Couple Drowning in Real Estate Debt
In British Columbia, a couple we'll call Sam, 33, a corporate manager, and Georgia, 32, on maternity leave from an administrative job, have a six-month-old daughter, a house and a small apartment building. The value of their real estate assets is $1,430,000. That's a good deal for a young couple, but Sam and Georgia have incurred total debt of $1,138,632, which is 8.3 times their gross annual income of $136,654. Debt service charges add up to 59 per cent of their after-tax income. With property taxes, the bill rises to 77 per cent.
"We're worried that we are carrying too much debt for our income level, especially if Georgia does not return to work," Sam says. "Are we overexposed to inflation and interest rate changes?"
Facelift asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Sam and Georgia.
"These are productive and ambitious people," he says. "But they are betting that the money financing their properties will remain relatively cheap. Odds are that interest rates will rise. Then they could be forced to sell to raise cash. It's a risky play in the end. But it's the numbers that tell the story."
The family's total after-tax monthly income is $8,057, including rental cash flows that add $1,850 a month. The couple can maintain the status quo in which they end each month with no cash left as long as interest rates do not rise substantially above the 1.45-per-cent interest rate on the mortgage on their apartment building and the 2.25-per-cent interest rate on the mortgage on their house. If rates do rise, they might not be able to pass on the higher costs to tenants nor find sufficient cash to pay their lenders, he warns.
They could finance a cash shortfall by adding to their line of credit, Mr. Moran notes. But can they afford to subsidize their property costs and have enough for retirement?
Sam has a defined contribution pension plan at work with a current value of $81,731. The plan grows at a rate of $11,648 per year. By his age 55, 22 years from now and assuming 3-per-cent after-inflation growth, the plan should have $522,970 in assets. If he worked to age 60, he would have $670,000.
The family's RRSPs currently total $27,034. They are growing at $4,800 per year. By age 55, with a 3-per-cent real annual return, they will total $202,775. At age 60, they will be worth $261,300, Mr. Moran estimates.
Adding up the value of the pension plan and the RRSPs, by Sam's age 55, their retirement savings would support annual income of $32,792 to Georgia's age 90. If Sam works to age 60, the plans would support annual income of $46,130 to her age 90.
Assuming that Sam's early retirement will cut his Canada Pension Plan benefits to 85 per cent of the current $10,905 annual maximum, and that Georgia will have no benefits, they will have total public pensions of $21,677 a year including two Old Age Security benefit cheques of $6,204 when each turns 65.
If the rental property is retained, the couple would be able to collect rent of $22,200 a year in present dollars, Mr. Moran estimates.
The couple's total retirement income at Sam's age 55 would be $32,792 in company pensions and retirement savings and $22,200 in rental income, or $54,992. By retiring at age 60, total income would be $46,130 from the company pension and $22,200 in rental income, or $68,330. By waiting to age 65 to draw Canada Pension Plan and Old Age Security, that would add $21,677 for total income of $90,000 a year, the planner estimates. With pension splitting, the OAS clawback, which starts at net incomes over $66,335, would not be a problem.
Sam has $17,295 in company shares that he receives as part of his income. He has several choices for the use of those shares, Mr. Moran notes.
First, he could sell them and use the proceeds to pay down debt. If he does that, he should start with the $79,380 line of credit, which has a 5.5-per-cent rate of interest.
Alternatively, Sam could put the shares in his RRSP, which has $16,796 of contribution space. That contribution would generate a refund of about 35 per cent or $6,035.
Or he could contribute the shares to a spousal RRSP. Sam would get the deduction and Georgia would get the lower tax rate on eventual withdrawal.
Finally, Sam could pay off personal debts, then borrow the same funds and repurchase the stock, making the debt deductible.
Yet none of these moves would make a dent in his $1,043,551 of real estate debt.
Their house mortgage is the largest and most expensive part of that burden.
"This couple has parlayed debt into real estate that is producing a good return," Mr. Moran says. "But if interest rates rise just [one percentage point], mortgage costs would consume all rental income. For that reason, they should consider downsizing their house. It is the safest course they can take."
The People: B.C. couple with a six-month-old child
The Problem: Debt would be hard to carry if interest rates rise
The Plan: Sell company shares to pay debt or add to RRSP; downsize house
The Payoff: Enhanced financial security
Monthly Net income: $8,057
Assets: Residence $1,100,000; Rental property $330,000; Pension $81,731; RRSPs $27,034; Company shares $17,295; Cash $6,700; Total: $1,562,760
Monthly disbursements: Mortgage (residence) $2,935; Mortgage (rental) $1,469; Prop. taxes residence $500; Prop. taxes rental apt. $900; Line of credit interest $400; Food & baby supplies $600; Dining out $100; Entertainment $100; Clothing $75; RRSP contributions $400; Car fuel & repairs $200; Car insurance $90; House insurance residence $117;
House insurance rental property $71; Charity & gifts $100; Total: $8,057
Liabilities: Mortgage residence $813,883 at 2.25 per cent; Mortgage rental prop. $229,668 at 1.45 per cent; Lines of credit $79,380 at 5.5 per cent; Student loans $15,701 at 4.5 per cent; Total: $1,138,632
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