Money Math vs Money Psychology
As an accountant and personal finance geek there are some things that people do and say about money that drive me crazy. That’s because often times people’s actions and thoughts on money issues make absolutely no sense mathematically. Examples include being happy about getting an income tax refund, carrying a balance on their credit card, or buying a house or car that is not really affordable.
However, my frustrations are usually tempered when I realize that there is more than just the “math” involved in making decisions about money. In fact, I have come to believe that psychological factors probably influence people more than the math. The biggest psychological factors are fear, greed, lack of self-control, and lack of understanding.
In my career as accountant advising people on financial decisions, I have come to accept the fact that I must consider more than just the math when giving advice. Here are some examples:
Dividends vs Salary
These days we normally tell most clients that the difference between taking a salary or dividend from your corporation depends on whether or not you want to contribute to CPP. In other words, the math usually results in dividends putting more money in your pocket because you don’t have to contribute to CPP. Furthermore, the historic rate of return on CPP contributions has been less than 4% for business owners. Thus, it usually makes sense to be compensated with dividends and invest CPP savings yourself.
However, we also warn clients not to blame us if they suddenly turn 65 and have no CPP income and no retirement savings. In making our recommendation to clients, we need to consider whether they have the self-control to save for their retirement and the knowledge to invest the savings in order to beat the CPP rate of return.
Buy or Rent a House
I’ll be honest here. I think buying a house is about the worst financial decision most people make. There are several reasons for this including:
- High house prices often means that buyers take on too much debt.
- Personal income has not kept pace with house price increases in recent history.
- An aging population means that the resale market for houses will probably not be great in 20 years.
- A house restricts mobility and is a major headache in case of job loss.
Despite my analytical bias, a house purchase can also be a good idea for the following reasons:
- It makes your spouse happy. A house is probably cheaper than a divorce.
- Mortgage payments are a form of savings and are sometimes a better option for those who lack the discipline to save on their own.
- There may be a lack of rental options where you live and it may actually be cheaper to buy.
Consolidating Credit Card Debt
Often, people who carry balances on multiple credit cards are advised to consolidate all of their high interest credit card debt into their lower interest line of credit or mortgage. Mathematically this makes sense because you can pay the debt off quicker due to lower interest rates. However, this solution often does not work because it just hides the problem and does not address the real issue of lack of self-control. The usual story is that the debt does not get paid off quicker because people forget about it now that the monthly minimum payment is lower. Sometimes a better solution is for people to pay off one card at a time in order to feel a sense of achievement and to remind them of the challenges still ahead of them.
Getting Advice from Your Accountant, Financial Advisor, or Banker
What this all means is that you really need to know yourself before blindly accepting advice from your advisor (or an accountant’s blog). Be honest about your ability to be disciplined, communicate your fears to your advisor, and always ask questions to make sure you understand the decision you are about to make.
Written by: Jeff Ross, CA
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