Blessed by the Potato

I’ve been off in over-time-for-a-project land so things have been quiet here. Here’s a good old-fashioned rant for you to celebrate being back to a normal schedule.

Michael Lewis’ book has been turned into a star-studded movie, which helps explain for people part of what drove the US housing bubble and collapse – and what a few people saw in advance to profit from it. So let’s talk housing bubble in Canada.

In case you’ve forgotten, I’m the biggest, most vocal bear on Canadian real estate there is.

Ok, maybe 2nd biggest.

Ok, I’m a bear with a blog. And I haven’t talked about it much lately because there isn’t too much to say that hasn’t been said. The housing market is a glacier: it is huge, it transforms the landscape, and it does very little until it suddenly does a whole lot at once. I’ve said what I needed to say and made the tools I needed to make to help people. The rest is waiting. And there’s the possibility that in the end, it may never correct (or have a mythical soft landing), though even then in many markets renting will be the more sensible move.

But with the movie in theatres now, maybe it’s time to revisit some points and consolidate those archives into something of a rabid bear manifesto.

Let me start with something of a mission statement: choosing a house/condo to live in is the largest single living expense you are likely to face, the biggest financial decision of your life, and it often does not get the consideration it deserves. It is challenging to make the “right” decision because there are a number of things to take into consideration, and you will not have the opportunity to learn by experience. Experts such as realtors or inspectors can tell you many interesting facts about a house, a building, a neighbourhood, or a market, but they are not able to help you on the most important aspects of the decision, such as whether you should buy at all. A realtor may be great at telling you how much an extra bathroom may cost, or how much cheaper a place an extra half kilometer from transit may cost, but they are by and large not able to tell you when you are over-stretching or when the market as a whole may be over-heated. And that’s not to mention that most people involved will have conflicts-of-interest. You also face a gauntlet of mantras, rules-of-thumb, and heuristics that have been developed over the years which sound completely convincing (some even rhyme) but which again do not actually help you make an informed decision and don’t allow for the existence of bubbles.

The first thing to realize is that you do have options. You can always rent. Many people — especially those of the baby boomer generation, parents of today’s first-time buyers — think of dingy apartments with no amenities when they think of rentals. This is a misconception: virtually every condo building going up in Toronto, Vancouver, or in the rest of the country has units for rent that are just like the ones people buy, and the renters have access to all of the amenities. Townhouses are widely available for rent. While they are rarer, detached single-family homes in good school zones are available for rent — I myself live in one, and it has a backyard for my daughter to play in, a renovated modern kitchen with granite countertops for me to cook and entertain and display my social status in, and every other feature that you would want in a house that you own. There is no way to know that I rent it unless you asked me or looked up the property tax rolls (or caught on to the fact that I’m suspiciously mum on the topic of renovating). Admittedly the selection is much reduced compared to what’s for sale on MLS at any given moment, but it is an option.

And this is the important part: it is financially better to rent the equivalent place in the midst of a housing bubble. Do the math yourself for your own situation, but when we’re looking at places with over 300X price-to-rent, the difference over time is staggering. And that’s before we even start to talk about life trajectory risk.

Consider for a moment some rule-of-thumb math: if a typical cost for shelter (in non-bubble times) is about a third of your budget, and the housing market is 30% over-valued, then that becomes ~10% more of your budget — which is about what many authors peg as a starting point for your retirement savings (which is a post for another day). And indeed, it looks as though people in bubbly cities stretch to buy houses and sacrifice their futures to make it happen. Renting and saving the difference may be the best move in this situation.

We can talk about large systematic issues, speculation, household debt, regulations, and all that jazz, but this is the main point I want you to walk away with: you have options in how to go about arranging for your shelter and largest expense. You have to live somewhere, and the rent-vs-buy decision for your neighbourhood is the only one that matters for your life. The macro factors and other discussions can be at turns fascinating or plain confusing, but ultimately it’s all esoteric and detached from your life. All that matters to you is making a rational decision on where to live and how to provide shelter for your family.

I’ll note that yes, in normal markets landlords make money (so renting should cost more/be “throwing your money away”). But note that this is not a universal, physical constant like the second law of thermodynamics. Landlords can and do lose money, i.e. subsidizing renters. Also, humans (and landlords) are prone to the yield-on-cost fallacy: by and large your potential landlord will not have paid the price you would have to pay to buy the equivalent house. They make money because they paid a sane price many years ago, and you save money by renting from them because in 2016 you don’t have the option of paying 2003 prices — your choice is between 2016 prices and 2016 rents.

The Big Short and the US Bubble

The US market in its frenzy was crazy. If you could fog a mirror, you could get a mortgage. A lot of articles focus on the aftermath of that: the bundling of mortgages into exotic securities that almost no one understood, how that nearly brought the entire system down, and how ridiculously terrible some of the lending was to generate those mortgages in the first place.

In The Big Short we get to see a group of misfit investors do the legwork to uncover the details of these subprime bundles of mortgages that everyone else was taking for granted. They find that absolute garbage is going in, assumptions are made about the risks being non-systematic (throwing enough crap together to make it diversified makes it magically not crap any longer), and the risk in these exotic securities is not understood. The system keeps getting driven in this terrible direction because the incentives are screwed up. They created incentives that helped drive the writing of ever-riskier loans to people who did not have the capacity to pay them back, secured by assets that were over-valued and could not be sold at those prices if the loose lending didn’t exist. Moreover, some of the heroes in the film see a catalyst in a cliff of teaser rates resetting in 2007, so not only is it unsustainable, but they have some idea of what the time-frame will be for gravity to re-assert itself.

Many point out that Canada’s lending system is not as bad as the US subprime market was and we don’t have all of the same esoteric products that they did, therefore no bubble. And for what it’s worth, strictly speaking that first part is true. But that’s a worthless distinction, like saying that a moose has antlers and not tusks so why are you worried about being gored like those guys who pissed off the elephant when all we’re facing is a moose that’s a tenth the mass? You don’t need conditions that specific to generate a bubble. Take the focus off the specifics of the instrument, and you’ll see that the same effects absolutely are present in our market.

Think of that scene in the movie where Steve Carrell’s character finds out that the stripper has five houses (and a condo), each with multiple mortgages: this person was only able to make that happen by rolling loans in the midst of a rising market — “a rolling loan gathers no loss” is one of my favourite aphorisms and completely applies to certain segments of the Canadian market. The risk she represented as a borrower was huge, but she had zero defaults (and would continue to have zero defaults as long as prices kept going up). And so the system kept pushing more and more leverage at her, and she kept taking it, out-bidding other people for houses, continuing to drive prices up.

And she did it because she thought it would benefit her: it was her path to riches.

And that, ultimately, is what drove the bubble. The lending enabled it, but it was people on the ground buying houses at any price that created the bubble in the first place. The banks can sell and incentivize all they want, but if people were smart about their purchases, considered the intrinsic value and their ability to pay, plus the risks involved in buying (and the financing), there never would have been a bubble in the first place. But that is not a good description of people. People are astoundingly good at seeking out relative value (which house has more bathrooms and a nicer kitchen and how much of a premium would I pay for that?) and incredibly bad at absolute valuation (is the market in a bubble? Does this price make sense relative to rents and incomes and the ability to eventually pay off the mortgage?).

A bubble is all about belief. There are lots of things that we can point to as being potential catalysts for the unwinding of a bubble, but don’t forget that loss of faith can also be one — if people don’t believe that prices will be higher in 3 years when they want to flip or refinance, they won’t buy, or at least won’t be in a rush to. And then it all spirals down, the positive feedback loop working in reverse.

The chase for yield that drove the banks to incentivize subprime lending is absolutely alive and well up here, it’s just in a different form. Instead of generating mortgages — any mortgages — to stuff in CDSs/CDOs, our banks push off loans to CMHC and Genworth. The net result is the same: if you can fog a mirror, you can get a loan — no skin off the bank’s nose. And the moral hazard exists: banks pass on the risk, so they do less work to validate and monitor (but see how fast they check incomes if you don’t qualify for CMHC).

Much is made about credit scores and subprime in the US. Up here the picture is cloudy: the really trashy stuff (under 600) doesn’t qualify for CMHC, but subprime (not rigidly defined) usually means anything under 640, so lots of what the Americans would call subprime is accepted as gold up here.

Moreover, something that gets lost in the arguments about credit quality is that the second-best predictor of mortgage default was how much skin in the game these buyers had, and even if Canada is not as risky as the US on lending to people with poor credit scores, we are awash in high loan-to-value lending (with its explicit government backing). And many hard-hit US states were full-recourse like most provinces — the ability to go after someone’s other assets is meaningless protection if they’re all-in on real estate and will declare bankruptcy if they get too far underwater.

And that’s not to mention the private mortgage market. The search for yield affects individuals just like it does the pension funds and institutions that created the market for CDS/CDOs in the US. There is no solid data on how big the private mortgage market is here, but advertising for it is everywhere in Toronto, and if you read into it the incentives are just set up in an insane way to push these products to the extreme. What’s scary is that this is possibly a real estate risk-squared situation: people with good credit are borrowing on HELOCs to fund private mortgages for those without: if prices start going down the first loan could default, putting stress on the underlying HELOC. (Unfortunately there isn’t enough data out there either way, just anecdotes).

In The Big Short, complacency was another big issue. Even as the default rate on the underlying loans was increasing, the rating agencies didn’t downgrade the CDOs. The appraisers were pressured to meet the numbers and not look too closely at fundamentals. Brokers helped clients make up incomes (where an income was even needed at all), and the underwriters never blinked. We see the same complacency here. Many know that fraud exists (and may even be rampant) in the Canadian mortgage market, but few care, and no one seems to crack down — the regulators absolutely appear to be asleep at the wheel. Look at HCG recently: they found out about a bunch of brokers feeding them mortgages with falsified incomes, but were in no especial hurry to disclose that to their investors, find out how deep the problem ran, or re-evaluate the loans in question. Their insurers and regulators also didn’t descend, smiting in fury. No one seemed to care much, which suggests a disturbing level of complacency with fraud-for-shelter in a market that’s already very easy to borrow in. (Oh, and AFAIK all of those brokers are still in business)

Lending and Mechanisms and Flawed Pricing Strategies

It’s easy to get lost in the weeds of the qualities of the lending system and the differences between then and now. That’s important if you’re seeking out mortgage securities to short, but on the ground the minor differences of kind and scale don’t matter as much: the lending could be crap, but if the people are being responsible and prices are sane, buying your place can still make sense. Even if lending is mostly fine while prices go nuts, renting will make sense.

And I think it’s pretty clear that lending practices are not stopping the rapid ascent in prices. There’s lots of fear of being priced out, but few actually are – the mortgage broker always finds a way.

So I like to think of how the system operates — the underlying mechanisms — imagining the tens of thousands of buyers each year, scurrying about. What is causing them to drive up prices? How are the individual agents behaving?

Some like to hand-wave supply and demand as the be-all and end-all, and sure, prices wouldn’t be going up if someone wasn’t paying them. But what might change the supply and demand picture, and what will happen to prices if that happens? How “firm” is the demand, what happens to it if prices stop rocketing upward (like the “gully” in the movie), or loans become harder to acquire, or employment stress and uncertainty sets in?

What factors really matter? After all, population growth does drive demand which drives price increases. And immigration exists. But these are not the only factors in the equation: the tide of immigrants to Toronto did not suddenly stop in 1989/1990, and they didn’t start making more land that year, either; immigration to the US was as strong as ever in 2006 when the market peaked. So bubbles can certainly form and implode despite stable population growth.

For sure interest rates have played a major role in the bubble, especially in the continuation of the Canadian bubble after the US one burst. That and speculative thinking (animal spirits) is where we need to look for the mechanism driving prices up.

Whether you do a full rent-vs-buy analysis or just hand-wave the monthly carrying cost, as interest rates (and your expectation of rates over the life of the mortgage) go down you become more willing to pay more for a place. Plus people generally don’t look at the big picture or radical alternatives when buying something: you may compare a Toyota to a Honda when shopping for a car, but not check out whether or how much it would cost to get by without a car and just use transit and taxis, or a car-share service, or an electric car. People buying houses tend not to consider whether the market overall is rational, or what their rental options are: the analysis likely stops at the neighbourhood boundaries and a few months of comparable sales to make sure they’re not being taken to the cleaners on a relative basis.

Combine these things with recency bias and flawed heuristics (real estate only goes up! renting is throwing your money away!) and the ever-lower interest rates clearly drive prices up.

Just look at the importance of ever-lowering interest rates and rate expectations. Take a place that rents for $2000/mo. If you were figuring on a long-term interest rate of 4.5%, you might be willing to pay as much as $400,000 for the place, but in 2012 the price may well have been $500,000. “You’d have to be nuts to buy at that price, it’s like you’re expecting to pay 3.5% forever, or for prices to keep doubling inflation!” the bears might say. “It’s 25% over-valued!” But then prices would keep going up and rates would keep going down.

So then you’re in 2014 and rates are now 2.99% and prices are up even more. Maybe you re-adjust your interest rate forecast for lower for longer and $500,000 for the place doesn’t sound too bad. But the bulls have bid it up even higher. “$600,000?! That’s crazy, you have to be expecting rates to not only stay low, but drop to like 2%!” And against all expectations, rates would drop again… but prices would take all of those shifted fundamentals and then some, going up even more. Each time the market participants seem to price in the lower rates and higher appreciation as a permanent feature when running their unconscious pricing algorithms. Indeed, to price in not just the current low levels, but anticipate even lower rates than the already-historic lows.

But then that’s why so many see increasing interest rates as a possible catalyst. For the buyer of the future, who may be facing rates of 4% (gasp!) when making their decision, it would now take a correction of 30% to get back to a fair price. If the long-term expectation goes back up to 5% (still lower than a fixed-rate mortgage could be had for in 2008), we’re looking at needing a 35% correction.

It’s also why a soft landing is so unlikely: at this point many Toronto neighbourhoods have price-to-rents that are so high you have to assume that the prices bake in not only zero-bound rates but also continued high appreciation. If a few years of stagnation puts a lie to that assumption, that alone should turn a soft landing into a crash.

And if there’s a loss of confidence, and the implied appreciation rate tanks while the interest rate assumption rises (i.e., if fundamentals matter again), it could be a ~45% trip to the bottom. At rates of ~5% and appreciation that just matches 2% inflation, break-even price-to-rent would be something like 185X (compared to over 350X in many detached areas of Toronto, and 240X for many condos). Then if you truly want to feel scared, consider that in many crashes prices undershoot, so maybe calls for a 50% crash aren’t so crazy.

You also see weird behaviour and rationalizations from people in bubbles. One that really sticks in my mind is a conversation from not too long ago when a real estate agent tried to argue that a particular condo development switching to become a rental apartment complex was taking supply off the market. Now for the usual meaning of supply — places for people to live — the move had absolutely no effect. But, as implied by the statement, the speculative purchase demand has detached from the need-for-shelter demand.

It’s important to remember that even in the worst of the US sub-prime lending spree, only about 15-20% of buyers were sub-prime. Most people buying houses were regular people just trying to put a roof over their heads, but who didn’t do the math or included a speculative component in their decision (“prices always go up” or “it’s a good investment”).

The Big Picture

I’m not much of a macro guy. You should go talk to Ben Rabidoux or someone like that.

But still, the facts are chilling and worth a moment of reflection.

• Record household debt and debt-to-income
• Massive financial vulnerability, with people unable to absorb even short periods of unemployment or small financial shocks
• Leverage
• Construction sector share of employment
• Ownership rate

Catalysts and Risk

I’m not big on trying to predict catalysts for the implosion of the Canadian real estate bubble. Catalysts are super-important if you’re trying to short the market and profit from the downfall — and decide on the timing of that — but if you’re just looking for a smart way to arrange shelter for you and your family, it doesn’t really matter too much. Even if there’s a soft landing or it never corrects, if renting forever is vastly better financially and lower-risk, then that’s that. A crash is just gravy in that case. If there is a crash, it won’t matter what the immediate cause was – people will get hurt either way.

And even when you call them, catalysts are hard to see coming. I’ve seen all kinds of predicted catalysts over the years, some made under the assumption that the catalyst will never happen, thus the market is forever bullish. Interest rates going up is of course the big one, but some have said that it won’t be until unemployment rises that prices will drop. Some proposed catalysts are esoteric, like an inversion in the yield curve (which, BTW, we briefly saw in 2015).

Some are related to regulations, like as long as negligible down payments and a lack of rigour for income and other fraud are permitted, the bubble will keep growing, and only higher down payments and documentation standards will pop it.

Some are regional, like oil prices and Alberta real estate – and few saw that actually coming even if they did identify it as a catalyst for corrections. If you listened to a RE bull in 2014 and they said forget valuation, Calgary/Ft. McMurray prices will never fall as long as oil’s at $80-100/bbl, well, they may have been absolutely correct about that necessary condition yet it did not change the fact that you probably wish you were renting right now. Same with all these other catalysts: what are you supposed to do, buy now and then dump the instant you see the yield curve invert or the property tax rate spike or the Chinese stock market crash or whatever supposedly necessary condition is being proposed?

So that’s why I focus so much on price-to-rent and making the choice for yourself and your own situation.

Which brings me around to a discussion of risk, which is really what it all comes down to. If you buy at stretched valuations and there is a correction (or if you put little down and prices just stop going up), you face a big risk to your life trajectory. If you can’t sell for lack of equity and need/want to move (for a new job, because of a divorce, planned larger space for children, unplanned larger space for surprise children, shitty neighbours, job loss, sick parents, or whatever reason comes up), you won’t be able to.

Conversely, if you rent and prices continue to go up at worst you’ve lost some paper gains you would likely never realize and some face, but you still have your roof over your head and your flexibility. The main risk is that you get evicted if the landlord decides to take their capital gains out from under you, which if you’re a good tenant is quite rare (I know it happened to one friend of mine recently, but to be fair, he had been there longer than most people stay in condos they buy).

And speaking of condos, that discussion of risk is particularly acute there: if you’re not in a space that’s at least approximately your “forever home” and you get trapped there, life can truly start to suck. The sad reality is that many new condos in Toronto and Vancouver are only built to sell to investors and not for real-life living; many are too small for a couple to comfortably share, let alone raise a family in¹.

For many rent-vs-buy analyses in Canada’s big cities you’ll find that even when renting doesn’t dominate, buying only wins by a little. Why take the risk that a bubble will pop to only do a bit better than break-even?

Foundations and Decision-Making

One thing that really irks me is otherwise smart people ignoring the housing bubble entirely and saying it’s always a good time to buy because “a house is the foundation for financial success.” Well, no, it’s a foundation for financial success. Just like driving posts down and building up from there is a foundation for a house, but so is digging a basement and pouring concrete.

And even then, it’s more of a thing that is correlated with financial success than a necessary condition for it — you could as easily say that having a paid-for car, a job with a DB pension, or kids who go to university is the foundation for financial success. Especially when many of the financial successes that were built on a foundation of houses were done so at much more reasonable pricing.

Buying anything, especially the largest purchase in your life, at any cost is not a foundation for financial success.

So you have a choice to make. If you can’t afford the risk of the housing bubble (or even stretched valuations relative to rent absent a correction), you can choose to rent. If you have more money than you know what to do with, you can decide whether the happy feelings of owning outweigh the higher cost of owning — money is there to be spent (assuming you have it in the first place). Some people are in that camp — what’s a hundred thou here or there? — but most are not.

And you have to consider the risks: getting trapped underwater can not only be a financial strain or possibly lead to bankruptcy, it can be psychologically stressful and can remove your ability to change your life trajectory. In particular, you’re not free to move to find a new job in a new city if you own.

Also remember that you don’t always get to dictate the timing of a sale. Lots of people buy thinking that they can ride out any correction because they’ll live there for twenty years or more, and can pick their exit — only to lose their job or their spouse.

Speaking of foundations, I like to think of warnings about the housing market like warnings from an engineer about cracks in the foundation of a bridge. The cracks may have been there yesterday before the report, and the bridge may keep supporting ever-increasing traffic loads (and concrete mass) despite the cracks for years to come. A collapse may even require an additional catalyst, like an over-sized load, high winds, or flash freeze. But the risk is higher, and now you know it could all come crashing down disastrously. And choosing not to take that route in to work is the smart decision, even if all your friends get there a few minutes faster on the shaky bridge — their temporary gains will seem meaningless if it all falls down.

Eschatology

Back to the Big Short for a moment: they had a fairly clear catalyst for the collapse, in the cliff of sub-prime ARMs resetting to higher interest rates in 2007. Defaults noticeably picked up, and Countrywide shut down. Yet the credit default swaps the protagonists had purchased somehow became less valuable when all reason screamed that they should have been cashing in just at that moment.

Markets don’t tend to crash over-night, and not smoothly. And for housing, especially not quickly.

Many people have heard so much about sub-prime and CDOs and the like that they think that caused the US bubble to burst. But that misses so much of the story: a bubble is all about belief and willingness to pay the crazy price. The subprime crisis was an accelerating factor: it helped the US market crash harder, and faster, with more repercussions for the broader economy. But don’t think that prices would have kept going to the moon if it weren’t for subprime.

How will it end here? I don’t know, but likely in tears. I would wager more slowly, at first: markets becoming illiquid as sellers refuse to lower their prices (and are not forced to sell by rates resetting higher) while buyers refuse to pay up². Then faster as it builds up momentum on the way down and people start to worry about getting ahead of it. The positive feedback cycle starts to play in reverse: construction jobs dry up, which causes more stress on the housing market. The lenders see risk again as rising prices stop masking bad debts, cutting down the pool of buyers. We’re starting to see this in Calgary: prices are down, but only a bit, while many sellers stubbornly hang on to their anchor valuations as volumes drop and days on market and listings rise.

Near the end of The Big Short is a good scene where Brad Pitt’s character chastises the two garage-band fund guys for celebrating over how much money they were going to make. “You just bet against the American economy. If we’re right people lose homes. People lose jobs. People lose retirement savings.” I know what it is that I’m predicting. This is not just about wise readers of the site sitting things out until they can buy a home at a more reasonable price, and those who aren’t having to sacrifice a vacation or meal out to afford their more expensive housing choice — if I’m right about a mismatch in valuations and price-to-rent, and that it really only makes sense to correct the one way, people are quite likely going to be hurt by what’s coming. Not likely as bad as the US or Ireland in the GFC, but 1990 in Toronto was no picnic, either. This is an important topic — and a sleeper, because it does take years to play out. Far too easy for the human attention span to get bored and tune out after a week or two.

And importantly, the bottom — where prices might be supported by rents at even modestly higher interest rate expectations — looks a long way down for Toronto and Vancouver.

As for when, well that’s the million-dollar question. Calgary’s already in a correction, while Vancouver is fully parabolic on the upside³. It was hard to see things going on for more than a few years past the Americans, and here we are in 2016 and it’s still not obviously upon us — hitting record highs, even.

When you’re a short seller being right-but-early is tantamount to being wrong. Much of The Big Short is about the pain these guys went through on finding the trade of the century, of being one of just a handful of people who saw the disaster coming, of being in an extreme minority… but being early on it, and having to live through years of their investors wanting to back out, the margin and collateral calls, the stress. When you’re just trying to live your life it doesn’t matter if you’re early. Don’t drive across the bridge, go on and rent.

Cracks

I hate trying to call the timing of a correction, because it’s a difficult prediction to make, though I am (mostly) human so not trying to extrapolate from the dots and see pictures in the stars is hard. There do seem to be ever-increasing cracks in the system, which may suggest the end is (finally) nigh.

• Syndicated financing on a few projects appears to be running into trouble
• The US may be increasing their rates
• Fear: hardly anyone fears loss or a downturn, the fear is all about missing out; this could change very quickly
• Contagion and confidence: Ft. McMurray prices are down a lot. Calgary’s down a bit and continuing to slide. These can affect confidence even outside the resource-heavy areas of the country, as it reminds people that RE is not invincible. Moreover, the dollar is down, and even though it’s not really all that meaningful, it’s one of the few pieces of macroeconomic data that people in the general public do pay attention to. And the dollar is down hard, making people think that the country is in trouble.
• Remember that CMHC stress test with the seemingly unfathomably low $35 oil? It was under $30 today.
• We appear to be entering a recession
• Mortgage fraud is being recognized in at least a few areas as an issue

Whatever the broker commissions and moral hazards of the financial institutions, whatever the differences between the products of the Big Short and Canada today, the US housing bubble wouldn’t have happened if it weren’t for millions of people making poor life choices⁴. So the only advice I can leave anyone with is to think of downside risk, of what happens in unfavourable scenarios, and to look at whether renting for them — in their area, their lives — may be the better move rather than starting from the assumption that they’re going to buy and the only question is what.

And that is the only advice I can give because the one big difference between Canada and the US of the Big Short is that there isn’t a big short. No one has crazy mis-rated CDOs that you can bet against with payouts of 500:1 (if you do, please call me). You can bet against some of the lenders and insurers⁵, but that costs more for less leverage, so the timing is more important. Some people may make money at it, but I doubt we’re going to see any Canadian contrarians walk away as billionaires.

1. While I haven’t personally seen many cases of the stripper with five houses (and a condo) kind of speculation, I have seen far too many cases of the couple that gets together, finds their shitty 1-bdrm condos aren’t big enough for them both to live in, and up-sizes while keeping one or both of the condos as an investment.

5. Disclosure: as per the comment on the follow-up post, I have 1 put contract on BMO (that I have kept rolling forward from 2014). Having 1 put contract is kind of like being short 100 shares except different.

Tax-Free Savings Accounts (TFSAs) and Registered Retirement Savings Plans (RRSPs) are great ways to let your investments grow tax-free — with the added benefit of making your paperwork simpler because you won’t have to track or report the gains of individual investments within them. Deciding which is best for you can be a bit complicated, so this decision tool should help you quickly figure out which to use, with some additional discussion below. Click here or on the preview image to open the PDF.

TFSA: The TFSA is a very flexible tax shelter, and also very straightforward. Everyone over 18 gets the same amount of contribution room each year. You put in money that you’ve already paid income tax on (“after-tax contributions”), your investments grow tax-free, and there’s no tax paid on withdrawals. What really makes the TFSA flexible though is that you can add back any withdrawals you make to your next year’s contribution room, so if you find you need access to your funds it’s easy to get at them and then catch up on your savings and get back on track later.

RRSP: The RRSP is a bit more complicated. It also shelters your investments from tax as they grow, but starts with pre-tax money (you get a deduction for contributions), with the withdrawals eventually added to your taxable income. If your tax rates when you contribute and withdraw are the same, the benefit is the same as that of a TFSA, and if you can withdraw at a lower effective tax rate than when you contribute, the RRSP can provide a bonus benefit on top of the tax-free compounding — but predicting if those tax rates will be different (and whether that will be beneficial to you) can be a bit tricky. Everyone has their own RRSP contribution amount, based on how much was made in the previous year along with adjustments for participating in pension plans. While we tend to think of the RRSP as an account strictly for retirement, there are programs for making withdrawals (loans) from your RRSP to buy a house or go back to school (the Home Buyer’s Plan [HBP] and Lifelong Learning Plan [LLP]). You can also make a withdrawal at any time for any reason, but will have to add that amount to your taxable income — and you won’t get the contribution room back.

Both: Both can hold a wide variety of investments, from savings accounts and GICs to mutual funds to stocks and exchange-traded funds. Both shelter your investments from taxes (and the associated reporting/tracking requirements). In all cases, if you have the room holding your investments in a TFSA will be better than non-registered (taxable) account. In most cases an RRSP will also be better than a taxable account, but when the taxes at withdrawal will be much higher than those at contribution (high enough to outweigh the benefit tax-free compounding), a non-registered account may be preferable. For example, if you expect to withdraw from an RRSP in retirement where it will cause GIS claw-backs, you may be better off with a non-registered account if your TFSA is full. Likewise, if you’ll need near-term access to your funds, a non-registered account or TFSA may be better than an RRSP.

If you don’t have money to contribute now, both the RRSP and TFSA let you carry your contribution room forward until you can use it.

So to help you decide between these two good options, here are some considerations, in order:

1. Default Option

The TFSA is flexible and easier to use, so if you don’t have the time to figure it out exactly, or lack some information on your current and future tax situation to optimize, go with the TFSA — you can always withdraw from your TFSA and switch to an RRSP later. The is also a good default option because the TFSA tends to be better for people with less money, but those in situations where they might prefer the RRSP (through the other steps below) will often have enough more than enough money to max out the TFSA, so starting with the TFSA will still lead to having investments in both.

2. Emergency Access

Any money you’ll need in an emergency has to be accessible. Have a cash emergency fund, and if you fill your TFSA keep that emergency fund in a non-registered (regular) savings account. But also consider keeping some of your long-term savings accessible in your TFSA, just in case you need more than your cash emergency fund. If you have to sell and withdraw some investments, there will be a lot fewer complications and you’ll get the room back if they’re in a TFSA. If everything is locked up in an RRSP it can add more stress to an already-stressful situation. So if you’re just starting out with your long-term savings, it can make sense to start in the TFSA regardless of other considerations just in case your planning for the long term was off or something unexpected comes up.

3. Free Money

Always take free money when offered. If your employer matches your RRSP contributions, sign up for that program, as that benefit will almost certainly outweigh any other advantage a TFSA might hold.

In some cases this may also point you towards making RESP contributions a priority, but that’s getting beyond the scope of this guide.

4. Behaviour

RRSPs can only beat TFSAs if you’re making RRSP contributions pre-tax. That means that you’re contributing the refund too, or having your contributions come straight off your paycheque with the tax withheld reduced — either way, you have to put more in the RRSP in the first place for it to equal out. Though more dollars go in, because it’s pre-tax it has the same effect on your after-tax spending dollars. If you would contribute the same amount you’ve saved up at the end of the year in either case and then fritter away your refund in the spring, go straight to the TFSA.

However, behaviour can also point you in the other direction: if you need your funds to be as locked up as possible to protect you from yourself in a weak moment, you may prefer the RRSP over the TFSA.

5. Low Income

If you’re lower income (less than about $40k/yr — in the lowest tax bracket), then look towards the TFSA. In particular if you may be eligible for GIS in retirement, the claw-backs from RRSP withdrawals will be a big disadvantage, and the TFSA will be better for you. Remember that claw-backs of these programs is part of your overall effective tax rate to consider when looking at the RRSP’s tax arbitrage ability.

6. Special Situations

Buying a house? The RRSP HBP lets you use pre-tax money for your down-payment, which cam help you avoid CMHC fees. If you already have more than enough saved up to put 20+% down no matter which tax shelter you use, then you may not care, and may even prefer the flexibility of the TFSA. But if you’re just under that mark, being able to put pre-tax money (i.e. your savings plus a refund) in an RRSP and then withdraw all of that (including the government’s portion) can help get you over the line and save a lot on CMHC fees.

Another special situation that might favour the RRSP is a gap in earnings, such as going back to school or an upcoming mat/pat leave. Having significantly lower earnings in a year may let you use tax arbitrage early, though you won’t get the contribution room back. Keep in mind that your taxable income is calculated by calendar year, so a leave starting or ending partway through the year may not bring your earnings down far enough for this move to be advantageous.

7. Tax Arbitrage

Most comparisons skip straight to this step, but it’s important to understand that the above factors can be more important than the math. However if there are no over-riding factors influencing the decision, then the RRSP will be better than a TFSA for people who have a lower effective tax rate when withdrawing (usually that’s in retirement) than in their contribution years. The TFSA will be better in the opposite case, where the tax rate is lower in the contribution years. Note that the withdrawals may move you up through several tax brackets if a large part of your retirement earnings come from your RRSP, so the average benefit may be there even if the last few marginal dollars are in the same brackets. Don’t forget the effect of clawbacks on government benefits (like GIS and OAS). Predicting your future tax rates (and how they compare to where you’re at now) can be a tough exercise given all the uncertainties of the future (not only your own earnings situation and the performance of your investments, but changes to the tax rates themselves by future governments), so this may be one to work through with the help of your planner.

Many people will end up using both accounts to an extent.

I’d like to thank Sandi, Dan, and Wayfare for feedback on early versions of the tool.

Every year I fall for it, the hopeless optimism of the holidays: “Oh, I’ve got two whole weeks out of the office, I’m going to get so much done!” The to-do list has been piling up all year, from little things like finally fixing the RAID array on the desktop and doing some much-deferred software updates, to making plans to see old friends, to finishing off some major side projects and long-overdue blog updates. Oh yeah, and with all that time “off” I’ll somehow catch up on sleep and have some fun playing trains with Blueberry and try all the video games on my wish list.

And every year it’s the same burnout: I didn’t quite manage to do all my shopping online before the break, and lose the first day off to traffic and parking and retail hell with the other last-minuters. Whoops, forgot to factor in that 5 days are “lost” to the insanity of Potatomas and related holidays. ‎And a day or two of work that I brought home with me has to get done at some point. Then I’m down to just a few days to get two weeks worth of planned stuff done, and I feel like crap for not accomplishing anything.

So next year I’m going to have to go in with lower expectations, which means accepting that some things are not going to get done. This year that’s going to mean Fallout 4 will just have to wait (and my Radblock just arrived from OPG, too!), and so will the course (which is fast becoming vapourware).