In Toronto, a couple we'll call Frank and Wendy are both 37. Frank is an engineer. Wendy is self-employed. They have a $630,000 house on which they have a $402,000 mortgage balance. As they approach middle age, they realize that they have to build a retirement plan.
Debt is the obstacle to their retirement. Currently, the couple spend $7,450 per month while taking in $5,000 after tax. The shortfall is caused by debt payments of $2,292 a month for their mortgage and $700 a month to service the line of credit they use to cover their monthly deficit. The line of credit, with a $27,000 balance, is rapidly approaching their $30,000 borrowing limit.
"We know that we don't have enough for retirement given our spending," Frank explains. "But we have to deal with the debt problem."
What our expert says:
Facelift asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Frank and Wendy.
"Frank and Wendy will evolve over time from debtors to creditors, but for now, their problem is whether to decrease debt or increase income," he explains. "It is a serious problem."
The couple's ability to raise income quickly is limited. Wendy's small business loses $1,000 a month. At one time, the business produced an income of $40,000 a year, but a serious illness forced Wendy to cut back her work time.
The alternative is to cut spending. That requires dealing with a house they cannot afford at present. The couple bought it with a $200,000 down payment that was the profit from selling a house they owned in Vancouver. They can extend the amortization of their mortgage from its present 22 years to 28 years, thus reducing their monthly payments to $1,748 from $2,292. That would still leave them with a large monthly deficit. Or they could sell the house and move to something less expensive, Mr. Moran notes.
Frank and Wendy have set a goal to have $1.5-million for their retirement when they reach age 65. In order to achieve that sum on top of their present $55,000 of investments, they would have to add $31,000 a year or $2,583 a month for the next 28 years, assuming a 3-per-cent real return a year. On their present income, this is not possible. But public pensions will provide guaranteed, inflation-indexed income, reducing their savings requirements.
They should both receive Old Age Security, currently $6,070 a year, and Canada Pension Plan benefits. Frank should get the CPP maximum of $10,615 a year while Wendy, who earns much less than Frank, will receive a lower level of benefit, which is likely to be half of the maximum or $5,308 a year. OAS and CPP will therefore provide $28,063 a year, the planner estimates.
Their monthly expenses should decline in retirement to $3,500 after $4,000 of debt service charges, employment expenses (suits, business lunches, commuting) and future RRSP contributions are removed from the budget, Mr. Moran estimates. On an annual basis, their reduced expenses would be $42,000 a year. They can cover that level of expenditure with $13,940 in 2008 dollars a year of investment income on top of the estimated amount of what they may get from CPP and OAS, the planner estimates. That investment income would require capital of $242,687 assuming a 6-per-cent annual return before inflation, Mr. Moran says.
They could build that capital in 2008 dollars by adding $715 a month or $8,580 a year to their present RRSP balance of $55,000 for the next 28 years. With their present net monthly negative cash flow, such savings are impossible. Moreover, the cash flow could become even more negative if their 3.9-per-cent current mortgage rate were to rise.
They have to face the reality that, for now, they should sell and harvest their equity. They could buy a condo or less expensive house and thereby remain in the usually bustling Toronto property market. With a $200,000 mortgage, half the size of their present mortgage, monthly payments would be $1,131 with the present 22-year amortization. If they extend the amortization to 2036, when they will be 65, then their payments would fall to $980 a month and leave them with monthly expenses of $6,188, a sum still in excess of their take-home income.
If Wendy were merely to close her money-losing business and save the $1,000 she is spending to subsidize its losses, the couple would be close to breaking even with estimated expenses of $5,188 a month. They could easily strip $188 from monthly disbursements by reducing the total of $400 they now spend each month on restaurants and entertainment.
Frank and Wendy have considered adopting a child. It is not possible to estimate with any accuracy the future costs of events that have not taken place, but on their present income and with their present expenses, the costs of child rearing would be a strain unless Wendy returns to employment on at least a part-time basis or generates a meaningful profit from her business.
"This couple has to make a tough decision on whether to live modestly now and have a secure retirement or keep their relatively expensive house and stay burdened under debts they cannot service. If they choose the latter, then with their present income, they would wind up insolvent."
Toronto couple, both 37.
A house they cannot afford with mortgage payments they cannot maintain.
Sell the house, harvest equity, buy something less expensive.
Money to pay down debts, build up retirement savings.
NET MONTHLY INCOME
House $600,000, car $10,000, RRSPs $55,000. Total: $665,000.
Mortgage $2,292, property taxes $345, house maintenance $415, line of credit $700, utilities & phones $435, food $450, restaurant $200, entertainment $200, clothing $200, Car fuel & repairs $150, car & home insurance $200, life insurance $75, charity & gifts $45, pet costs $75, commuting $120, medical & dental $180, business loss $1,000, business & job expenses $300, miscellaneous $118. Total: $7,500.
Mortgage $402,000, line of credit $27,000. Total: $429,000.
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