Situation: Debts and spending exceed means, retirement and education savings underfunded
Solution: Move downmarket, extract equity, cut debts, build savings for kids, then for retirement
A couple we’ll call Harry, 51, and Libby, 46, live in B.C. with 14-year-old twins. They bring home $6,090 in after-tax income from their jobs, his in power management, hers in office administration. They add $1,500 rent from a basement apartment and $325 from the Canada Child Benefit.
Cash inflow totals $7,915 but they spend $9,155 per month. That’s a deficit of $1,240 per month. Their largest cost is debt service. Their mortgage costs them $3,150 per month and other credit card bills add $500. They are going broke and headed for disaster. They need a fix and it has to start soon.
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“My house is worth $1.3 million,” Harry explains. “If I sell it and move to a condo with a price range of $600,000 to $800,000, can I have enough money to pay for my twins’ university costs at $10,000 per year each and then travel around the world?”
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Harry and Libby. The prognosis isn’t good.
“They are over their heads with debt,” Moran says.
The couple’s biggest debt, the mortgage, has a 2.54 per cent interest rate and a 30-year amortization. At today’s rate from one major bank, 3.54 per cent, they would have to pay $4,358 a month, an increase of $708 over their present payments. Rolling over the mortgage is not going to improve matters.
They have about 34 per cent equity in their home from the down payment that came from the sale of their former home. They might qualify for a secure credit line for other expenses. But this is adding fuel to the debt fire. If they are able to keep their house, Harry will be his 80s before it is fully paid off. Their mortgage costs will also reduce their ability to save in RRSPs and to build up educations savings for their children. The house is not a shelter anymore. It is an unaffordable burden. Above all, they need to raise cash.
They could leave their expensive city and try to find a condo in a less costly city. Selling the house might net $1,235,000 after selling costs. Take off the $860,000 balance of their mortgage and they would have about $375,000 cash left, more than enough to support the mortgage on a $600,000 condo somewhere else. The balance of debt would be just $225,000. If that were amortized over 20 years, monthly payments at 3.54 per cent, they would have to pay just $1,309 per month. That would liberate $1,841 per month of former mortgage payments.
Unfortunately, there is a catch. Downsizing will also likely mean foregoing the rent they were receiving on their basement apartment, leaving only $340 in monthly savings from the move. It doesn’t seem like a lot, but it might be the best they can do, especially given the higher anticipated mortgage payments in the years ahead.
Some monthly expenses will have to be cut by half, including $1,600 for food and $200 for restaurants, saving them $900. Lower property taxes and repair costs, in addition to reductions in all other discretionary spending might raise an additional $400.
Life insurance, at $450 a month, can also be cut dramatically. An examination of no-frills term insurance plans from many companies indicates they could get two basic $500,000 policies for a tenth of what they are paying. Review of their policies could be financially rewarding, Moran says.
Altogether, these moves will cut nearly $2,000 out of their allocations, closing the initial deficit and leaving them $800.
They can use some of the cash pay down balances on high-interest unsecured loans, which include $21,000 on credit cards at 11 per cent and $20,000 on another credit card. Those cost about $300 month in total to service. And a $50,000 secured renovation loan at 4.3 per cent which costs about $200 per month. If they raise payments to $1,000 per month total immediately after the home change, the loans could be reduced to a more manageable level before retirement.
Next — use the remaining $300 savings on debt service to boost present Registered Education Savings Plans. That will make total RESP contributions $2,500 per child per year for time remaining to age 17 when the $500 maximum Canada Education Savings Grant per child per year ends.
The plans would have a value of about $18,000 when the kids are ready for post-secondary education, assuming 3 per cent growth after inflation. If the kids live at home, university costs for tuition and books are likely to be $10,000 per child per year. The kids will still need student loans or have to work part time jobs to pay for school, Moran concludes, but its a start.
When the kids are finished with their first degrees, which would be seven years from now, Harry and Libby can focus on building up their RRSPs. The current balance, $35,000 in total, is inadequate. The RRSPs with the addition of $200 per month and growth at 3 per cent after inflation for 14 years will become $93,947 when Harry is 65.
This sum could support payouts of $5,400 for 25 years. Alternatively, Harry and Libby continue the $200 monthly contributions for seven years and then raise them to $1,000 per month for seven more years when the kids are through with their first degrees. The RRSPs would have a balance of $171,000. That sum could support payouts with the same assumptions of $9,820 per year.
Given the debts to be paid, kids to be educated, and retirement financed, it is unlikely that Harry and Libby can retire before Harry is 65. At that time, their RRSPs under the second scenario would pay $9,820 per year. They would have two Old Age Security benefits totaling $14,320. They would have two CPP benefits totaling $20,415.
With these changes, their annual pre-tax income would be $44,555 If split and age and pension credits applied. Their tax rate would be negligible and their monthly income therefore $3,700. Their living costs with the above cuts, no more child care or savings to consider, and more than half of their debt service charges eliminated would be about $3,500 per month. It would be tight, but a few years of part-time work for Harry to 71 would provide a safety blanket.
“This is a case of too much debt, too little income, and a way of life they cannot support,” Moran concludes. “That’s the bad news, but the good news is that they can recover and have a secure retirement. This plan will work, but their dream of world travel is not in it.
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Retirement stars: ** out of 5