Too Much Risky Debt Threatens Retirement
In Edmonton, a business manager we'll call Theo, 45, and his wife, Marge, 38, are raising two children approaching their teenage years. Their yearly gross income of $147,500, works out to $93,600 after tax, ample for their prairie city.
Theo and Marge have piled on too much debt. They have already purchased a retirement home in another city. Currently, it is rented out for income.
Their problems centre on that property. They are prepaying the cost of retirement now while paying the high cost of raising two children, limiting their choices today and in future. And they know it.
"Do I try to accomplish the goal of early retirement or should I sell the retirement house and use the equity to pay down our residence mortgage?" Theo asks.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Theo and Marge to sort out their priorities. "There are several problems here, partly due to the cost and complexities of raising two kids and partly due to Marge's wish to expand her career," Mr. Moran explains. "Fortunately, the problems are all fixable."
Educating the Kids
Theo and Marge have put just $1,200 into their children's registered education savings plan. It's not much, but Theo's plan is to sell a collection of rare books that he thinks could fetch five figures. Yet the market for such things is thin and subject to appraisals, Mr. Moran notes. For RESP purposes, it would be better to inject cash and receive the Canada Education Savings Grant (CESG). The CESG would be the lesser of 20% of annual contributions per child, or $500. There is an option to fill up unused RESP space.
If they add $2,500 per child, per year, and get the full 20% CESG contribution, the kids would have $48,584 in seven years (in 2010 dollars). That would provide about $25,000 per child toward the cost of post-secondary education, Mr. Moran notes.
Theo and Marge owe a good deal of money: $342,000 on their house on a variable rate mortgage, $249,000 on an income property at 1.85% on another variable rate loan and $109,000 on a 4.45% variable rate line of credit. The total, $700,000, is almost five times their gross annual income. They have become highly leveraged investors. They must cut debt exposed to rising interest rates, the planner insists. Moreover, if the debt continues to grow, Theo and Marge will find their choices narrowed severely.
First step: Pay down the line of credit. Interest charges at 4.45% per year are the highest of all their debt service charges and are not deductible from income.
Second step: Pay only interest on the income property mortgage and no principal until the mortgage on their residence is eliminated or the property is sold. The rate of interest on the rental property, 1.85%, is deductible in full for tax purposes. The after-tax rate in Theo's 36% bracket is 1.18%. This is a small carrying cost until the next step is evaluated.
Third step: Sell the rental property. The net rent on the rental house is $956 per month or $11,472 per year. Divide the rent by their equity, $301,000 and the yield or return on equity is 3.81%, which is not sufficient for the risk. Interest rates will eventually rise. If Theo winds up paying 6.5%, the return on equity would go to zero and there would be no economic rationale for tying up money in the property.
Fourth step: Take money from selling the rental property and use it to pay off other debt. Assume that the $550,000 rental property estimated price is realized at sale.
The adjusted cost base of the property is $400,000, so tax will be due on the $150,000 capital gain. The estimated taxes would be $24,375, leaving Theo and Marge with $276,625 after discharging their $249,000 mortgage. That would be enough to eliminate the $109,000 line of credit and $167,625 of the house mortgage. The remaining debt would be $174,375. With diligent saving, this balance could be cleared in 10 years or less at the couple's current rate of saving, the planner says.
Theo and Marge have a large, unfunded liability. Should they die before their children cease to be financially dependent, the kids or their guardian would need to replace income. Theo has $240,000 of group coverage while Marge has no life insurance at all. The couple has $342,000 of bank-issued mortgage life insurance that covers the lender's interest but nothing more. For that restricted coverage, they are paying $720 per year. Marge needs life insurance -- $500,000 for starters at a cost of $388 per year. Theo should have $500,000 plus his employer's group coverage. His annual premium would be $660. Total is $1,048, but they can cancel their present mortgage life insurance, so that the net cost of improved and extended coverage would be just $328, Mr. Moran says. Of course, if Theo and Marge sell their rental property, they could reduce coverage.
Theo and Marge are far from retirement, but they can make some estimates of what income they will have and what they will need. They currently have $260,000 in RRSPs. If they continue to supplement Theo's annual bonus of $12,000 per year and maximize his contribution, $21,000 for 2010 (though he will not receive a bonus this year as a result of tough business conditions) and, assuming he obtains a 3% annual real return, his RRSP will grow to $597,400 by his age 55, $807,370 by his age 60 and $1,333,000 by his age 65, Mr. Moran estimates.
This capital would produce income in inflation-adjusted dollars of $24,470 beginning at Theo's age 55 until Marge's age 90. If Theo began retirement at age 60, RRSP savings would produce an income stream of $35,360 to Marge's age 90. And if Theo delayed retirement to age 65, the income stream would rise to $63,475 to Marge's age 90.
Theo should qualify for full Canada Pension Plan (CPP) benefits of $11,210 per year at age 65. Early commencement of payments under present rules would impose a penalty of 6% per year, but proposals for change would raise the penalty to 7.2% per year. Early retirement is becoming increasingly expensive. It is not likely to be advantageous for either Theo or Marge to take benefits before age 65, Mr. Moran notes.
Marge's career has been interrupted by extended education and raising kids. For planning purposes, we can assume that she will have half CPP maximum benefits or $5,605 per year. Theo and Marge will each receive Old Age Security of $6,204 per year at age 65. Public pensions would therefore total $29,223. On top of that, the couple would have RRSP income of $24,470 to $63,475, depending on when they retire.
"This couple has the opportunity of foresight," Mr. Moran says. "If they reduce their debt, they can cut risk and focus on their children's RESPs and their retirement savings. They have the time to do it."
Excess debt imperils family with six-figure income and modest financial assets
Sell a rental property, build up RESP and RRSPs
More money for kids' education, retirement and peace of mind
MONTHLY AFTER-TAX INCOME $7,800
House $470,000, Rental property $555,000, RRSPs $260,000, Collectibles $25,000, RESP $1,200
House mortgage, 2.25% variable $342,000, Rental property, 1.85% variable $249,000, Line of credit, 4.45% variable $109,000
MONTHLY EXPENSES AND DISBURSEMENTS
Residence mortgage $1,400, Rental property mortgage $2000, Property taxes $450, Home utilities, phones $150, House insurance $80, Food $800, Car, home, life insurance $294, Car fuel $100, Child care (dental, etc.) $200, Books, entertainment $200, Line of credit interest $350, Miscellaneous $400, Savings $1,376
Used By Permission (c) 2010 The Globe and Mail