Financial (Il)literacy Month: 3 big misreads

November is Financial Literacy Month. The designation is the brainchild of a coalition of seven finance-related groups that hope to improve our understanding of finances.

That’s a tough job when you consider Canadians are drowning in record amounts of debt and we lag way behind in saving for comfortable retirements.

You don’t need to dig too deeply to find where some of the misunderstandings are rooted. Here are three of the biggest financial misreads:

1. Interest versus compound Interest

Albert Einstein called compound interest the eighth wonder of the world: “He who understands it, earns it ... he who doesn't ... pays it.”

Einstein nailed the average consumer today who owes an estimated $27,000 and probably has no idea how the interest is calculated in the lender’s favour.

Take a $10,000 balance on a typical credit card like VISA or MasterCard, for example, which charges interest of about 18 per cent annually. On $10,000 that's $1,880 a year, and after 10 years that’s $18,000 - right?

Not quite. Most lenders compound interest monthly. That means interest is added to the loan after one month, and each month afterward you pay interest on the interest in addition to the original $10,000. That $10,000 compounded monthly actually generates $49,693 in interest after 10 years.

Compound interest is a double edged sword that can work in your favour. If you save, you will get interest on the interest you generate, like Einstein says – sort of.

2. RRSPs and TFSAs are not investments

You often hear investors blame their registered retirement saving plan (RRSP) or tax free savings (TFSA) accounts for market losses – especially in the wake of the 2008 financial meltdown. The fact is RRSPs and TFSAs are not investments at all. They are plans and accounts that hold investments and provide tax advantages, which enhance performance without additional risk.

An RRSP allows investors to defer paying tax on their contributions and investment gains until they retire in a lower tax bracket. A TFSA protects investment gains from any taxation – ever.

Once you open an RRSP or TFSA it’s up to you what investments go inside. Options are nearly limitless - mutual funds, exchange traded funds, bonds, stocks, options – you name it.

If risk isn’t your thing you can put your money in a high interest savings account and let it compound (see #1) in an RRSP or TFSA, and still get the tax advantages.

3. The government will provide

We live in a compassionate country; one that strives to provide a basic standard of living from the time we are born to the time we die. But for many, a basic retirement isn’t enough to maintain our standard of living.

That’s why relying on the Canada Pension Plan or Old Age Security to get us through our golden years isn’t enough.

If you have paid into CPP for at least 40 years, the maximum payout is about $1,000 a month or $12,000 a year. The maximum payout for OAS is currently $550 a month or $6,600.

Together that’s $18,600 a year at best.

Most financial advisors suggest budgeting 60 per cent to 80 per cent of your pre-retirement income for a comfortable retirement.

Unless your living requirements are very modest CPP and OAS are intended as retirement income supplements. A livelong savings plan is required to retire comfortably and it should start early in life.

In addition, average life expectancy is getting longer, which means delayed or longer retirements. Ottawa has already raised the age of eligibility for Old Age Security and could very well do it again.