Good Debt vs Bad Debt: Key Characteristics

Not all debt is bad! The specific definitions of good debt vs bad debt will vary from person to person. For people who plan to retire very early and live on a limited income or for people who know that they have a hard time paying their bills either for lack of money or organization skills, most debt is likely to be problematic.  For other people, taking on debt is less of an issue.

One of my followers was thinking of expanding his business and was concerned that taking on debt would be harmful. As part of helping him with his thinking, I identified general characteristics that distinguish good debt vs bad debt. He ended up selling his business instead of expanding it, but I am sharing my insights in this post. These characteristics may not apply to your particular situation, so be sure to think about them in the context of your own situation and temperament.

Characteristics of Bad Debt

Here are five characteristics of debts that I would consider bad.

You Don’t Understand the Terms

Loans and other sources of borrowing, such as credit cards, all have different terms. It is important that you understand the terms of your debt. For example, some loans, mortgages in particular, have adjustable rates. That is, the interest rate that you pay on your loan will change as a benchmark interest rate changes. If the benchmark interest rate increases, your loan payments will also increase.

Credit cards also can have interest rates that change. A teaser rate is an interest rate that applies to credit card debt for the first several months to a year. After that initial period, the interest rate charged on credit card debt can be very high.

Another example of a loan provision that can be problematic is a balloon payment. Some loans, including some mortgages in the US and many mortgages in Canada, have balloon payment provisions. For the initial period of time (often five years for Canadian mortgages), you make payments on your loan as if you were re-paying the loan over 30 years. However, at the end of the fifth year, the entire balance of the loan is due. The Canadian mortgage I reviewed requires the lender to re-finance the loan at the end of the fifth year, but at an interest rate that reflects the then-current interest rate environment and your then-current credit rating. In effect, that loan has an adjustable interest rate that depends not only on a benchmark interest rate but also changes in your credit score.

I consider any debt for which you don’t fully understand the terms, best avoided by reading the entirety of the loan document, as bad debt.

You Can’t Afford the Payments

When you enter into a loan agreement, you will be provided with the amount and timing of loan payments. With credit cards, the payments are usually due monthly and are a function of how much you charge and the card’s interest rate. Any debt that has payments that don’t fit in your budget is bad debt.   I would even take it one step further and say that any debt that has payments so high that you aren’t able to save for emergencies, large purchases and retirement is bad debt.

High Interest Rate

Some types of debt, such as credit cards and payday loans, have very high interest rates. The definition of a high interest rate depends on the economic conditions. Currently (around 2020), I would say any interest rate of more than 8% to 10% is high. By comparison, when I was young in the early 1980s, the interest rate on a 10-year US Government bond was more than 15% and mortgage rates were even higher.

If you have debt with high interest rates, you will be better off re-paying them as quickly as possible as you can’t earn a high enough investment return on any excess savings to cover the interest cost. That is, the investment return you can earn on the money, especially after tax, is going to be less than the interest rate you pay on the debt. In that case, it doesn’t make financial sense to invest any excess cash but rather you will be better off by using any excess cash to pay off the debt.

Depreciating Collateral

In many cases, debt is used to purchase something large, such as a boat, a home or a car. When you make a large purchase, the item you bought is considered collateral and the lender can take the collateral if you don’t make your loan payments.

The value of some items goes down (depreciates) faster than the principal of the loan. If you default on your payments when that happens, the lender is allowed to make you pay the difference. Determining whether your purchase is something that will retain its value or will depreciate quickly is a good test of whether it is financially responsible to use debt to make the purchase. If not, I would consider the purchase a poor use of debt.

No Long-Term Benefit

Many other purchases for which debt, such as credit cards and payday loans, is used have no long-term benefit. For example, if you buy a knick-knack for your home with a credit card and don’t pay the balance when the credit card is due, you will be paying interest for something that has no long-term benefit to you. I consider using debt for items or experiences with no long-term benefit to be bad.

There is a gray area. If you use debt to buy clothes that are required for your job, the clothes themselves don’t have a long-term benefit, but they could be considered as creating the ability to go to work and earn money.   As such, while I would normally consider clothes as a poor use of debt, I can see how work clothes that allow you to increase your income might need to be financed for a month or two on a credit card.

Characteristics of Good Debt (vs Bad Debt)

The first requirement of good debt is that it doesn’t have any of the characteristics of bad debt. That is, good debt:

  • Has terms you fully understand.
  • Fits in your budget, especially if your budget also includes saving for retirement, large purchases and an emergency fund.
  • Is one that has a reasonable interest rate.
  • Isn’t backed by depreciating collateral.
  • Is used for something with long-term benefit.

There are many ways in which a debt can create a long-term benefit. I’ve mentioned buying clothes required for a job that allows you to earn money, in particular a lot more money than the cost of paying off the debt.

Your Primary Residence

Most people borrow, using a mortgage, to purchase a home.   The market values of homes generally increase over long periods of time, though there are periods of times when the market values of homes decrease. In addition, there are a lot of carrying costs of owning a home, such as insurance, property taxes, maintenance and repairs. However, by owning a home, you don’t have to pay rent which, in theory, covers all of the costs of home ownership.

I think that buying a house is a good use of debt as long as the mortgage meets all of the criteria identified above. Although not specifically related to the use of debt, you might want to think carefully about buying a home (with or without debt) if you plan to live in it for only a short period of time. The transactions costs of buying and selling a home are high and you increase the likelihood that the value of the house will decrease if you own it for only a few years.

Your Car

Using debt to buy a car is also quite common. If you are using the debt to cover the cost of your only mode of transportation and you need it to get to work, it can be a good use of debt. Again, you’ll want to check that it has the other characteristics of good debt identified above.   Using debt to buy a car that is more expensive than you need or leads to loan payments that are higher than you can afford is not as good a use of debt.

Your Education

Many people use student loans to pay for college. From an economic perspective, student loans can be either good or bad. The criteria for evaluating the student loans are:

  • Will the increase in your wages will cover your loan payments?
  • Will you earn enough after graduation to allow the loan payments to fit in your budget?

For example, let’s say you can earn $30,000 a year if you don’t go to college and $40,000 if you get a degree. If you borrowed $50,000 a year for four years at 5% with a 10-year term, your payments would be more than $25,000 per year.

First Criterion

Over the term of the loan, your increase in wages ($10,000 per year) is less than your loan payments. Over your working life time, the return on your investment in your student loans is about 3.5%. The return on investment is positive, so the use of debt could be justified using the first criterion.

Second Criterion

It might be very difficult to cover the $25,000 of annual student loan payments on annual wages of $40,000 a year. If you are willing and able to live on $15,000 a year until your student loans are re-paid, they could be considered a good investment economically.

A smaller amount of debt or a larger increase in salary will improve the economic benefit of student loans. If you are considering student loans to finance your education, you’ll want to look at their economic costs and benefits carefully.

Your Business

When you start your own business, you often need to invest in one or more of equipment, inventory or a place to run your business.  Many people borrow money to make these initial investments. Starting a profitable business can be a very good use of debt, as it provides you the opportunity to increase your net worth. However, 30% of businesses fail in the first year and 50% fail in five years, according to the Small Business Administration, as reported by Investopedia. If you borrow money to start a small business and it fails, you will often still be liable for re-paying the debt, depending on whether you had to personally guarantee the loan or if the business was able to procure the loan.

There are at least a couple of ways you can use “debt” to invest.

Don’t Pre-Pay Your Debt

The most common way to use debt to invest is to invest extra money rather than using the money to pre-pay your mortgage or other debt. Whether it is good or bad to use this “debt” to increase your investing depends on several factors and your financial situation:

  • The longer the term on your debt, the better the choice is to invest instead of pre-paying your debt. If your loan payments only extend over a year or two, it is more likely that your investments will lose money making you worse off than if you pre-paid your loan. Over long periods of time, your investment returns are more likely to be positive.
  • The lower the interest rate on your debt, the better the choice it is to invest instead of pre-pay your debt. If the interest rate on your debt is higher than you can expect to earn on the investments you would buy (after considering income taxes), you will almost always be better off pre-paying your loan. If your interest rate is low, e.g., less than 3% or 4%, you are more likely to earn more in investment returns than the interest cost on your debt.
  • You have another source of income to make your loan payments if your investments decrease in value. For example, if you were planning to retire in the next few years, pre-paying your debt is more likely to be a better decision than investing. On the other hand, if you plan to have other sources of income besides your investments for the next 10 or more years, you might be better off investing rather than pre-paying your debt.

Investing on Margin

Another way you can use debt to invest is to buy your investments on margin. Under this approach, you borrow money from the brokerage (or similar) firm to buy your investments using your existing invested assets as collateral. In many cases, you can borrow up to 50% of the value of your existing assets. So, if you have $100,000 of stocks, you could borrow $50,000 to make additional investments.

The drawback of buying investments on margin is that the lender can make you re-pay the loan or a portion of it as soon as the value of the assets you own (the $100,000 of stocks in my example) decreases to less than twice the amount you’ve borrowed. Unfortunately, the amount you borrowed may have decreased in value at the same time while the amount you borrowed as stayed constant. As such, buying investments on margin is considered very risky and should be done only by people who fully understand all of its ramifications.

Final Thoughts on Good Debt vs. Bad Debt

Debt, when used carefully, can greatly improve your life and your ability to earn money. However, if you take on too much bad debt, it can lead to significant financial problems. This post has provided a framework to help you decide whether any debts you have or are considering are likely to be good debt vs bad debt.

Picking Stocks

Picking Stocks in Companies You Know

Our Kids’ Choices

  • Microsoft
  • John Deere
  • Canadian Pacific Railway
  • Canadian National Railway
  • ASV – a company that makes skid-steer loaders.

  • Apple
  • Nordstrom
  • JC Penney
  • Target
  • One other company that I don’t recall.

How it Turned Out

Don’t Invest in What You Don’t Understand

One Example of My Choices

Ten Baggers

Do Your Research

Once you’ve identified a company with an appealing product or service, it isn’t time to buy yet! Lynch suggests looking at the company’s financial statements and several financial metrics. I’ll talk about a few of them here.

Percent of Sales

Future Earnings

Ways to Increase Earnings

He identifies the following five ways for increasing earnings:

  • Reduce costs
  • Raise prices
  • Expand into new markets
  • Sell more product to existing markets
  • Revitalize, close or otherwise dispose of losing operations

Expanding into New Markets

Berkshire Hathaway

General Electric

P/E Ratio

Debt/Equity Ratio

Other Metrics

Create Your Story

Two-Minute Story

Additional Details

Final Thoughts

[2] Taken from Yahoo Finance on November 8, 2019

[3] General Electric 2008 Annual Report,, p3.

Investing for Dividends

Investing for dividends is one of many strategies investors use to identify stocks for their portfolios. Among the strategies I identified in my post on what you need to know about stocks, this is not one that I have ever used.  So I reached out to one of my Twitter followers who uses it to get more information, Dividend Diplomats (aka Lanny and Bert) to get some real-life insights. With Lanny’s and Bert’s help, I will:

  • define dividends.
  • talk about the criteria that Lanny and Bert use for selecting companies and why they are important.
  • show some historical returns for dividend-issuing companies.
  • explain the tax implications of dividends on your total return.

What are Dividends?

A dividend is a cash distribution from a company to its shareholders. The amount of the dividend is stated on a per-share basis.  The amount of cash you receive is equal to the number of shares you own times the amount of the dividend. When companies announce that they are going to pay a dividend, they provide two dates.  The first is the date on which share ownership is determined (also known as the ex-dividend date).  The second is the date on which the dividend will be paid. For example, a company might declare a 15₵ dividend to people who own shares on May 1 payable on May 15. Even if you sell your stock between May 1 and May 15, you will get 15₵ for every share you owned on May 1.

When a company earns a profit, it has two choices for what to do with the profit. Under one option, the company can keep the profit and use it to support future operations. For example, the company might buy more equipment to allow it to increase the number of products is makes or might buy another company to expand its operations. Under the second option, the company distributes some or all of its profit to shareholders as dividends. My experience is that companies that are growing rapidly tend to keep their profits, whereas companies that can’t find enough opportunities to reinvest their profits to fund growth tend to issue dividends.

Dividend Diplomats – A Little Background

Lanny and Bert have been blogging for over 5.5 years and have been best friends for 7.  They both are pursuing the same goal of reaching financial freedom and retiring early to break the “9 to 5” chains.  They hope to achieve financial freedom through dividend investing, frugal living, and using as many “personal finance” hacks as possible to keep expenses low and bring in additional income. For more information about the Dividend Diplomats, check out their web site at

Why Use the Investing for Dividends Strategy

As you’ll see in future posts, I have used several strategies for my stock investments, but have never focused on investing for dividends.

My Preconceived Notions

I have always considered investing for dividends as most appropriate for people who need the cash to pay their living expenses, such as people who are retired. I am retired, but currently have cash and some bonds that I use to cover my living expenses. As I get further into retirement, I will need to start liquidating some of my stocks or start investing for dividends.

Lanny’s & Bert’s Motivation

So, when I started reading about Lanny and Bert, I wondered why people who are still working (and a lot younger than I am) would be interested in investing for dividends.   Here’s what they said.

“There were a few different motivating factors.

Lanny had endured a very difficult childhood, where money was always limited and his family had struggled financially.   Due to this, he personally wanted to never have to worry about money, period.

Bert was not a dividend growth investor until he met Lanny.  Once he talked to Lanny, learned about dividend investing, and saw the math, he was sold and hasn’t looked back since.

Therefore, we are looking to build a growing passive income stream so we can retire early and pursue our passions.  Building a stream of growing, truly passive dividend income has always been a very attractive option to us.  We love the fact that dividend income is truly passive (outside of initial capital, we don’t have to lift a finger) and we are building equity in great, established companies that have paid dividends throughout various economic cycles.

Second, the math just makes sense.  It is crazy how quickly your income stream grows when you are anticipating a dividend growth rate of 6%+ (on average).  Lanny writes an article each quarter showing the impact of dividend increases and we have demonstrated the impact of dividend reinvesting on our site in the past. When you see the math on paper, it is insane. “

Lanny and Bert provided links to a couple of their posts that illustrate the math: Impact of Dividend Increases and Power of Dividend Reinvesting.

Lanny’s & Bert’s Strategy

Lanny and Bert developed a dividend stock screener that helps them identify undervalued dividend growth stocks in which to consider investing.  At a minimum, the companies must pass three metrics to be further considered for investment:

  • Valuation (P/E Ratio) less than the market average.
  • Payout Ratio Less than 60%. (Unless the industry has a higher benchmarked figure. i.e. oil, tobacco, utilities, REITs, etc., then they compare to the industry payout ratio.)
  • History of increasing dividends.

They don’t consider dividend yield until later in the process.  They never advocate chasing dividend yield at the risk of dividend safety. That is, they would rather a dividend that has very low risk of being reduced or eliminated (i.e., safety) than a higher dividend be unsustainable over the long term.

That’s why they don’t look at yield initially.  It allows them to focus on the important metrics that help them gain comfort over the safety of the dividend.  Here is a link to their Dividend Stock Screener.

Payout Ratio

Lanny and Bert mention that that one of their key metrics is a payout ratio. A dividend payout ratio is the annual amount of a company’s dividend divided by its earnings per share.  For more about earnings per share, check out my post on reading financial statements.

A dividend payout ratio of less than 1 means that a company is retaining some of its earnings and distributing the rest. If the ratio is more than 1, it means that the company is earning less money than it is paying out in dividends.

I worked for a company that had a payout ratio of more than 1. When I first started working there, the company had more capital than it could use. The company was returning its excess capital to its shareholders through the high dividend. After several years, the company’s capital approached the amount it needed to support its business. If it had cut its dividend to an amount lower than its earnings, the stock price might have decreased significantly. Instead, the company was sold. Had the company not been sold, its shareholders might have had both a decrease in future dividend payments and a reduction in the value of their stock at the same time.  This double whammy (dividend cut at the same time as a price decrease) is a risk of owning a stock in a dividend-issuing company especially those with high dividend payout ratios.

Performance – Lanny and Bert’s View

Lanny and Bert are not assuming they can do better than management or the market.  As noted above, they tend to focus on companies with a dividend payout ratio less than 60%.  This approach allows for all three of increasing dividends to shareholders, share repurchases, and internal growth for profit.  Also, this approach ensures the company is continuing to invest in itself as well.  You can’t pay a dividend in the future if you can’t grow, or even maintain, your current earnings stream.  Therefore, if revenues are stagnant or shrinking, the safety of the company’s dividend comes into question.  Companies “can” pay out a dividend that is larger than your earnings over the short-to-medium term.  However, it is not sustainable as was the case with the company for which I worked.

Historical Performance

I was curious about how stocks that met Lanny and Bert’s criteria performed. I have a subscription to the ValueLine Analyzer Plus. It contains current and historical financial data and stock prices about hundreds of companies. I looked at two time periods.  I first looked at the most recent year (November 2018 to November 2019).  Because I was curious about how those stocks performed in the 2008 crash, I also looked at the ten-year period from 2003 to 2013. I would have used a shorter period around the 2008 crash and the period thereafter, but didn’t save the data in the right format so had to look at time periods for which I had saved the data in an accessible manner.

How I Measured Performance

For both time periods, I identified all stocks for which the data I needed for the analysis were available at both the beginning and end of the period.  There were 1,505 companies included in the sample in the 2018-2019 period and 952 companies for the 2003 to 2013 period.

I then identified companies (a) whose dividend grew in each of the previous two fiscal years, (b) whose dividend payout ratio was less than 60% and (c) whose P/B ratio was less than the average of all of the companies in the same. That is, I attempted to identify the companies that met Lanny and Bert’s criteria. There were 332 companies in the 2018-2019 period and 109 companies in the 2003-2013 period that met these criteria.

ValueLine ranks companies based on what it calls Timeliness, with companies with Timeliness ratings of 1 having the best expected performance and those having a rating of 5 having the worst expected performance. Because I suspected that Bert and Lanny’s screen would tend to select more companies with favorable Timeliness ratings than those with poorer ones, I looked at both the overall results, as well as the results by Timeliness rating.

November 2018 – November 2019

In the most recent year, the stocks that met Lanny’s and Bert’s criteria had an average total return (dividends plus change in stock price) of 11% as compared to 8.5% for the total sample. That is, in the current market, dividend issuing companies meeting their criteria returned more than the average of all companies.

Interestingly, when I stratified the companies by Timeliness rating, it showed that for companies with good Timeliness ratings (1 and 2), the Lanny’s and Bert’s companies underperformed the group. For companies with two of the three lower Timeliness ratings (3 and 5), though, Lanny’s and Bert’s companies not only did better than the average of all companies in the group, but also did better than even the group of companies with a Timeliness rating of 1! It looks to me as if their approach might identify some gems in what otherwise appear to be poorer performing companies.

The chart below shows these comparisons.

2003 to 2013

Over the longer time period from 2003 to 2013, the companies meeting Lanny’s and Bert’s criteria didn’t do quite as well as the average of all companies. In this case, the stocks meeting their criteria had a compound annual return of 5% as compared to 7% for all stocks in the sample. Without more data, it is hard to tell whether the difference in return is the sample of dividend-issuing companies is small, because those companies didn’t fare as well during the Great Recession or something else.

I looked at the total returns by Timeliness rating and the results were inconsistent for both the “all stocks” group and the ones that met our criteria. A lot can happen in 10 years! Nonetheless, it was interesting to see that the dividend-yielding stocks that had Timeliness ratings of 5 in 2003 out performed all other subsets of the data. So, while these stocks didn’t have quite as high a total return over the 10-year period in the aggregate, there are clearly some above-average performers within the group.

Tax Ramifications of Dividends

One of the drawbacks of investing in companies with dividends, as opposed to companies that reinvest their earnings for growth, is that you might need to pay taxes on the dividend income as it gets distributed.

Types of Accounts

If you hold your dividend-yielding stocks in a tax-deferred (e.g., Traditional IRA or 401(k) in the US or RRSP in Canada) or tax-free (e.g., Roth IRA or 401(k) in the US or TFSA in Canada), it doesn’t matter whether your returns are in the form of price appreciation or dividends. Your total return in each of those types of accounts gets taxed the same. That is, if you hold the stocks in a tax-deferred account, you will pay tax on your total returns, regardless of whether it is interest, dividends or appreciation, at your ordinary income tax rate. If you hold the stocks in a tax-free account, you won’t pay taxes on any returns.

The only type of account in which it matters whether your return is in the form of price appreciation or dividends is a taxable account. In the US, most people pay 15% Federal income tax plus some additional amount for state income taxes on dividends in the year in which they are issued. They pay taxes at the same rate on capital gains, but only when the stock is sold, not as the price changes from year to year. In Canada, the difference is even greater. Dividends are taxed at your ordinary income tax rate (i.e., they are added to your wages) and capital gains are taxed at 50% of your ordinary income tax rate and only when you sell the stock.

Dividend Reinvestment

When you earn dividends from a company, you often have the option to automatically reinvest the dividends in the same company’s stock. This process is a dividend reinvestment plan. Lanny and Bert take this approach.

Dividend reinvestment plans are terrific ways to make sure you stay invested in companies that you like, as you don’t have to remember to buy more stock when the dividend is reinvested. The drawback of dividend reinvestment plans is that you will owe tax on the amount of the dividend, even if you don’t receive it in cash. If you reinvest 100% of your dividends, you’ll need to have cash from some other source to pay the taxes unless you hold the investments in a tax-free or tax-deferred account.

Let’s assume you are a US investor subject to the 15% Federal tax rate and pay no state income tax. You have two companies you are considering. You expect each to have a total return of 8%. One company’s return will be 100% in dividends, while the other company issues no dividends. You plan to own the stock for 10 years. Your initial investment will be $1,000 and you will pay your income taxes out of your dividends, so you reinvest 85% of the dividends you earn each year.

At the end of the 10th year, you will have $1,931 if you buy the company with 8% dividends. If you buy the company with no dividends, your stock will be worth $2,159. After you pay capital gains tax of $174, you will have $1,985 or 2.8% more than if you buy stock in the company that issues 8% dividends.

If you pay Canadian taxes, the difference is even bigger because of the much lower tax rate on capital gains than dividends. Over the full ten-year period, you will end up with almost 11% more if you buy stock in the company with no dividends than if you buy stock in the dividend-issuing company.

As such, you’ll want to put as much of your portfolio of dividend-issuing stocks in a tax-deferred or tax-free account as possible to minimize the impact of taxes on your total return.

Reading Financial Statements

Reading financial statement guides many investors in their decisions to buy and sell stocks.   Investors who focus on financial fundamentals look at recent financial statements in the context of other trends to estimate how much a company’s future profit might grow.  High-dividend yield investors need to understand the company’s financial statements to evaluate the sustainability of current dividend payments into the future.

Before investing in the stock of individual companies, it is good to understand the basics of their financial statements. In this post, I’ll identify the important values in the income statement and balance sheet and discuss important ratios that investors use to evaluate financial performance.  This post provides the basics of how stocks work.  In future posts, I’ll illustrate how these values can be used to evaluate companies and their stock prices under different investment strategies.

Every company’s financial statements will be slightly different because every business is different. For illustration, I will use excerpts from the financial statements in the McCormick 2018 Annual Report. McCormick sells spices under its own name, but also owns the French’s mustard, Club House crackers and Lawry’s seasonings brands, among others. To be clear, my selection of McCormick for illustration is not intended to be a recommendation.

In this post, I’ll explain the key line items in McCormick’s financial statements.  If you are interested in other line items, you can either ask me in the comments or by e-mail or do some research on your own.

Income Statement

An income statement presents a summary of the financial aspects of a company’s operations and other financial transactions that occur during the financial reporting period. Publicly traded companies are required to provide their income statements to financial regulators (e.g., the Security & Exchange Commission in the US) quarterly and annually in reports known as the 10-Q and 10-K, respectively.

Here is a picture of the income statement from the McCormick 2018 Annual Report.[1]   All of the numbers in the excerpts from McCormick’s financial statements are in millions.

Revenue is the money that a company receives for the goods and services it delivered during the year.  As you can see in its income statement McCormick had $5.4 billion in total revenues (net sales) in 2018.

Expenses represents all the money that a company spends in the year, with one exception.

When the company purchases something that is expected to last for a long time, it is called a capital asset. Companies don’t include the full cost of capital assets in expenses in the year in which they buy them. Rather, they spread the costs of capital assets over several years. The amount spread to each year is called depreciation. The depreciation of capital assets is included on the Income Statement, not the actual cash expense.

Operating Expenses or Cost of Goods Sold

Operating expenses, sometimes called Cost of Goods Sold for sellers of products, are those that are directly related to the manufacture of products or provision of services sold in the year. For McCormick, these expenses were $3.0 billion in 2018.

General and Administrative (G&A) Expenses

G&A expenses, sometimes called overhead expenses, represent the cost to run the company and are not directly related to specific products or services. Some companies include research and development (R&D) expenses with G&A expenses while others show them separately. For McCormick, these expenses were about $1.4 billion, an amount I had to find in its Notes to Financial Statements.

Other Income/Expenses

There are many types of income and expenses that don’t relate to products and services and aren’t G&A expenses. These items are usually small relative to the other line items on the income statement. For McCormick, there are three line items that fall in the Other Income/Expenses category

  • Transaction and integration expenses of $22 million
  • Special charges of $16 million
  • Other income, net of $13 million

These amounts combine to a net total of $25 million (=$22 million + $16 million – $13 million) in 2018. Compared to the other revenue and expense items, all of which are measured in billions of dollars, these amounts are small, as expected.

Interest Expenses

Interest expense represents interest that the company pays on its debt.  McCormick’s had $175 million of interest expense in 2018.

Income Taxes

These expenses represent income taxes that the company pays to any federal, state or local governments. McCormick had a tax benefit of $157 million in 2018. By looking at the Notes to Financial Statements included in the Annual Report, I found that McCormick owed $183 million in taxes related to 2018 operations, but the reduction in the US Federal tax rate on corporations in early 2018 caused an adjustment to McCormick’s tax liabilities. The decrease in tax rate created a benefit of $340 million. The $157 million tax benefit on the income statement is equal to the $183 million for current operations offset by the $340 million reduction in future taxes. When looking at McCormick’s profits going forward, the $183 million of taxes for current operations is the more important number because the $340 million is a one-time adjustment.

Accrual Basis vs. Cash Basis

One of the hardest things for most people to understand about income statements is the difference between the values on the income statement and the cash the company receives and pays. The income statement is said to be on an “accrual” basis. Accrual amounts relate to goods and services delivered during the year, regardless of when the cash is actually received or paid.

To clarify, revenues on the income statement represent the amount of cash the company has or will receive for goods or services delivered in the year. If the company hasn’t received some of its compensation for goods or services by the end of the year, it creates an asset on its balance sheet for accounts receivable. If it receives the cash before it delivers the goods or services, it creates a liability for goods or services due to customers.

Similarly, the expenses on the income statement relate to the products or services delivered in the year. If a company has to pay for components of its products, for example, before it delivers them, it will create an asset on its balance sheet for inventory. If it hasn’t paid all of the bills related to products delivered in the year, it creates a liability on the balance sheet for accounts payable.

As you can see, many balance sheet items (discussed further below) are really differences between amounts accrued on the income statement and actual cash received or paid.

Measures of Profit

Companies have several measures of profit. They can be measured as either dollar amounts or percentages or revenues. In this post, I’ll put “%” after the type of profit when I’m referring to the profit as a percentage of revenue.

Gross Margin

The gross margin is calculated as revenues minus operating expenses. This line is labeled as “Gross profit” in the McCormick income statement. In 2018, McCormick’s gross margin was $2.4 billion and corresponds to 44% of revenues. It represents the amount of profit the company would have had if its only expenses were those directly related to products and services.

Operating Income

Operating income is calculated as the gross margin minus G&A expenses and some components of other income and expenses. For 2018, McCormick’s operating income was $903 million or 17% of revenues. It represents the amount of profit the company would have had if it didn’t have any interest expense or taxes. It is sometimes called EBIT or earnings before interest and taxes.

Pre-tax Income

Pre-tax income is calculated as operating income minus interest expense and some components of other income and expenses. For 2018, McCormick had $741 million of pre-tax income (also known as EBIT or earnings before income taxes) or 14% of revenues.

Net Income

Net income is the bottom-line profit after taxes. It is calculated as pre-tax income minus income taxes. For 2018, McCormick had net income of $899 million. Recall, though, that McCormick had a one-time benefit from the change in tax rate of $340 million, so its net income would have been $559 million on a “normalized” basis or 10% of revenues. This adjusted net income is a better value for estimating future profits, as McCormick won’t get the benefit of a tax rate change every year.

Other Comprehensive Income

There are some values that impact the net worth of a company that don’t appear in the calculation of net income, but rather appears either at the bottom of the Income Statement or on a separate schedule in the financials. These items are referred to as Other Comprehensive Income. They can include the impact of changes in foreign exchange rates, certain transactions or changes in valuation related to investments and changes in the value of pension plans. As with other income, Other Comprehensive Income is usually small relative to other values on the income statement. If it isn’t, you’ll want to read the Notes to Financial Statements to understand the sources of Other Comprehensive Income and how it might affect profitability and growth in the future.

Balance Sheet

A balance sheet shows everything that a company owns or is owed (assets) and owes (liabilities) on a particular date.  As I mentioned earlier that many balance sheet items represent the differences between what the company has accrued on its income statement and what it has actually paid or received in cash. The balance sheet also shows the difference between assets and liabilities, which corresponds to its net worth or shareholders’ equity.

Here is a picture of McCormick’s 11/30/18 balance sheet taken from its Annual Report.[2]

Assets represent the value of things the company owns and amounts it is owed. Current assets are assets that a company can sell and turn into cash within a year. They are usually reported separately on a balance sheet.

McCormick had $10 billion in total assets on November 30, 2018. As you can see, inventory was its largest current asset at $786 million. Inventory represents the amount already spent on products that are ready to be sold or are in the process of being manufactured.

McCormick’s largest assets overall are its $4.5 billion of goodwill and $2.9 billion of intangible assets. These assets appear on some companies’ financial statements but not others. As you look at the net worth of a company, you’ll want to understand these assets.

Goodwill is created when one company buys another for a price that is higher than the net worth of the acquired company. That difference between the price and the net worth is intended to represent the present value of future profits on the acquired business. Goodwill is generally reduced as the profits emerge. In 2017, McCormick’s bought RB Foods which includes the French’s mustard, Frank’s RedHot and Cattlemen’s brands. More than three-quarters of McCormick’s goodwill was created when it bought RB Foods.

In McCormick’s case, the intangible assets represent the value of its brand names and trademarks. Although not exactly correct, the amount can be thought of as the present value of the future profits McCormick thinks it will get as the result of owning the brand names and trademarks.

Liabilities represent money or the value of products or services a company owes to others. McCormick had $7.1 billion in liabilities on November 30, 2018. The largest of these liabilities was Long Term Debt of $4.1 billion. McCormick issued roughly $3.4 billion in debt to finance its acquisition of RB Foods in 2017.

Shareholders’ equity represents the difference between assets and liabilities. It represents what is known as the “book value” of the company. On November 30, 2018, Boeing’s shareholders’ equity was $3.2 billion.

Key Financial Ratios

When deciding whether to buy or sell stock in a company, there are a number of ratios that many investors consider. I’ve highlighted a few important ones in this section, using the McCormick financial statement excerpts from above for illustration. I note that I have used simplified versions of the financial statements and the calculations, so you will likely see published values for McCormick that differ a bit from those calculated here.

ROE or Return on Equity

Return on equity (ROE) can be approximated as Net Income for the year divided by Shareholders’ Equity at the beginning of the year. For McCormick, it is approximated for 2018 as the $899 million of net income divided by the $2,571 million of shareholders’ equity at the end of its 2017 fiscal year or 35%. That ROE is very high. Recall, though, that McCormick had a one-time tax benefit of $340 million in 2018. If we exclude that benefit as it won’t be repeated in the future, we get an adjusted ROE of 22%.

According to CSI Market[3], the average ROE for the total market for 2018 was around 13%. ValueLine, a source for lots of qualitative and quantitative information about companies, reports that the average ROE for companies in the food processing industry (in which McCormick falls) is about 15%.[4] As such, even McCormick’s adjusted ROE is higher than these averages.

P/E Ratio or Price/Earnings Ratio

The Price/Earnings or P/E ratio is the stock price divided by the earnings per share. McCormick had roughly 130 million shares of stock outstanding in 2018. As such, its earnings per share was about $7 (=$899 million/130 million shares). McCormick’s stock price on November 30, 2018 (the date of the financial statements) was $150, which corresponds to a P/E ratio of about 22.

According to ValueLine, the average P/E of companies in the food processing industry on October 31, 2019 was 23. By comparison, the average P/E for the market has been between 16 and 18 for the past year or so. As such, McCormick’s P/E is in line with its peers. If we adjust McCormick’s earnings to exclude the one-time tax benefit, its earnings per share would have been about $4.25 per share. When we divided the $150 stock price by this smaller number, the adjusted P/E is about 35 or much higher than its peers.

P/B Ratio or Price/Book Ratio

The Price/Book or P/B ratio is the stock price divided by shareholders’ equity (book value) per share. McCormick’s equity as of November 30, 2018 was $3,182 million. When divided by the number of outstanding shares, the book value per share was $24. The stock price divided by the book value is about 0.90. ValueLine indicates that the average P/B ratio on October 31, 2019 for the food processing industry was about 3.3 or much higher than McCormicks’ P/B ratio.

P/B Ratio > 1

When the P/B ratio is greater than 1, the difference between the stock price and the book value per share is the present value of future earnings estimated by investors. The higher the P/B ratio, the higher the value investors place on future earnings.

P/B < 1

When the P/B ratio is less than 1, it means that investors either think that the future earnings are going to negative (which doesn’t appear to be the case for McCormick) or they don’t think shareholders’ equity is fairly valued. In the case of McCormick, it could be that investors think that the goodwill and intangible assets might be overvalued or they might be concerned that the future reductions to income as the goodwill and intangible assets are reduced will have a significant adverse impact on earnings. If either of those is the case, investors may be adjusting the company’s book value (equity) in their analyses for their perceived overstatement of goodwill and intangible assets.

Within the group of investors who look at financial fundamentals for decision-making, there is a subset called “value investors.” Value investors look for companies whose stock price doesn’t full reflect the value of the company which is often determined by P/B ratios of less than 1.00. A value investor who was confident that McCormick could maintain its current profitability and that the company had fairly estimated its goodwill and intangible assets might find McCormick to be an attractive stock.

Debt-to-Equity Ratio

Both debt and equity are ways in which a company can get money to finance their operations – either when it issues bonds or new shares of stock. The sum of the two is sometimes called total capital.

The Debt-to-Equity ratio is the amount of long-term debt divided by shareholders’ equity and is a measure of the mix the company has chosen to use for financing its operations, growth or acquisitions. McCormick has a total of $4.1 billion of debt ($4.05 billion recorded as long-term debt plus $84 million reported as the portion of long-term debt on its balance sheet). The debt-to-equity ratio is 1.30 (=4.1/3.2).

The higher the debt-to-equity ratio, the more leveraged a company is said to be. To clarify, when there is a lot of leverage, its ROE will be much higher than if some or all of the debt were equity instead. For example, McCormick’s ROE for 2018 was 35%. If all of its debt had been equity instead, its ROE would have been 13% (=$899 million/[$3.2 billion + $4.1 billion]).   The opposite it true when a company has a negative ROE. If McCormick’s ROE in 2018 had been -10% based on its current leverage, it would have been only -4% if it had only equity capital instead of its current mix of debt and equity.

Tangible Equity/Total Equity

I wasn’t planning to talk about tangible equity in this post, but my choice of McCormick almost forces me to. If you recall, I pointed out earlier in this post that McCormick’s two biggest assets are Goodwill and Intangible Assets. If a company encounters financial difficulties, it sometimes has to reduce or write-off the value of any goodwill or intangible assets. When these assets are reduced, its total equity will be reduced by the same amount, after adjustment for income taxes. In addition, goodwill and intangible assets are reduced as the future profits are expected to be earned. As such, goodwill and other intangible assets cause future net income to be lower than it would otherwise be, even if there are no write-offs.

Tangible equity is equal to total equity minus goodwill minus intangible assets. Because these assets can’t be quickly turned into cash and can have their value reduced, many investors look at ratio of tangible equity to total equity. The total of McCormick’s goodwill and intangible assets was $7.4 billion. This amount is more than twice its shareholders’ equity. What this means is that McCormick’s book value would become negative if it were required to write-down more than half of its goodwill and intangible assets.  As long as everything goes as expected, though, McCormick will be just fine. As such, this ratio is a measure of the riskiness of the stock price.

Earnings Growth Rate

Another important metric that investors consider is the earnings growth rate. When considering when to buy a stock, investors try to estimate future earnings growth rates. In the estimation process, they often consider historical growth rates. The historical earnings growth rate is the ratio of this year’s net income to last year’s net income minus 1.00.

For McCormick, after adjustment for the one-time tax benefit, the earnings growth rate from 2017 to 2018 was 25% (=$559 million / $444 million – 1). From 2016 to 2017, it was a much more modest 2%.

Stock prices tend to reflect estimated future earnings as well as estimated future earnings growth rates. There are many investment analysts who estimate the future earnings growth rates for publicly-traded companies. Yahoo Finance and most large brokerage firms’ web sites include information about analysts’ estimates of future earnings growth rates. Also, some investors look at recent growth rates and trends in the markets in which companies operate to estimate the future earnings growth rates.

Investing Decisions

These ratios, along with others, are often used by investors to evaluate the financial condition of the company and the reasonableness of its stock price. For example, one rule of thumb is that stocks are fairly priced when the P/E ratio is less than the expected future earnings growth rate. I’ll take about this rule of thumb and other decision criteria in future posts in my series on investing in stocks.

[1], 2018 Annual Report, p50.

[2], 2018 Annual Report, p. 51.

[3], November 7, 2019

[4] ValueLine Investment Analyzer, October 31, 2019.

What You Need to Know About Stocks

  • Stocks and how they work.
  • The price you will pay.
  • The risks of owning stocks.
  • Approaches people use for selecting stocks.
  • How stock are taxed.
  • When you might consider buying stocks.
  • How to buy a stock.

What are Stocks?

Stocks are ownership interests in companies.  They are sometimes called equities or shares.  When you buy a stock, you receive a certificate that indicates the number of shares you own.  If you buy your investments through a brokerage firm, it will hold your certificates for you.  If you buy them directly, you will usually receive the certificate (and will want to maintain it in an extremely safe place as it is your only proof that you own the stock).  Some companies track their stock’s owners electronically, so you may not always get a physical certificate.

How Do Stocks Work?

Companies sell stock as a way to raise money.  The company receives the amount paid for the shares of stock when they are issued, minus a fee paid to the investment banker that assists with the sale.  The process of issuing stock is called a public offering.  The first time a company offers its shares to the public, it is called an initial public offering (IPO).

Stockholder-Company Interactions

After the stock has been sold by the company, the stockholder has the following interactions with the company:

  • It receives any dividends paid by the company.
  • It gets to vote on matters brought before shareholders at least annually.  These issues include election of directors, advisory input on executive compensation, selection of auditors and other matters.
  • It has the option to sell the stock back to the company if the company decides to repurchase some of its stock.

In addition to these benefits of owning stock, you also can sell it at the then-current market price at any time.

Why Companies Care About Their Stock Prices

Interestingly, after the stock has been sold by the company, future sales of the stock do not impact the finances of the company other than its impact on executive compensation.  That is, if you buy stock in a company other than when it is issued, you pay for the stock and the proceeds go to the seller (who isn’t the company)!

You might wonder, then, why a company might care about its stock price.  That’s where executive compensation comes in!  Many directors and senior executives at publicly traded companies have a portion of their compensation either paid in stock or determined based on the price of the company’s stock.  When the leadership owns a lot of stock or is paid based on the stock price, it has a strong incentive to act in a way that will increase the price of the stock.  As such, with appropriate incentive compensation for directors and executives, their interests are more closely aligned with yours (i.e., you both want the price of the company’s stock to go up).

What Price Will I Pay?

The price you will pay for a stock is the amount that the person selling the stock is willing to take in payment.  Finance theory asserts that the price of a stock should be the present value of the cash flows you will receive as the owner of a stock.

In my post on bonds, I explain present values.  They apply fairly easily to the price of a bond, as the cash flows to the owner of a bond are fairly clear – the coupons or interest payments and the return of the principal on a known date.

By comparison, the cash flows to the owner of a stock are much more uncertain.  There are two types of cash flows to the owner of a stock – dividends and the money you receive when you sell the stock.

Dividends are amounts paid by the company to stockholders.  Many companies pay dividends every quarter or every year.  In most cases, the amount of these dividends stay fairly constant or increase a little bit every year.  The company, though, is under no obligation to pay dividends and can decide at any time to stop paying them.  As such, while many people assume that dividends will continue to be paid, there is more uncertainty in whether they will be paid than there is with bond interest.

Proceeds from the Sale of the Stock

The owner of the stock will receive an amount equal to the number of shares sold times the price per share at the time of sale.  This cash flow has two components of uncertainty to it.

  1. You don’t know when you will sell it. You therefore don’t know for how long you need to discount this cash flow to calculate the present value.
  2. It is impossible to predict the price of a stock in the future.

What are the Risks?

The biggest risk of buying a stock is that its value could decrease.   At the extreme, a company could go bankrupt.  In a bankruptcy, creditors (e.g., employees and vendors) are paid first.  If there is money left after creditors have been paid, then the remaining funds are used to re-pay a portion of any bond principal.  By definition, there isn’t enough money to pay all of the creditors and bondholders when there is a bankruptcy.  As such, the bondholders will not get all of their principal re-paid and there will be no money left after payment has been made to bondholders and creditors.  When there is no money left in the company, the stock becomes worthless.

Any of the following factors (and others) can cause the price of the stock to go down.

Economic Conditions Change

Changes in economic conditions can cause the interest rate used for discounting in the present value calculation to increase. When the interest rate increases, present values (estimates of the price) will go down.

Company Changes

Something changes at the company that causes other investors to believe that the company’s profits will be less than previously expected. One simple way that some investors estimate the price of a company’s stock is to multiply the company’s earnings by a factor, called the price-to-earnings ratio or P/E ratio.  Although P/E ratios aren’t constant over time, the price of a stock goes down when its earnings either decrease or are forecast to be lower than expected in the future. For more about P/E ratios and how a company calculates and reports on its earnings, check out this post

Increased Risk

Changes either in the economy or at the company can cause investors to think that the future profits of the company are more uncertain, i.e., riskier. When a cash flow is perceived to be riskier, a higher interest rate is used in the present value calculation.  This concept is illustrated in my post on bonds in the graph that shows how interest rates on bonds increase as the credit rating of the company goes down.  Recall that lower credit ratings correspond to higher risk.  The same concept applies to stock prices.  The prices of riskier stocks are less than the prices of less risky stocks if all other things are equal.

How Do People Decide What to Buy?

There are a number of approaches investors use to decide in which companies to buy stocks and when to buy and sell them.   I will discuss several of them in future posts.

Reasonable Price Investing

Reasonable price investors look at the financial fundaments and stock prices of companies to decide whether and when to buy and sell them.

Technical Analysis

Technical analysts, sometimes called momentum investors, look at patterns in the movement of the prices of companies’ stocks.  Day traders tend to be technical analysts whose time horizon for owning a stock can be hours or days.

High-Yield Investing

Some investors focus on companies who issue dividends.

Mutual Funds and Exchange-Traded Funds (ETFs)

Rather than invest in individual companies, some investors purchase either mutual or exchange-traded funds.  Under this approach, the investor relies on the fund managers to select the companies and determine when to buy and sell each position.

How are Stocks Taxed?

There are two ways in which stocks can impact your income taxes:

  • When you receive a dividend.
  • When you sell your ownership interest in the stock.

The total amount of the dividend is subject to tax.  The difference between the proceeds of selling the stock and the amount you paid for the stock is called a realized capital gain or loss.  It is gain if the sale proceeds is more than the purchase amount and a loss if the sale proceeds are less than the purchase amount.

In the US, realized capital gains and losses on stocks you have owned for more than a year are added to dividends.  For most people, the sum of these two amounts is taxed at 15%.  For stocks owned for less than a year, the realized capital gains are taxed at your ordinary tax rate (i.e., the rate you pay on your wages).

In Canada, dividends and half of your realized capital gains are added to your wages.  The total of those amounts is subject to your ordinary income tax rate.

When Should I Buy Stocks?

Understand Stocks

The most important consideration in determining when to buy stocks is that you understand how stocks work.  One of the messages I wished I had given our children is to invest only in things you understand.  If you don’t understand stocks, you don’t want to invest in them.

Understand the Companies or Funds

You also want to make sure you understand the particular company or fund you are purchasing.  One of the biggest investing mistakes I made was when I was quite young and didn’t understand the business of the company whose stock I owned.

My parents gave me some shares of a company called Wang Laboratories.  In the 1970s and early 1980s, Wang was one of the leaders in the market for dedicated word processors.  Picture a desktop computer with a monitor that’s only software was Microsoft Word, only much harder to use.  That was Wang’s biggest product.  At one time, the stock price was $42.  Not understanding that PCs were entering the market and would be able to do so much more than a dedicated word processor, I was oblivious.  As the stock started going down, I sold a few shares in the high $30s.  When the stock dropped to $18, I told myself I would sell the rest when it got back to $21.  It never did.  A year or so later, the stock was completely worthless. Fortunately, I was young enough that I had a lot of time to recover and learn from this mistake.

Be Willing and Able to Understand the Risks

You should also not buy stocks if you can’t afford to lose some or all of your principal.  Even though only a few companies go bankrupt, such as Wang, the price of individual stocks can be quite volatile.  As discussed in my post on diversification, you can reduce the chances that your portfolio will have a decline in value by either owning a large number of stocks or owning them for a long time.  Nonetheless, you might find that the value of your portfolio is less than the amount you invested especially over short periods of time when you invest in stocks.  If you want to invest in stocks, you need to be willing to tolerate those ups and downs in value both mentally and financially.

Market Timing

There is an old investing adage, “Buy low, sell high.”  In principle, it is a great strategy.  In practice, though, it is hard to identify the peaks and valleys in either the market as a whole or an individual stock.

People who invest over very short time frames – hours or days – often use technical analysis to try to identify very short-term highs and lows to create gains.  I anticipate that most of my followers, though, will be investing for the long term and not day trading.  While you will want to select stocks that are expected to produce a return commensurate with their riskiness, it is very difficult to time the market.

That is, my suggestion for new investors with long-term investment horizons (e.g., for retirement or your young children’s college expenses) is to buy stocks or mutual funds you understand and think are likely to appreciate whenever you have the time and money available to do so.  If you happen to buy a fundamentally sound stock or index fund just before its price drops, it will be difficult to hang on but it is likely to increase in the price by the time you need to sell it.

As Chris @MoneyStir learned when he reviewed the post I wrote about whether he should pre-pay his mortgage, a fall in the stock market right after he started using his extra cash to buy stocks on a monthly basis was actually good for him!  While he lost money at first on his first few month’s investments, the ones he made over the next several months were at a lower stock price and produced a higher-than-average return over his investment horizon.  The process of buying stocks periodically, such as every month, is called dollar-cost averaging.

How and Where Do I Buy Stocks?

You can buy stocks, mutual funds and ETFs at any brokerage firm.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

Once you have an account, you need to know the name of the company or its symbol (usually 2-5 letters that can be found using Google or Yahoo Finance, for example), how many shares you want to buy and whether you want to set the price at which you purchase the stocks or buy them at the market price.

Limit Orders

If you determine you want to buy a stock at a particular price, it is called a limit order.  The advantage of a limit order is you know exactly how much you will pay.  The disadvantages of a limit order are:

  • You might pay more than you have to if the stock price is lower at the time you place your order.
  • You might not buy the stock if no one is interested in selling the stock at a price that is a low as your desired purchase price.

Market Orders

If you place a market order, you will buy the stock at whatever price sellers are willing to take for their stock at the moment you place your order.  In some cases, you may end up paying more than you want for a stock if the price jumps up right at the time you place your order.  The advantages of a market order are (1) you know you will own the stock and (2) you know you are getting the best price available at the time you buy the stock.

Transaction Fees

Many of the major brokerage firms have recently announced that they will no longer charge you each time you purchase or sell a stock.  Some firms charge you small transaction fees, such as $4.95, each time you place a buy or sell order.  Other firms have higher charges.  You’ll want to consider the fees when you select a brokerage firm.

Annual Retirement Savings Targets

Once you know how much you want to save for retirement, you need a plan for building that savings.  Your annual retirement savings target depends on your total savings target, how many years you have until you want to retire and how much risk you are willing to take in your portfolio.  In this post, I’ll provide information you can use to set targets for how much to contribute to your retirement savings each year.

Key Variables

There are several variables that will impact how much you’ll want to target as contributions to your retirement savings each year.  They are:

  • Your total retirement savings target.
  • How much you already have saved.
  • The number of years you are able to contribute to your retirement savings.
  • How much risk you are willing to take in your portfolio.
  • The impact of taxes on investment returns between now and your retirement. That is, what portion of your retirement savings will be in each of taxable accounts, tax-deferred retirement savings accounts and tax-free retirement savings accounts.  For more information on tax-deferred and tax-free retirement savings accounts, check out this post.  I provide a bit more insight on all three types of accounts in these posts on how to choose which assets to buy in which type of account in each of the US and Canada.

Some of these variables are fairly straightforward.  For example, you can check the balances of any accounts with retirement savings that you already have and you can estimate (within a few years, at least) how many years until you retire.

Other variables are more challenging to estimate.  For example, I dedicated a whole separate post to the topic of setting your retirement savings target.

Your Risk Tolerance

Your risk tolerance is a measure of how much volatility you are willing to take in your investments.  As indicated in my post on risk, the more risk you take the higher your expected return but the wider the possible range of results.  My post on diversification and investing shows that the longer period of time over which you invest, the less volatility has been seen historically in the annualized returns.

Here are a few thoughts that might guide you as you figure out your personal risk tolerance.

  • If you have only a few years until you retire, you might want to invest fairly conservatively. By investing conservatively, you might want to invest in money market or high-yield savings accounts that currently have yields in the 1.75% to 2% range.
  • If you have five to ten years until you retire or are somewhat risk averse (i.e., can’t tolerate the ups and downs of the stock market), you might want to invest primarily in bonds (discussed in this post) or bond mutual funds. Depending on the maturity, US government bonds are currently yielding between 1.5% and 2% and high-quality corporate bonds are currently returning between 2.5% and 4%.
  • If you have a longer time period to retire and/or are able to tolerate the volatility of equities (discussed in this post), you might invest in an S&P 500 index fund or an index fund that is even more risky. These funds have average annual returns of 8% or more.

As can be seen, the more risk you take, the higher the average return.  As you are estimating how much you need to save each year for retirement, you’ll need to select an assumption about your average annual investment return based on these (or other) insights and your personal risk tolerance.

Taxability of Investment Returns

In addition to considering your risk tolerance, you’ll need to adjust your investment returns for any taxes you need to pay between the time you put the money in the account and your retirement date.  For this post, I’ve assumed that your savings amount target includes income taxes, as suggested in my post on that topic.  If it does, you only need to be concerned with taxes until you retire in estimating how much you need to save each year.

In the previous section, you selected an average annual investment return.  The table below provides approximations for adjusting that return for Federal income taxes based on the type of financial instruments you plan to buy and the type of account in which you hold it.

US – Taxable

Canada – Taxable

All Tax-Deferred & Tax-Free Accounts

Money Market

Multiply by 0.75

Multiply by 0.75

No adjustment

Bonds and Bond Mutual Funds

Multiply by 0.75

Multiply by 0.75

No adjustment

Equity Mutual Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Equities and Index Funds

Multiply by 0.85

Multiply by 0.87

No adjustment

Further Refinements to Tax Adjustments

You’ll need to subtract your state or provincial income tax rate from each multiplier. For example, if you state or provincial income tax rate is 10%, you would subtract 0.10 from each multiplier. For Equities and Index Funds, the 0.85 multiplier in the US-Taxable column would be reduced to 0.75.

The assumptions in this table for equities and index funds in particularly and, to a lesser extent, equity mutual funds, are conservative.  Specifically, if you don’t sell your positions every year and re-invest the proceeds, you will pay taxes less than every year.  By doing so, you reduce the impact of income taxes.  Nonetheless, given all of the risks involved in savings for retirement, I think these approximations are useful even if they cause the estimates of how to save every year to be a bit high.

Also, the tax rates for bonds and bond mutual funds could also be conservative depending on the types of bonds you own.  The adjustment factors shown apply to corporate bonds.  The tax rates on interest on government bonds and some municipal bonds are lower.

Calculation of After-Tax Investment Return

From the table above, it is clear that calculating your after-tax investment return depends on both the types of investments you plan to buy and the type of account in which you plan to hold them.  The table below will help you calculate your overall after-tax investment return.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Money Market, Bonds or Bond Mutual Funds

Equity Mutual Funds, Equities, Index Funds

0.85 if US; 0.87 if Canada

Other than Taxable

There are three assumptions you need to enter into this table that reflect the types of financial instruments you will buy (i.e., reflecting your risk tolerance) and the types of accounts in which you will hold those assets in the Percent of Portfolio column.  These assumptions are the percentages of your retirement savings you will invest in:

  • Money markets, bonds or mutual funds in taxable accounts.
  • Equities, equity mutual funds and index funds in taxable accounts.
  • Tax-deferred or tax-free accounts (IRAs, 401(k)s, RRSPs and TFSAs).

For each of these three groups of assets, you’ll put the average annual return you selected from the Risk Tolerance section above in the Pre-Tax return column.  You also may need to adjust the multipliers as discussed above.

Once you have filled in those six boxes, you will multiply the three numbers in each row together to get a single product in the last column of each row.  Your weighted average after-tax investment return will be the sum of the three values in the last column.

Illustration of Weighted Average Return Calculation

I have created an illustration in the table below.  For this illustration, I have assumed that you will invest 50% of your portfolio in bonds and 50% in equities.  You are able to put 60% of your portfolio in tax-deferred and tax-free accounts.  Although not consistent with my post on tax-efficient investing, you split your bonds and stocks between account types in the same proportion as the total.  As such, you have 20% of your portfolio in taxable accounts invested in each of bonds and equities.  The 60% you put in your tax-deferred and tax-free accounts goes in the All Other row.

Investment Type

Account Type

Percent of Portfolio Pre-tax Return Tax Adjustment

Money Market, Bonds or Bond Mutual Funds

20% 3% 0.75

Equity Mutual Funds, Equities, Index Funds

20% 8% 0.85 if US; 0.87 if Canada

Other than Taxable

60% 5.5% 1.00

I’ll use a pre-tax return on bonds of 3% and equities of 8%.  Because the All Other category is 50/50 stocks and bonds, the average pre-tax return for that row is the average of 3% and 8% or 5.5%.

I then calculated the products for each row.  For example, in the first row, I calculated 0.5% = 20% x 3% x 0.75.  The weighted average after-tax investment return is the sum of the three values in the product column or 5.2% = 0.5% + 1.4% + 3.3%.  The 5.2% will be used to help estimate how much we need to save each year to meet our retirement savings target.

Annual Savings Targets

By this point, we have talked about how to estimate:

  • Your total retirement savings target
  • The number of years until you retire
  • An after-tax investment return that is consistent with your risk tolerance and the types of accounts in which you plan to put your savings

With that information, you can now estimate how much you need to save each year if you don’t have any savings yet.  I’ll talk about adjusting the calculation for any savings you already have below.

I assumed that you will increase your savings by 3% every year which would be consistent with saving a constant percentage of your earnings each year if your wages go up by 3% each year.  For example, if you put $1,000 in your retirement savings this year, you will put another $1,030 next year, $1,061 in the following year and so on.  In this way, your annual retirement savings contribution will be closer to a constant percentage of your income.

Annual Savings/Total Target

The graph and table below both show the same information – the percentage of your retirement savings goal that you need to save in your first year of savings based on your number of years until you retire and after-tax annual average investment return.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

17.6% 7.8% 4.6% 3.0% 2.1% 1.6% 1.2% 0.9%

17.3% 7.4% 4.3% 2.8% 1.9% 1.4% 1.0% 0.8%

16.9% 7.1% 4.0% 2.5% 1.7% 1.2% 0.9% 0.6%

16.6% 6.8% 3.7% 2.3% 1.5% 1.0% 0.7%

6% 16.3% 6.5% 3.5% 2.1% 1.3% 0.9% 0.6%

7% 16.0% 6.2% 3.2% 1.9% 1.2% 0.7% 0.5%

8% 15.7% 6.0% 3.0% 1.7% 1.0% 0.6% 0.4%

As you can see, the more risk you take, the less you need to save on average.  That is, as you go down each column in the table or towards the back of the graph, the percentage of your target you need to save in the first year gets smaller.  Also, the longer you have until you retire (as you move right in the table and graph), the smaller the savings percentage.  I caution those of you who have only a few years until retirement, though, that you will want to think carefully about your risk tolerance and may want to use the values in the upper rows of the table corresponding to lower risk/lower return investments, as there is a fairly high chance that your savings will be less than your target due to market volatility if you purchase risky assets.

How to Use the Table

First find the percentage in the cell with a row that corresponds to your after-tax investment return and a column that corresponds to your time to retirement.  You multiply this percentage by your total retirement savings target.  The result of that calculation is how much you need to save in your first year of saving.  To find out how much to save in the second year, multiply by 1.03.  Keep multiplying by 1.03 to find out how much to save in each subsequent year.

Earlier in this post, I created an example with a 5.2% after-tax investment return.  5.2% is fairly close to 5%, so we will look at the row in the table corresponding to 5% to continue this example.  I have calculated your first- and second-year savings amounts for several combinations of years to retirement and total retirement savings targets for someone with a 5% after-tax investment return below.

Years to Retirement

Savings % from Table (5% Row) Total Retirement Savings Target First-Year Savings Amount Second-Year Savings Amount

16.6% $500,000 $83,000 $85,490

3.7% 2,000,000 74,000

30 1.0% 500,000 5,000

40 0.5% 1,000,000 5,000

The first-year savings amounts in this table highlight the benefits of starting to save for retirement “early and often.”   It is a lot easier to save $5,000 a year than $75,000 or $85,000 a year.  By comparing the last two rows, you can see the benefits of the extra 10 years between 30 years of savings and 40 years of savings.  With the same starting contributions, on average, you end up with twice as much if you save consistently for 40 years than if you do so for 30 years.

Adjusting for Savings You Already Have

The calculations above don’t take into account that you might already have started saving for retirement.  If you already have some retirement savings, you can reduce the amount your need to save each year.

The math is a bit complicated if you don’t like exponents, but I’ll provide a table that will make it a bit easier.  To adjust the annual savings calculation for the amount you already have saved, you need to subtract the future value of your existing savings from your total retirement savings target.  The future value is the amount to which your existing savings will grow by your retirement date.  The formula for future savings is:

where n is the number of years until you retire.  The annual return is the same return you’ve been using in the formulas above.  If you don’t want to deal with the exponent, the table below will help you figure out the factor by which to multiply your current amount saved.

After-tax Return

Years to Retirement
5 10 15 20 25 30 35

1.10 1.22 1.35 1.49 1.64 1.81 2.00 2.21

1.16 1.34 1.56 1.81 2.09 2.43 2.81 3.26

1.22 1.48 1.80 2.19 2.67 3.24 3.95 4.80
5% 1.28 1.63 2.08 2.65 3.39 4.32 5.52

6% 1.34 1.79 2.40 3.21 4.29 5.74 7.69

7% 1.40 1.97 2.76 3.87 5.43 7.61 10.68

8% 1.47 2.16 3.17 4.66 6.85 10.06 14.79

Illustration of Adjustment for Existing Savings

Let’s say you have $50,000 in retirement savings, 25 years until you retire and have selected an annual return of 5%.  You would use the factor from the 5% row in the 25 years column of 3.39.  You multiply $50,000 by 3.39 to get $169,500.

If your total retirement savings target is $1,000,000, you subtract $169,500 and use an adjusted target of $830,500.  Using the same time to retirement and annual return, your annual savings target is 1.5% of $830,500 or $12,458.  This annual savings amount compares to $15,000 if you haven’t saved any money for retirement yet.

Having been subject to Actuarial Standards of Practice for most of my career (which started before the standards existed), I can’t finish this post without providing a caution.  All of the amounts that I’ve estimated in this post assume that you earn the average return in every year.  There aren’t any financial instruments that can guarantee that you’ll earn the same return year in and year out.  As mentioned above, riskier assets have more volatility in their returns.  That means that, while the average return is higher, the actual returns in any one year are likely to be further from the average than for less risky assets.

As such, you should be aware that the amounts shown for annual savings will NOT assure you that you will have your target amount in savings when you retire.  I suggest that, if possible, you set a higher target for your total retirement savings than you think you’ll really need or save more each year than the amounts resulting from these calculations. You don’t want to be in the situation in which my friend found herself at age 59 starting over financially.

The Best Ways to Pay Off Your Debt

The Best Ways to Pay Off Your Debt

The best way to pay off your short-term and revolving debt depends on your priorities and what motivates you.  Two of the common approaches for determining the order in which to re-pay your loans discussed in financial literacy circles are the Debt Snowball and Debt Avalanche approaches.

Both of these methods apply when you have more than one debt that needs to be re-paid.  If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, making the minimum payments as often as you can to avoid finance charges which will be added to your principal in addition to the interest charges on any portion of your balance you don’t pay.

In this post, I’ll describe how the two debt-repayment methods work using some illustrations.  I will then help you understand which approach might be better for you.  For more information about the fundamentals of debt, check out my posts on loans and credit cards.

What’s Included and What’s Not

The debts covered by this post include credit cards (one kind of revolving debt), personal loans, car loans and other bills that are overdue. While longer-term loans, such as mortgages, are referenced in the budgeting process, I haven’t included them in the debt re-payment examples. If you have unpaid short-term debt, you’ll want to keep up with the payments on these longer-term loans first, but don’t need to pre-pay them. For this discussion, I will assume that you intend to re-pay all of your debts to your current debtholders. That is, you haven’t dug a hole so deep you need to declare bankruptcy and you don’t feel you’ll benefit from transferring some or all of your high-interest rate loan balances to one with a lower interest (i.e., debt consolidation).

Debt Snowball

Dave Ramsay, a well-known author on financial literacy topics, proposed the Debt Snowball method for paying off your debts.  Under this method, you do the following:

  1. Identify all of your debts, including the amounts of the minimum payments.
  2. Make a budget. (See this post for more on budgeting generally or this one for the first of a step-by-step series on budgeting including a helpful spreadsheet.) Your budget should include all of your expenses excluding your short-term and revolving debts but including the payments you plan to make on your longer-term debts (e.g., car loans and mortgages).
  3. Determine the total amount left in your budget available to re-pay your debts, remembering that you need to be able to pay for the total cost of all of your current purchases before you start paying off the balances on your existing debt. If the amount available to re-pay debts is less than the total of your minimum payments, you may need to look into your options to consolidate or re-structure your debts, get them forgiven or declare bankruptcy.
  4. Otherwise, make the minimum payment on all of your debts except the smallest one.
  5. Take everything left over in your budget from step (3) and reduce it by the sum of the minimum payments in step (4). Use that balance to pay off your smallest debt. After you fully re-pay the smallest debt, you’ll apply the remainder to the next smallest debt and so on.

Debt Avalanche

The Debt Avalanche method is very similar to the Debt Snowball method, except you re-pay your debts in a different order.

The first three steps under the Debt Avalanche method are the same as the first three steps under the Debt Snowball method.  It differs from the Debt Snowball method in that you pay the minimum payment on all of your debts except the one with the highest interest rate at any given time instead of the one with the smallest balance.

I’ve created the two examples to compare the two methods.  In both examples, I have assumed that you use a different credit card or pay cash for all new purchases until your current credit card balances are re-paid.  That is, to make progress on getting out of debt, you need to not only make extra payments on your existing debts, but also not create additional debt by borrowing to pay for new purchases.  It’s tough!

Example 1

In this example, you have two debts with the balances due, interest rates and minimum payments shown in the table below.

Example 1 Balance Due Interest Rate Minimum Payment
Debt 1 $1,500 20% $30
Debt 2 500 10% 10

You have determined you have  $100 available to pay off these two debts.  The minimum payments total $40 in this example, so you have $60 available to pay off more of the principal on your debts.

Example 1: Debt Snowball

Under the Debt Snowball method, you will use the additional $60 a month you have to pay off Debt 2 first, as it has the smaller balance.  That is, you will pay the minimum payment of $30 a month on Debt 1 and $70 a month on Debt 2 for 8 months, at which point Debt 2 will be fully re-paid.  You will then apply the full $100 a month to Debt 1 for the next 17 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 25 months and will pay $428 in interest charges.

Example 1:  Debt Avalanche

In Example 1, you will use the additional $60 a month you have to pay off Debt 1 first under the Debt Avalanche method, as it has the higher interest rate, whereas you used the additional amount to pay off Debt 2 first under the Debt Snowball method.  That is, you will pay the minimum balance of $10 a month on Debt 2 and $90 a month on Debt 1 for 20 months, at which point Debt 1 will be fully re-paid.  You will then apply the full $100 a month to Debt 2 for the next 4 months until it is fully re-paid

Under this approach, you will have fully re-paid both debts in 24 months and will pay $352 in interest charges.

Example 2

In this example, you have five debts with the balances due, interest rates and minimum payments shown in the table below.

Example 2 Balance Due Interest Rate Minimum Payment
Debt 1 $1,000 10% $40
Debt 2 500 0% 25
Debt 3 10,000 20% 100
Debt 4 3,000 15% 75
Debt 5 750 5% 30

You have $500 available to pay off these debts.  In this example, the minimum payments total $270, so you have $230 available to pay off the principal on your debts in addition to the principal included in the minimum payments.

Example 2: Debt Snowball

Example 2 is a bit more complicated because there are more debts.  As a reminder, under this approach, you apply all of your extra payments ($230 in this example) to the smallest debt at each point in time.  In this example, you will make the additional payments on your debts in the following order:

Debt 2

Debt 5

Debt 1

Debt 4

Debt 3

It takes only two months to pay off Debt 2 and another four months to pay off Debt 4.  As such, you will have fully re-paid two of your debts in six months.  In total, it will take 43 months to re-pay all of your loans and you will pay $5,800 in interest.

Example 2:  Debt Avalanche

Debt 3

Debt 4

Debt 1

Debt 5

Debt 2

It turns out that Debt 2 is fully re-paid in 20 months even just making the minimum payments.  Debt 5 is paid off 7 months later again with only minimum payments, followed by Debt 1 2 months later.  As each of these debts is re-paid, the amounts of their minimum payments are added to the payment on Debt 3 until it is fully re-paid after 39 months.  At that point, the full $500 a month is applied towards Debt 4 which then takes only 2 additional months to fully re-pay.  In total, it will take 41 months to re-pay all of your loans and you will pay $5,094 in interest.

Dollars and Sense – Two Examples

Looking at the two examples, we can get a sense for how much more interest you will pay if you use the Debt Snowball method instead of the Debt Avalanche method.  The table below compares the two methods under both examples.

Example 1 Example 2
Interest Paid Months of Payments Interest Paid Months of Payments
Snowball $428 25 $5,800 43
Avalanche 352 24 5,094 41
Difference 74 1 706 2

In these two examples, you pay more than 10% more interest if you use the Debt Snowball method than the Debt Avalanche method, leading to one or two additional months before your debts are fully re-paid.

Dollars and Sense – In General

The difference in the amount of additional interest depends on whether your debts are similar in size and the differences in the interest rates.  I’ll take that statement apart to help you understand it.

  • If the debt with the lower interest rate is very small, you will pay it off quickly.  As a result, there is only a very short period of time during which you are paying the higher interest on the larger loan under the Debt Snowball method.  As such, there will be very little difference in the total amount of interest paid between the two methods in that case.
  • If the debts all have about the same interest rate, it doesn’t really matter which one you re-pay first, as the interest charges on that first loan will be very similar to the interest charges on your other loans.

Dollars and Sense – Illustration

The graph below illustrates the impact of the differences in interest rates and sizes of two loans on the difference in the total interest paid.  To create this graph, I took different variations of Example 1.  That is, you have two loans with outstanding balances totaling $2,000 and the interest rate on the larger debt is 20%.

How to Read the Axes

The interest rate on the smaller loan was calculated as 20% minus the increment shown on the axis labeled on the right.  That is, the interest rate on the smaller loan for scenarios near the “front” of the graph was 18% or 2 percentage points lower than the 20% interest rate on the larger loan.  Near the “back” of the graph, the interest rate on the smaller loan is 0% or 20 percentage points lower than the interest rate on the larger loan.

The loan balance on the smaller loan divided by the total debt amount of $2,000 is shown on the axis that goes from left to right.  The small loan is $40 (2% of $2,000) at the far left of the graph and increases as you move to the right to $960 (48% of $2,000) on the far right.  Note that, if the small loan exceeded $1,000, it would have become the bigger loan!

The Green Curve

The green curve corresponds to the total interest paid using the Debt Snowball method minus the total interest paid using the Debt Avalanche method.  For example, at the front left, corresponding to the small loan being $40 with an 18% (=20% – 2%) interest rate, there is a $2 difference in the amount of interest paid.  At the other extreme, in the back right of the graph (0% interest rate on a small loan with a balance of $960), you will pay $167 more in interest ($308 versus $140 or more than twice as much) if you use the Debt Snowball method rather than the Debt Avalanche method.

What It Means

Interestingly, moving along only one axis – that is, only decreasing the interest rate on the small loan or only increasing the size of the smaller loan – doesn’t make very much difference.  In the back left and front right, the interest rate differences are only $15 and $22, respectively.  The savings from the Debt Avalanche method becomes most important when there is a large difference in the interest rates on the loans and the outstanding balances on the loans are similar in size.

Sense of Accomplishment

For many people, debt is an emotional or “mental-state” issue rather than a financial problem.  In those situations, it is more important to gain a sense of accomplishment than it is to save money on interest.  If you are one of those people  and have one or more small debts that you can fully re-pay fairly quickly (such as Debts 2 and 5 in Example 2 both of which were paid off in six months under the Debt Snowball method), using the Debt Snowball method is likely to be much more successful.

Key Points

Here are the key points from this post:

  • A budget will help you figure out how much you can afford to apply to your debts each month.
  • If you can’t cover your minimum payments, you’ll need to consider some form of consolidation, re-financing or even bankruptcy, none of which are covered in this post.
  • If you have only one debt to re-pay, the best strategy is to pay it down as quickly as possible, but making the minimum payments as often as you can to avoid finance charges.
  • You will always pay at least as much, and often more, interest when you use the Debt Snowball method as compared to the Debt Avalanche method.
  • Unless you have two or more debts that are all about the same size and have widely varying interest rates, the total interest you will pay is essentially the same regardless of the order in which you re-pay them.  As such, if the sense of accomplishment you get from paying off a few debts will help keep you motivated, using the Debt Snowball method may be the right choice for you.
  • If you have two or more debts that are all about the same size and have disparate interest rates, you will want to use the Debt Avalanche Approach.  Because the balances are all about the same, it will take about the same amount of time to re-pay the first loan regardless of which loan you choose to re-pay first!  As such, it is better to focus on the interest you will save by using the Debt Avalanche approach.

Credit Cards: What You Need to Know

Credit cards are a terrific convenience but also can be very costly.  Effective use of a credit card can make life easier and improve your credit score.  On the other hand, credit cards are an example of bad debt. It is easy to buy more than you can afford using a credit card, leading to high interest charges and a lower credit score.  The latter process can lead to a downward spiral as the purchases you couldn’t afford lead to ever increasing finance and interest charges on your credit card.  At the same time, your credit score goes down which increases the interest rate on other loans, if you can get them at all as discussed in this post. For a real-world example of how credit cards and lead to a financial disaster, check out this post about a friend of mine.

In this post, I’ll explain how credit cards work, including how finance and interest charges normally apply.  Every credit card is different, so you’ll want to look closely at the terms of any credit cards you currently carry or for which you plan to apply.

How They Work

When a financial institution issues you a credit card, it is offering you a loan in an amount that you can choose based on the amount of your purchases up to your credit limit.

Credit Cards from Your Perspective

From your perspective, you:

  • Pay the annual fee, if there is one.
  • Make purchases or get a cash advance. When you get a cash advance, you are borrowing cash from your credit card company instead of borrowing money to buy something.  You can get a cash advance at an ATM, among other places.
  • Pay your bill – hopefully the full amount every month, but at least the minimum payment if at all possible. If you don’t pay your bill in full, issuers will add interest charges to your next bill, as discussed below.  If you don’t pay as much as your minimum payment, they will also add finance charges.
  • Get rewards. Many credit cards provide rewards in the form of cash back or “points” that can be used for travel or other purchases.

In addition, you have the option to transfer your balance from one credit card to another.  Many people make this type of transfer when they have at least one credit card with a very high interest rate and one with a low interest rate.  By transferring the balance from the high-rate card to the low-rate card, you can reduce the amount of interest you will pay.  Most issuers charge a fee of roughly 3% of the amount transferred when you make a transfer.  If your interest rate decreases by more than 3 percentage points and you are paying off your credit card debt fairly slowly, though, your interest savings will be more in one year or a little longer than the transfer fee. As discussed below, though, the transfer could impact the interest charged on other purchases, so you’ll want to look at the whole picture before making a transfer.

Credit Cards from the Issuer’s Perspective

The credit card issuer generates revenue from several sources:

  • Your annual fees.
  • Interest and financial charges you pay.
  • Fees it receives from vendors who accept their credit cards. Most issuers require vendors to pay them 2% to 4% of the amount of your purchases.  Recently, some vendors have started passing these fees on to customers.  That is, they charge customers who use credit cards more than customers who use a check or pay cash.  I ran into that when paying for many of the costs of our daughter’s wedding.  To keep the cost down, I made sure I paid any vendors who charged these fees using an electronic transfer.
  • Finance charges. If you don’t make a payment toward your credit card bill at all or the amount you pay is less than the minimum payment, issuers charge you a fee in addition to the interest charges.
  • Cash advance fees.  Many issuers charge $10 to $25 or 5% of the amount every time you get a cash advance.  I never use my credit card for a cash advance as 5% of the cash is a steep charge to access cash.  There are emergencies, though, when having cash at any price is imperative.
  • Foreign transaction fees. Many issuers charge fees when you buy something outside your home country.  I carry two Visa cards one of which charges me 3% on my purchases every time I leave the US.  For years, I carried only one credit card but I was leaving the US for a month to travel and decided I wanted a back-up card.  I went to the bank where I keep my checking account and clearly didn’t read the fine print! In hindsight, it was silly to get a back-up credit card for travel with such a high foreign transaction fee.

Issuers’ Expenses

Credit card issuers have four primary expenses – their overhead costs (salaries, rent, etc.), the cost of the rewards they give customers, the cost of borrowing the money that they “loan” you between the time you make a charge and pay your bill, and the amount of money they have to write off because customers don’t pay their bills.

When Do You Pay Interest

If you pay your credit card bill in full every month, you don’t transfer a balance from another card and you don’t get a cash advance from your credit card, you won’t pay any interest.   When you do any of those things, you’ll get interest charges.

Interest on Unpaid Balances

You pay interest on unpaid balances from the day they are due until the day the issuer receives your payment for those charges.  Once you haven’t paid your previous bill in full by its due date, though, the issuer starts charging interest on the day you make each future purchase rather than starting on the day the bill is due until all charges have been paid in full.  I’ll provide an example of this difference below.

Interest on Cash Advances

You pay interest on cash advances from the day you withdraw the money until the day the credit card company receives your payment.  I looked at one of my credit cards and it has a higher interest rate on cash advances in addition to having interest charges from the date of the withdrawal.  The same is true with other credit cards I’ve seen on line or discussed with my friends.

Interest on Balance Transfers

Some issuers allow you to transfer the balance from one credit card to another. You might want to do this type of transfer if the interest rate on one card with a balance is significantly higher than another card you hold.  When you make this type of transfer, the issuer starts charging you interest on the day of the transfer and continues to do so until you pay the balance in full.

In addition, even if you had previously paid off the balance on the card to which you transferred your balance, you will pay interest on all new purchases starting on the date of purchase.  That is, until you have fully paid off your credit card balance including the amount transferred, you do not get a grace period between the date of purchase and the due date of your bill.  The additional interest could offset some or all of the savings you attain by reducing your interest rate when you transfer a balance.  This article from provides more details about some of the risks and benefits of transferring a balance.

How Is Interest Calculated

Still confused about how and when interest is calculated?  Hopefully these examples will help.  Before going into the examples, I need to explain what the interest rate or APR (annual percentage rate) really means.

A 24% APR, for example, doesn’t mean you pay 24% interest if you carry your balance for a full year.  The 24% is divided by 365 (number of days in a year) to get a daily rate.  The daily rate is multiplied by your balance on each day and added to the balance for the next day.  As such, if you didn’t pay or charge anything on your balance for a year, the interest rate on the beginning balance would not be 24%, but rather 27.1%!  I calculated 27.1% as (1+.24/365)365 – 1.  By raising the term inside the parentheses to the 365 power, I’m compounding the daily interest charge for a full year (365 days).

Example 1 – Paid Bill in Full Last Month

In the first example, I’ll show how interest is calculated if you paid your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Cash advance interest rate = 24%
  • The cash advance fee is the greater of $10 or 5% of the amount of the cash advance
  • You make a $500 purchase on Day 5
  • You take a $100 cash advance on Day 8
  • Your issuers receives your payment on Day 10 of the next billing cycle (i.e., 33 days after you took the cash advance)

In this example, you don’t pay any interest on the $500 purchase during this billing cycle.

The cash advance is different.  First, you are charged the cash advance fee.  5% of your cash advance is $5 which is less than the $10 minimum, so you will be charged $10 as a cash advance fee.  In addition, you will pay interest at a 24% APR.  The interest charge is $2.19 which is calculated as:

As such, you will re-pay the issuer $112.19 for the $100 cash advance you received. This example illustrates why it is often better to tap sources of cash other than your credit card, if at all possible.

Example 2 – Didn’t Pay Bill in Full Last Month

In this example, I’ll show how interest is calculated if you didn’t pay your bill in full at the end of the previous billing cycle.  Here are the assumptions for this example:

  • Interest rate on charges = 18%
  • Unpaid balance from last month = $750
  • You make a $500 purchase on Day 5
  • Your issuer receives your payment in full on Day 10 of the next billing cycle

I haven’t included a cash advance in this example because it will cost you the same amount regardless of whether you paid your bill in full in the previous month.

In this example, you will pay interest on your unpaid balance for the 30 days in the month plus the 10 days into the next billing cycle, for a total of 40 days. The interest on this balance totals $14.93 and is calculated as:

In addition, you pay interest on the $500 purchase for 25 days in this billing cycle plus the 10 days in the next billing cycle, for a total of 35 days.  The interest charge on this purchase is $8.70 for a total interest charge of $23.63. If you have gotten behind on your credit card balances, check on this post for strategies that will help you get caught up.

The Best Credit Card for You

As with every financial decision, picking the best credit card for you requires balancing the costs and benefits.  In large part, the best credit card for you depends on how you will use it.  The bottom line is that you want the credit card that will have the greatest net benefit or lowest net cost for you.  Here’s how you can calculate that benefit/cost.

The plus in the equation that determines your net benefit is the value of any rewards you earn.  Some credit cards provide no rewards, so the total plusses equal 0.  Other credit cards provide rewards, such as  1% of all purchases or 5% of gas purchases plus 3% of food purchases plus 1% of everything else.

To calculate the value of the benefits, you’ll need to estimate how much you expect to charge on your credit for each category of expense.  You can then multiply those benefits by the corresponding reward percentage.  As an illustration, I’ll use the 5% for gas, 3% for food and 1% of everything else example I mentioned above.  The table below shows three different combinations of monthly expenses in those categories and the rewards you would earn.

Category Scenario 1 Scenario 2 Scenario 3
Gas 100 200 500
Food 300 500 300
Other 600 300 200
Monthly Rewards 17 23 33
Annual Rewards 204 276 396

By comparison, you would receive $10 a month or $120 a year with a credit card that provides 1% back on every purchase under all 3 scenarios.  I note that most credit cards do not give rewards for cash advances, so I have not included them in the table above.

Some rewards are harder than others to access or might be in a form that isn’t useful for you.  If that is the case with one of the credit cards you are considering, you might reduce the annual benefit by some amount, such as 50%, for the chance that you don’t use it.

Offsetting the rewards are all of the fees and charges I mentioned above – the annual fee, cash advance fees, finance fees, foreign exchange fees and interest charges.

The table below shows the fees I’ve used for illustration for the two cards above.

Rewards 5%/3%/1% 1%
Annual fee $75 $0
Cash advance fee $10 $10
Cash advance APR 24% 18%
Purchase APR 18% 12%

To keep the examples simpler, I’ve assumed you make at least the minimum payment every month so there are no finance charges and you have no foreign transactions.

Example 1

In the first example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  You pay your bill in full every month.

In this example, your annual costs are $243 using the higher reward card and $150 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards, remembering that the lower-reward card has the same rewards under all three scenarios.  A negative net cost means that you pay more in fees than you get in rewards, whereas a positive net cost means you get more in rewards than you pay in fees.

Card 5%/3%/1% 5%/3%/1% 5%/3%/1% 1%
Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -243 -243 -243 -150
Net Cost -3 +93 +189 -30

In this example, you don’t incur many fees, so the lower fees in the lower-reward credit card don’t help you.  As such, you are better off with the higher-reward credit card under all three spending scenarios.

Example 2

In the second example, you have $1,000 a month in charges plus a $200 cash advance 30 days before your issuer receives your payment.  Unfortunately, you got behind on your credit card payments so you average 60 days between the time you make each purchase and take out your cash advance and pay your bill.

Your annual costs are $652 using the higher reward card and $379 using the lower reward card.  The table below shows the net cost of using your credit card under each of the 3 scenarios above for both cards.

Scenario 1 2 3 All
Rewards +240 +276 +396 +120
Costs -652 -652 -652 -379
Net Cost -412 -316 -220 -259

In this example, the lower-rewards credit card has a lower net cost than the higher-rewards card, unless you buy a lot of gas in which case you are somewhat better off using the higher-rewards card.

This comparison illustrates that high-rewards credit cards are not always the best.  To select the best credit card, you’ll want to balance the fees you are likely to pay based on your spending and payment patterns with the available rewards and their usefulness to you.

6 Ways to Slay Your Student Debt This Year

From Susie Q: I’m not as familiar with student debt as I am with the other topics on which I write, so was pleased to accept this guest post from Kate Underwood.  Kate is a freelance writer and staff writer for Club Thrifty, a website dedicated to helping people dream big, spend less, and travel more.  With Kate’s permission and approval, I’ve interspersed some comments and numerical examples in italics to expand on a few of her points.

Unless you’ve been living under a rock, you’re probably aware that we’ve got a bit of a student loan crisis on our hands. The amount currently owed by borrowers isn’t in the billions…nope, it’s actually past the $1 trillion mark!

Chances are, you don’t want to be saddled with your own student debt forever. Debt can hold you back from buying a home, starting a family, traveling the world, and other exciting parts of life. Don’t let student loans ruin your dreams – it’s time to start slaying your student debt this year.

Think it’s impossible? Check out the following ways to attack your student loans with a vengeance.

Follow A Budget

A budget is an essential financial tool that gives a job to every dollar you earn. Get yourself on track by making and following a smart budget. Be sure to account for all necessary expenses, including your student loan payments.

Balance out how much you’re earning with how much you’re spending (and don’t spend money you don’t have). When you’re stuck with student loan debt, it’s key to eliminate luxury spending. Put every spare dollar, after necessities, into paying off your loans.

While it’s tempting to overspend when you get your first “real” job, it’s a bad move. Don’t make the mistake of financing new cars or spending too much on stuff you don’t need. Living within – or below – your means could make a big dent in your student debt. Just live like a college kid for a little longer.

Susie Q adds: For a more detailed discussion of how budgets can be helpful, check out this post or start here for my week-by-week guidance on creating a budget using a spreadsheet template I’ve provided.

Trust me, it’ll be worth it! The faster you pay off your loans, the sooner you can get started building wealth and planning for your next big goal!

Start Repayment Right Away

That little grace period from your lender is appealing, but don’t hang out there too long. The sooner you can begin repayment, the better.

Even during the grace period, interest accrues for many types of loans. So, while you’re allowed to postpone repayment for a time (usually 6 months), it’s prudent to begin repayment as soon as possible.

Susie Q adds: As an example, if you have a $30,000 balance on a 5% loan with 15 years left in the term and don’t defer your payments during the grace period, your payments will be $237 a month. You’ll pay a total of $12,703 in interest over the life of the loan. If you make the same payments and defer your loan, you’ll pay an extra $1,628 in interest payments and extend your loan by 13 months (6 months of grace period and 7 months of extra payments to cover the extra interest).

Pay Extra Each Month

Once you know what your minimum payment amount is every month, don’t get too comfy with it. If you push yourself to increase that amount by even $25 or $50 more each month, you could destroy those loans much faster! At the very least, round up to the nearest $10 or $50 mark. So, a minimum payment of $62 could be rounded up to $70 or $100.

Just be sure that, if you’re making extra payments, they’re applied to the principal, not the interest. If you’re in doubt, talk directly to your lender or loan provider to find out how you can go about doing this.

Susie Q adds: Using the same example as above, if you don’t defer your loan for the grace period and round up to $250 a month, you’ll save over $1,000 as you’ll pay only $11,676 in interest and will pay off your loan a full year earlier.   You can include your student debt in your debt repayment strategy to figure out how much you can pre-pay each month, as discussed in this post.

Another tip: make biweekly payments rather than monthly. After one year, this simple step will add up to having slashed an extra month’s payment off your total. However you choose to set it up, paying more than the minimum will lead to student loan freedom sooner!

Refinance Your Loans

One strategy for paying off your loans faster is to refinance your student loans. The general idea is that if you refinance to a lower interest rate, you’ll end up paying less over the life of the loan. Plus, you can pay them off faster, since you won’t owe as much in interest! Win-win!

A couple of factors to beware of: you usually don’t want to refinance if your credit score has taken a recent hit. That will likely only get you a higher interest rate – you definitely don’t want that! Also, if you plan on utilizing student loan forgiveness programs, you typically need to stay away from refinancing. Most of the forgiveness programs will disqualify you if you’ve refinanced.

If you’re unsure about how to go forward with refinancing, Credible is an online loan marketplace that can make that decision easier. Compare interest rates for which you may qualify with different lenders in order to make the best choice.

Susie Q adds: Using the same example as above, if you are able to re-finance your loan at 3.5% and continue to make the same $237-a-month payment, you’ll save over $5,000 as you’ll pay only $7,485 in interest and will pay off your loan almost two years earlier. This savings will be offset by any fees you need to pay when you re-finance your loan.

Now, if you’re such a rock star that you plan to pay off the full balance within a really short time, like 2 or 3 years, refinancing might not be worth the trouble. Just pay those babies off and be done with them!

Start A Side Hustle

One of the best ways to pay off any debt fast is to increase your income. I’m a big proponent of side hustles. You can make extra cash to pay down debt and side hustles are often super flexible with your other responsibilities.

If you’re looking to begin your own side hustle, you can check out these work-from-home jobs and see which might be a good fit. The possibilities are nearly limitless, so be creative and think about your skills and things you enjoy doing anyway.

You could start doing freelance writing or blogging from home (our favorites!). Or start selling your to-die-for cakes for special occasions. Try your hand at bookkeeping, photography, or proofreading or any number of other ways people are raising their income.

Susie Q adds: For more ideas about ways to increase income or reduce expenses to help free up money to reduce your student loan debt, check out this post. Also, if you decide to pursue a side hustle, you’ll want to make sure you don’t spend more money than you earn!

Just imagine how much extra money you could throw at your student debt by starting a side hustle!

Use Employer Benefits

Some companies are looking to build positive relationships with employees by offering student loan repayment assistance. So, before you decide to take a job, it might be beneficial to ask if it offers this option. If you’ve already signed on to work somewhere, talk to your HR department to see if it’s available.

You should also explore various government student loan forgiveness programs. Though it’s extremely important to follow all of their rules to be eligible, if you’re working in a career field that allows you loan forgiveness, you might as well go for it!

A piece of advice: save enough during your repayment period that you could pay the entire loan balance off just in case the forgiveness doesn’t come through! Most applications for forgiveness so far have been rejected, so those borrowers are still on the hook for the full balance.

Say Goodbye to Student Loans Fast

Debt sucks. You know you don’t want to keep your student loans around forever, so use any and all of these tips to slay your student debt as fast as you can!

How to Budget Step 9 – Monitoring your Budget

Entering Your Budget

Enter Your Category Names

  1. Type the names directly into Column A.
    3. Go to the Budget Comparison tab of the monitoring spreadsheet.
    4. Put your cursor in A8.
  3. Link your monitoring spreadsheet to your Budget Template spreadsheet.
    2. Hit the equal sign on your keyboard.
    3. Go to the Budget Template spreadsheet.
    4. Go to the Budget tab.
    5. Put your cursor in A11.
    6. Hit Enter.
    7. Excel should return you to cell A8 of your Budget Monitoring spreadsheet.
    8. Hit the F2 (edit) key.

Enter Your Budget Amounts

Entering Your Actual Income and Expenses

Options for Expenses You Don’t Pay Monthly

    • take your budget amount
    • divide the annual amount by 4
    • put 0 in your budget column in all other months

A Few More Words about Budget

Download Budgeting Monitoring Spreadsheet Here