12 steps to financial independence

[Jon Chevreau]

A couple of bloggers have attempted to boil down the essential steps the protagonists took in my novel, Findependence Day: notably Larry MacDonald at Canadian Business here:

http://blog.canadianbusiness.com/roa...-independence/

and here:

http://blog.canadianbusiness.com/12-...-independence/

To clarify, I did my own version of the "skeleton" of the novel and came up with 12 sequential steps, which I described at a talk at the Financial Forum in January.

Jeff Wareham's Beyond Funds blog reproduced the 12 steps to financial independence here:

http://beyondfunds.blogspot.com/2009...ce-day-by.html

[archanfel]

We all need a place to live and if you’re renting you’re still paying a mortgage: your landlord’s mortgage! Eventually, he or she has built up equity with your rent payments: you get to live there month by month but have nothing to show for it. In fact, the landlord will likely increase the rent each year to keep up with inflation.

Once you own a home and pay if off, your property taxes and maintenance expenses should come in at less than half what you’re paying out in rent. Of course, condos may also charge monthly maintenance fees.

The fastest route to a paid-for home is putting up a large down payment rather than take on the higher debt of a low-ratio mortgage. Once the emergency fund is established, keep maximizing contributions to the TFSA in order to accumulate a down payment for first home, preferably putting up 25% down payment.

Jon, I am afraid I don't agree with the above paragraph. Property taxes and maintenance are certainly not the only expenses left after mortgage is paid off. The opportunity cost of money tied up in home equity can easily make home ownership more costly than renting.

For example, say I got $250,000 cash right now. I can either invest it in the stock market or I can buy a house using cash. With the stock market, I get dividends and capital gain. With the house, I get rent saved and home value appreciation. Therefore, home ownership should be evaluated just like a stock purchase. Let's say my monthly rent is $1500, that's $18,000 yearly. Property tax should be $2500 and maintenance is usually estimated as 1-2% of the home value, that's another $2500. The net rent saved is $13000, or 5.2% yield, which is good, but not spectacular considering that home appreciation are historically much slower than capital gain. In certain cities (like Toronto), the yield is probably even lower due to the unfavorable rent/price ratio.

Another issue with home ownership is living above one's need. Because home purchase is such a major investment, people tends to leave rooms for growth. For example, they will usually budget for future children, inlaw visitings, etc...., which means a couple can live in a 3-4 bedroom home unnecessarily. Thus causes significant drains on a family's finances.

I still think home ownership is not a bad investment, especially considering the favourable tax treatments. However, I don't think it's necessarily helpful for the road to financial independence.

[CanadianCapitalist]

Originally Posted by archanfel

Therefore, home ownership should be evaluated just like a stock purchase.

In theory, everything you've said here is true. But in practice, it doesn't work out that way (keeping in mind I'm taking about the average experience of most people here). Numerous studies have shown that mutual fund investors earn much less than the returns of the mutual funds, stock investors earn far less than the market averages (DALBAR study) etc. I think the reason is very simple: it is so easy to buy or sell stock (usually takes only a push of a button) but not so with residential homes. Houses are relatively illiquid not to mention the hassles and headache involved in moving. So, people stay put and get the benefits of long-term ownership.

Also, home ownership initially costs more than renting, which forces home owners to save more. In theory, renting and wisely investing the savings will put a person ahead. In practice, any savings coming from renting over owning will be spent.

[archanfel]

Originally Posted by CanadianCapitalist

In theory, everything you've said here is true. But in practice, it doesn't work out that way (keeping in mind I'm taking about the average experience of most people here). Numerous studies have shown that mutual fund investors earn much less than the returns of the mutual funds, stock investors earn far less than the market averages (DALBAR study) etc. I think the reason is very simple: it is so easy to buy or sell stock (usually takes only a push of a button) but not so with residential homes. Houses are relatively illiquid not to mention the hassles and headache involved in moving. So, people stay put and get the benefits of long-term ownership.

Also, home ownership initially costs more than renting, which forces home owners to save more. In theory, renting and wisely investing the savings will put a person ahead. In practice, any savings coming from renting over owning will be spent.

That's a good point. Home ownership does force people to save and stick with their investment.

[Jon Chevreau]

The stock market may give you capital gains and dividends; then again you may get losses and dividend cuts, as with General Electric. Not sure if I read you correctly: if you're talking a Turner-like "The Strategy" of sucking equity out of a home, I wouldn't agree with you. Others may.

So I repeat Theo's line: "a paid-for home is the foundation of financial independence."

www.financialpost.com/fd

[archanfel]

Originally Posted by Jon Chevreau

The stock market may give you capital gains and dividends; then again you may get losses and dividend cuts, as with General Electric. Not sure if I read you correctly: if you're talking a Turner-like "The Strategy" of sucking equity out of a home, I wouldn't agree with you. Others may.

So I repeat Theo's line: "a paid-for home is the foundation of financial independence."

www.financialpost.com/fd

Yes, stock market has its risks (GE is a non-system risk that can be easily avoided by diversification, but system risks would still remain), but so does real estate. What I was trying to say was that home ownership can cost significantly more than renting (even after the mortgage is paid off), thus potentially lower one's net worth, costing him financial independence in the end.

[ethos1]

I agree that carrying a mortgage to get to finally owning a home is forced savings.

On the other hand a home totally paid for can and does as Archanfel said, could cost a lot of money in upkeep

In the area that I live in Pickering there are two identical 2400 sq'ft homes on the same street (circa 1990) - one is for sale at $375k (market price) the other is a rental at $1600/mth

taking away the ultilities which each has to pay, the comparison is

The mortgage free home owner pays insurance, maintenance and property taxes, which I figure is about $4500 - $5000 year ($400/mth)

The renter has only the rent and contents insurance to pay

Should the home owner sell their house then puts the money into GIC or dividend paying stocks & rents for $1600/mth - they would have positive cash-flow as well as the original equity in cash

Owning a home that is paid off is fine for most, so is having the equity in it - but paying the running costs and not having access to the equity is a negative IMO - it can reduce the total equity value as well in some cases for seniors have them struggling

Renting is not for everyone, neither is leveraging your home for investment purposes. Its a tough decision and one which each must figure out the best choice for them based on their financial savvy and the countless sleep easy or sleepless nights you may have

Then there is reverse mortgages

There are I'm sure many seniors that live in million dollar homes or any home that is paid off who are struggling to pay the running costs & who do not have enough food or warmth. But not too worry - when the senior(s) die the family will be thankful for the generosity of their frugal dead relatives

[DrStan]

Originally Posted by Jon Chevreau

The stock market may give you capital gains and dividends; then again you may get losses and dividend cuts, as with General Electric. Not sure if I read you correctly: if you're talking a Turner-like "The Strategy" of sucking equity out of a home, I wouldn't agree with you. Others may.

So I repeat Theo's line: "a paid-for home is the foundation of financial independence."

www.financialpost.com/fd

What many people fail to take into consideration is that the home you buy will likely be larger and more luxurious than any rental accommodation. For instance, renting the equivalent to my home would be something like $2K per month, making ownership an attractive solution. Of course, I could rent for $900 a month, but the two properties would not be of equal size and quality. If someone is perfectly happy living in a rental at a low price, doesn't need the extra room, doesn't want to customize and doesn't enjoy maintenance, etc., rental is fine.

As pertains to the "12 steps" Mr. Chevreau mentions, I can't find a single thing wrong with them. In fact, we have implemented successfully every single one of these steps, except number 3, hiring a financial advisor, and 11, because we plan on never touching the TFSAs.

1. Eliminate debt. Done.
2. Be frugal. Well... getting all the other steps right makes this one a bit less important.
3. Prepare a financial plan. Done, but without an advisor. It's still very detailed and I'm sure it would stand up to any scrutiny.
4. Use TFSAs. Done.
5. Enrol in pension plan/RRSPs. Topped up.
6. Buy a home. Done.
7. Prepay the mortage. Done, paid off.
8. Protect your family. Done with term insurance.
9. Teach your children. Absolutely.
10. Use TFSA for big purchases. Better than debt, if it's required.
11. Use a non-registered plan. Done and growing nicely.
12. Develop multiple streams of income. Done: freelance and dividends.

For the vast majority of Canadian families, this represents very sound advice. I think the most important are :

1. Eliminating crippling consumer debt
2. Saving for retirement
3. Protecting your family with adequate insurance

Baby stuff, but so many people screw up the basics. Just get this done, and you're on your way.

[Rickson9]

Originally Posted by DrStan

1. Eliminate debt.
2. Be frugal.
3. Prepare a financial plan.
4. Use TFSAs.
5. Enrol in pension plan/RRSPs.
6. Buy a home.
7. Prepay the mortage.
8. Protect your family.
9. Teach your children.
10. Use TFSA for big purchases.
11. Use a non-registered plan.
12. Develop multiple streams of income.

I never read the 12-steps in context, but they all sound good!

[archanfel]

Originally Posted by DrStan

What many people fail to take into consideration is that the home you buy will likely be larger and more luxurious than any rental accommodation. For instance, renting the equivalent to my home would be something like $2K per month, making ownership an attractive solution. Of course, I could rent for $900 a month, but the two properties would not be of equal size and quality. If someone is perfectly happy living in a rental at a low price, doesn't need the extra room, doesn't want to customize and doesn't enjoy maintenance, etc., rental is fine.

As pertains to the "12 steps" Mr. Chevreau mentions, I can't find a single thing wrong with them. In fact, we have implemented successfully every single one of these steps, except number 3, hiring a financial advisor, and 11, because we plan on never touching the TFSAs.

1. Eliminate debt. Done.
2. Be frugal. Well... getting all the other steps right makes this one a bit less important.
3. Prepare a financial plan. Done, but without an advisor. It's still very detailed and I'm sure it would stand up to any scrutiny.
4. Use TFSAs. Done.
5. Enrol in pension plan/RRSPs. Topped up.
6. Buy a home. Done.
7. Prepay the mortage. Done, paid off.
8. Protect your family. Done with term insurance.
9. Teach your children. Absolutely.
10. Use TFSA for big purchases. Better than debt, if it's required.
11. Use a non-registered plan. Done and growing nicely.
12. Develop multiple streams of income. Done: freelance and dividends.

For the vast majority of Canadian families, this represents very sound advice. I think the most important are :

1. Eliminating crippling consumer debt
2. Saving for retirement
3. Protecting your family with adequate insurance

Baby stuff, but so many people screw up the basics. Just get this done, and you're on your way.

Exactly. I lived in shared accommodations for years. For several hundred dollars with TV and Internet included, it's hard to beat in Toronto.

As for the 12 steps:

1. Eliminate debt. Done.
2. Be frugal. I am bordering being cheap.
3. Prepare a financial plan. Not really. I do my best, that's all I can do.
4. Use TFSAs. Done, but not invested yet.
5. Enrol in pension plan/RRSPs. Maximized.
6. Buy a home. Renting. I plan to buy using cash before I retire for the tax benefits though.
7. Prepay the mortage. Don't have one.
8. Protect your family. Never. It's the same as gambling, just reversed. The odds is never in our favour.
9. Teach your children. N/A.
10. Use TFSA for big purchases. Not really. Can't think of a purchase that would need to touch TFSA.
11. Use a non-registered plan. Done and losing nicely.
12. Develop multiple streams of income. Too lazy. I really need to work on this.