance programs, the lottery, gambling, or get rich quick schemes. Money is the direct result of working hard every day. This lesson is best taught practically. If your children want money, they should do something around the house to earn it. Since education often equals higher paying jobs, pay them to reach the highest educational goals.

Giving

Money should be saved but it should also be used for the good of society. Teach your children to find valuable, true needs in the world and donate. Set up an account in their name on sites like Kiva to allow them to understand the power of giving. Although Kiva isn’t a true donation, it allows them to lend it back out to somebody else in need making the giving perpetual allowing your children to continue learning this lesson over time.

Live By Example

What’s the best way to teach your children how to be good money managers? Live the life and show them real world examples of how you save today for prosperity tomorrow.

Kids who don’t learn how to manage money become adults without the skills needed to live prosperously. Prosperously doesn’t have to mean rich. It only needs to mean comfortable and with the ability to purchase what you need without resorting to credit cards and for those who hope to be among the nations wealthy, spend less and invest more.

Related Posts:

• Why It’s Important To Teach Children About Savings
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Want Your Kids to Manage Money Well? Teach Them originally appeared on Canadian Finance Blog on October 24, 2011.

Daily/Weekly Alarms

A specific timed alarm is a great way for you to force yourself to take action on specific tasks. If nothing else, it is a physical reminder of something that you need to do, increasing the chance that you will actually do it. I use primarily for daily or weekly tasks that I have a hard time remembering. For example, I use alarms for daily tasks like getting out of bed and taking my vitamins. Every weekday I have two alarms. One for getting up and out of bed to start my day, and another one about 30 minutes later to remind me to take my vitamins for the morning. I’ve tried all sorts of ways of remembering to do vitamins, and the only way that has worked so far is having an alarm.

I also use alarms for weekly chores, like taking out the garbage and the recycling. Because we just moved, I’m not used to the schedule of refuse and recycling pickup. They come on different days, and on different weeks, so it is difficult for me to remember when I am used to the same day, each and every week. So I set up an alarm to go off just before I would normally head out for work, as a way to provoke myself to leave a little early and to take the trash out with me when I go. I may eventually get used to the habit and get rid of the alarm, but until I stop getting surprised from the alarm going off every other Wednesday, I’m keeping it. It saves me the stress of trying to figure out whether or not they are coming to pick up the garbage this Wednesday, or next, and it saves me from having to make a trip to the dump with my trash.

Monthly/Yearly Alarms

I think monthly tasks are the best suited for setting up alarms. They come infrequently enough that it is very difficult for them to become a habit or ritual. I set up alarms for monthly tasks like paying bills, or going over bank accounts. These are things that need to be done on time each and every month, but are often neglected or forgotten about. Setting an alarm will not only force you to remember, but will also guilt you into knowing that you no longer have a choice about whether or not to balance your chequebook. It’s that time of the month, it needs to be done. Missing a bill payment or two can really add up financially, so it is definitely in your best interest to make sure that you are always remembering to pay your bills on time. Setting up a specific alarm for the task may just be what you need in order to consistently get your bills paid on time.

Finally, I use alarms for yearly events like Birthdays/Anniversaries, setting up or updating a will, making changes to benefit plans, and the like. There are tons of things that can only be done once per year, and if you miss it or forget, you’ll probably end up paying for it more than just financially. I set up yearly alarms to remind me before it is too late so that I can take action.

Related Posts:

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Need A Reminder? Using Alarms to Save Money originally appeared on Canadian Finance Blog on October 12, 2011.

Find the Highest Interest Rate You Can Get

If you are placing your hard earned savings into a savings account that doesn’t give you the highest interest rate you can get, you are leaving money on the table and not giving your savings account the best chance it has to grow. Over the course of time, even small increases in the interest rate you receive can have a large impact on the amount your account will grow to.

With the Internet, it is easy to research and find the best interest rate for high interest savings. Online banks are typically able to offer higher interest rates because they have less overhead, but with a simple click of your mouse, you can peruse many banks to find out their minimum opening requirements and interest rates are as well and schedule of fees.

Try to find banks that offer savings accounts that compound the interest daily. Most banks only compound interest on a quarterly basis, so look around for a daily compounding bank.

Start Saving While You Are Young

The power of compound should be used to your advantage. The longer period of time you can save, the more powerful the compounding will be. If you can start saving while you are young, you can save large sums with relatively small deposits.

Make Regular Deposits Into Your Account

It is wonderful if you have a large amount of money to place into your savings right away, but that is not an option for most people. Saving money can seem difficult, but if you make small, regular deposits, it is easier to save than you think.

The best way to make regular deposits is to set up automatic withdrawals from your checking account and have the money sent to your savings account every month or on a weekly basis if you prefer.

Start with an amount you can handle, whether its $10 a week or $50 or $100 per month. You can always increase the amount later as you make more money. The key is be faithful to your savings plan and not to deviate from it.

Do Not Withdraw Money Out Of Your Savings Account

A savings account is meant to be left alone to grow. Resist temptation to treat your savings account like a checking account. After you put money in the savings account, do everything you can to not take the money out. One way to leave the money alone is to make a list of emergency situations that would warrant taking money out of the savings account. If a situation doesn’t appear on that list, then don’t take the money out of the savings account.

Avoid Paying Banking Fees

Be sure to always read and understand the terms and conditions of the account you choose to watch out for hidden fees. Some banks offer high rates of interest, but watch out for high fees that are imposed if your balance drops below a certain minimum level. Some banks may charge fees if you want paper statements or using other bank’s ATMs. Many banks charge maintenance fees every month. Be sure to avid fees that exceed what you make in interest.

Set a Budget and Stay Focused on Savings

Saving money and sticking to a budget go hand-in-hand. If you stay within your budget, it is easier to save money as planned. There are many websites and software tools that can help you set up a budget and save.

Many money experts recommend that you try to save ten percent of your income on a regular basis. Even if you can’t save ten percent, pick an amount you can respect and stick with it.

Even small amounts saved regularly can add up to large sums over a period of years. Speak with a financial advisor or your bank manager about the best option for your personal situation.

Related Posts:

• TFSA – Tax Free Savings Account
• What Should You Do With Your Tax Free Savings Account?
• What Is Simple Interest and Compound Interest?

Tips For Growing Your High Interest Savings Account originally appeared on Canadian Finance Blog on October 1, 2011.

If you’ve ever applied for a car loan, one of the items you look at first is the interest rate. We all understand that the higher the interest rate, the more money we will pay in the end but let’s look at a few other facts about interest rates that you may not know.

Simple interest is not as SIMPLE as you think

Simple interest is the easiest type of interest to understand. If you loaned a buddy $100 and told him that when he pays you back, he has to pay you $106, you charged him 6% on the loan. In finance terms, simple interest is calculated by multiplying the principal amount (100) times the rate (6%) times the amount of time (let’s say 1 year) 100 X .06 X 1 = $6. Pretty easy.

Banks are much more savvy than that, though. They aren’t going to give you $10,000 for a car and charge you 6% each year spread equally between interest and principal. They front load the interest in case you pay the $10,000 off early. If you looked at the amortization table that came with your loan documents you noticed that more interested is factored in to the first few years of the loan and as you reach the end, it becomes almost all principal.

This is far from “simple” and if you saw the calculations, you would agree. If you didn’t know what an amortization table was before now, just remember that it lays out how your total payment is broken down. If you want to see how interest is frontloaded in your loan, you can create your own amortization table by going to www.amortization-calc.com.

If you own certain fixed income investments the interest being paid to you is paid using a simple interest formula. You can reinvest your dividends (called the coupon) if you would like but it’s not compounded within the investment itself.

Compound interest IS SIMPLER than you think

Compound interest is more difficult to calculate and for most of our purposes, the way it is calculated isn’t overly important. Since there is a seemingly endless supply of compound interest calculators, we won’t worry about the particulars but here’s what you need to know when you’re shopping around: Unless you’re working with six figure numbers, the type of compounding is unimportant. Let’s look at an example:

I found a compound interest rate calculator at webmath.com and came up with these figures:

Let’s say that you have $50,000 in a 1 year Guaranteed Investment Certificate at 5% interest that is compounded monthly. After one year you will have in your account $52,558.09.

Now, let’s say that you have that money in a GIC from a different bank but the interest is compounded daily. After one year you will have in your account $52,563.37.

Although many unknowing consumers find themselves comparing the different types of compounding, in reality, it makes very little difference. Some may argue that if you’re investing in GICs for 30 years that $5 difference adds up. It’s true. Over 30 years that would be about $674 but once 30 years of inflation eats in to it, that $674 is far less impressive.

Look at the “Y” instead of the “R”

When comparing loan rates, don’t look at the APR. The APR or annual percentage rate is the amount of money you would pay or receive if the interest was calculated using simple interest. Since the APR doesn’t account for any compounding, look at the APY or annual percentage yield. The APY takes into account the type of compounding used.

For example, if a car dealership offered to finance a $10,000 loan at a 5% APR, you could go to another dealership and get the same APR but pay those couple of dollars more per year because of the compounding. A $10,000 loan at 5% compounded daily has an APY of 5.13% but if it is compounded monthly the APY is 5.12%. (By the way, the difference annually is all of $1.05)

Don’t Count on Compounding

If you’re investing, there’s no doubt that when you reinvest your returns over time, compounding does wonders for your portfolio. You can’t live on your RRSP contribution alone for entire retirement so you have to rely on compounding to grow your nest egg.

However, you can’t use compounding as an excuse to not take an active part in the management of your retirement plan. If the world markets have another meltdown, compounding isn’t going to save you if you’re close to retirement. Make sure you have a qualified and more importantly, approachable investment advisor.

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What Is Simple Interest and Compound Interest? originally appeared on Canadian Finance Blog on September 12, 2011.