The Family Debt Trap
SITUATION Debt is trapping family, limiting life's options
STRATEGY Pay off debt for education, retirement funding
SOLUTION More education funds, disposable income
In Alberta, a couple we'll call Herb and Caroline, both 47, have a combination of steady work and odd jobs in the communications industry. They home-school their three teenage children. Herb handles the teaching, sacrificing much work and income so he can provide the lessons. But the couple has run up debts of $435,000, which is about 2.7 times their annual gross income of approximately $160,000. That's not entirely unsupportable, but they recognize they have to reduce the debt load drastically if they want to avoid sacrificing other goals, such as sending their children to university and financing their retirement.
"We feel the effects of debt fatigue and would welcome the chance to put our money to better use than making endless payments," Caroline says.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Herb and Caroline on a debt-management strategy, and to devise ways of financing their other obligations.
"They have made expensive choices, such as home-schooling, but the most serious problem is that, until recently, they have not taken a keen interest in their finances," Mr. Moran says. "In a financial sense, they are behind where they should be at their stage in life. Yet it is not too late to catch up--if they follow a strict plan."
Herb and Caroline pay $2,100 a month on their $335,000 mortgage. It carries a 5.1% interest rate. If they do not accelerate payments, they will have to continue paying off the mortgage for 22 years, until the couple turns 69. They are also paying $1,050 a month on a $60,000 line of credit. At a 5.0% interest rate on the loan, they will have it paid off in 5.5 years, Mr. Moran estimates.
The payments on the two debts eat up 37% of their $8,600 after-tax monthly income and limit their options. First move: Ask the unsecured lender to set up a secured line of credit on their home equity. That should cut the interest rate to prime plus 1%. The secured loan can only be 80% of the $450,000 market value of the house, or $360,000 less their existing mortgage debt of $335,000. The net loan amount would therefore be $25,000, but it can grow as they pay down their mortgage.
Once Herb and Caroline eliminate the line of credit, they can shift the $1,050 per month they pay on it to mortgage reduction. That would reduce the amortization period by seven years and one month and save them $62,200 in interest. They would then be mortgage-free by age 62.
If they divert their $500 monthly RRSP payments and $400 per month TFSA contributions to reducing the line of credit, they will have it paid off in three years rather than 5.5 years.
The total amount of cash flow going to debt reduction in this scenario would be $2,100 on the mortgage, $1,050 on the line of credit and $900 clipped from RRSP and TFSA savings, or $4,050 per month. If that cash is directed to mortgage reduction, they will have the mortgage eliminated in 10 years and eight months. They will save $108,600 in total interest payments, Mr. Moran says. A final note -- the $40,000 car loan they carry as a liability is a family debt. Debt forgiveness or postponement could be arranged with the lender, Mr. Moran suggests.
The reallocation of RRSP and TFSA to debt reduction is possible because Herb and Caroline expect to be able to get by with yearly Canada Pension Plan benefits that should total $19,057, combined yearly OAS payments of $12,408 and annual RRSP payouts.
Assuming $72,000 in present RRSP balances grows to $122,600 at 3% interest for 18 years, and adding Caroline's projected retirement allowance of $52,000, their RRSPs would have principal of $174,600 beginning at age 65 and generate $10,025 per year. Combine that with her employment pension of $34,800 per year and the sum of the payments and benefits would be $76,290, before tax, at age 65.
Their pre-tax income after 65 will provide about twice as much disposable income as they have today, for they will be free of as much as $48,000 per year of interest expenses, retirement savings and child-rearing expenses. If the $700 they spend each month running and repairing their two cars is reduced to, say, $300 for one car, they can save an additional $4,800 a year and raise their personal spending to perhaps $42,600 per year. If they remain in Alberta and pay that province's relatively low income tax rate, they would have about $51,300 per year in after-tax income. The difference in this level of income and what would be about $38,300 in retirement expense could go to travel, for which they currently budget only $1,200 per year, Mr. Moran says.
Herb and Caroline can get more out of their RRSP investments. Without taking on additional investment risk, and using exchange traded funds, for example, they can cut fees and add 1.5% to 2.0% to their returns, the planner says. That cost savings would help cover inflation erosion running at a similar rate, Mr. Moran notes.
If they elect to use ETFs, they should ensure that they have both stock and bond exposure. Studying capital markets before making any portfolio changes could pay handsomely, the planner says.
Herb and Caroline pay their children wages of $150 each per month for work they do in connection with the parents' own business sidelines. Money taxed in the kids' hands is tax-free as long as each child's total income is less than $10,320 for federal tax and $16,825 for Alberta tax in 2010. Money paid to the children does not add to Herb's tax liability, for he reports net business income as his own. Payment for legitimate work by the children is not only reasonable, but could be increased from $150 per child to $360 per child, with the money being used to fund their RESPs. The family currently has only $3,000 of RESPs, the planner notes.
Payments of $208 per child, or $2,500 per year to each of the three children, will qualify the children to receive the Canada Education Savings Grant, which is the lesser of $500 per beneficiary or 20% of RESP contributions up to $2,500. They have a sum of 10 years up to and including the calendar year the youngest child turns 17 to contribute and receive CESG grants. As each child turns 17, the CESG would stop, but the current $3,000 in their RESPs would grow to $33,000 through this process.
Given the existing retirement resources of the family and the parents' modest aims for retirement, shifting retirement savings to debt reduction will enable the parents to breathe a sigh of relief.
"Herb and Caroline will have to work to their early 60s, perhaps to age 65," Mr. Moran says. "If they put every bit of money they can spare to debt elimination, they can achieve their goals."