Should Charity Begin at Home

ANDREW ALLENTUCK

In Victoria, a couple we'll call Ed and Susan, both 30, are trying to raise their two children, ages six and four, on a modest budget. Their mortgage payments of $25,800 a year eat up 38 per cent of their total income based on annual home pay of $59,500, plus $9,000 a year from renting out a basement suite in their house.

To pay the mortgage, they have given up a lot. They limit dining out to $50 a month, registered education savings plan contributions to $80 a month, and vacations to $100 a month.

They also tithe $475 a month to their church. They finish each month with no cash left over. Understandably, they feel financially stretched.

"Should we be sacrificing our long-term savings to pay for our house?" Ed asks.

"All our eggs are in one basket. Sometimes it feels like it would be easier to move to the Prairies, buy a house for $150,000 and take a cut in pay."

What our expert says:

Facelift asked Derek Moran, president of Smarter Financial Planning Ltd. of Kelowna, B.C., to work with Ed and Susan in order to find ways to improve their fortunes.

"With the combination of Ed's rising income, they will be fine," the planner says. But there are a lot of intervening issues. First, Susan is a stay-at-home mom who earns $5,000 a year before tax doing odd jobs. She may go back to work once her younger child begins school in two years. At that time, Ed, an engineer, expects his salary to be $80,000. Eventually, when he has earned his full professional designation, his salary should be up to $130,000."

Until then, Ed and Susan have to deal with the problem of meeting their expenses and paying their debts on an income that is trailing the rise in real estate prices in Victoria.

Their house has a $435,000 mortgage with a 5.1-per-cent interest rate and their lines of credit total $25,000 with an 8.5-per-cent interest rate. They also have a $9,000 loan with a 7-per-cent interest rate. Their monthly interest charges for all this debt total $2,800, 49 per cent of their $5,708 monthly after-tax income.

Before Susan returns to work and, indeed, as a beginning in reducing their debts, Ed and Susan should review the amounts they give to charity. Ed and Susan believe deeply in the church and the principles for which they tithe so much. This is a delicate subject involving family finance and family values, Mr. Moran notes. However, if they were to add the $475 to mortgage pay downs, and if the interest rate were to remain unchanged for the life of their 40-year mortgage, they would save $251,588 in interest and shave 15 years and two months off the amortization period, he calculates. As it is, at the end of their present five-year term, if no extra payments are made, they will have paid $128,100 to their lender and still owe $419,871, he explains.

The debt exposes the family to a huge risk. If Ed and Susan were to renew their mortgage in five years at 7 per cent, the monthly payment would rise to $2,653 on what would then be a 35-year amortization. At 8 per cent, the monthly payment would rise to $2,942.

Moving to a less expensive house on the Prairies is not quite the solution that Ed and Susan imagine. If they sold their house tomorrow, their $15,000 of equity based on market price, less debt, would pay the cost of a moving van and perhaps some real estate commissions.

Ed and Susan have time on their side, Mr. Moran says. Ed is saving $200 a month in his registered retirement savings plan. If contributions continue for 30 years until a potential retirement age of 60 and earn 6 per cent a year less 3-per-cent annual inflation, Ed will build up $161,300 in his account. Were he to defer starting saving to age 40, he would have $98,950 in his RRSP using the same assumptions, the planner says.

Raising RRSP contributions to $1,000 a month beginning in 2010, which Ed may be able to do after expected pay raises, and including a 5-per-cent match from his employer, would allow him to build up $588,304 by the time he is 60, using the same assumption, Mr. Moran estimates.

Ed is likely to qualify for Canada Pension Plan benefits at the current maximum rate of $10,365 a year. Susan will also have time to qualify for benefits, Mr. Moran estimates. If she qualifies for 50 per cent of the maximum, she could draw $5,183 at age 65. They will also qualify for full Old Age Security pensions that are currently paying $6,028 a year. Both of these government pensions are indexed and taxable.

Ed and Susan would be able to retire on total income of $56,744 in 2007 pretax dollars. That income, which would begin in 2038 when each is 60, would last to age 90, Mr. Moran explains. Any rental income they might have would add to the total.

For now, Susan can make a dent in their debts by taking $4,500 out of her RRSP.

That would exhaust it, but in her tax bracket, there would be little or no tax. The funds would go into her income and would reduce Ed's full spousal tax credit, but it is still worthwhile, Mr. Moran says. The money could be used to pay down their lines of credit that currently cost 8.5 per cent a year in interest. The reduction in the line of credit will open up space for emergency expenses.

Ed could also use the $4,500 from Susan's RRSP for his retirement plan or to make a spousal contribution. That would generate 30.65 per cent in tax savings. His bracket will rise in future, so it might also be prudent to let the money stay where it is and take it out before Susan goes back to work and has a higher tax to pay on RRSP withdrawals, Mr. Moran says.

"Risk management is the story here," Mr. Moran says. "If Ed and Susan accelerate paying down their mortgage, reduce their other debts, and just keep healthy, Susan's return to work and Ed's career advancement will get them past their debts into a time when they will have more room to breathe."

Ed and Susan remain committed to their principles.

"I think that when my kids are grown up, they will still gladly have given up some luxuries so that others could have the basics," he explains. "We are responsible and at least in part this comes from sharing what we've got."


Client situation

The Couple

Victoria couple, each 30, with two children ages four and six.

The Problem

Huge mortgage payments have to be made.

The Plan

Adjust expenses and RRSPs and use extra cash to reduce debt.

The Payoff

Discharge of mortgage, reduction of other debts.

Net Monthly Income

$5,708.

Assets

House $450,000, RRSP $18,000, cars $15,000. Total: $483,000.

Monthly Expenses

Mortgage $2,150, other debt service $54, property tax $100, utilities $345, house & car insurance $200, child care $85, food $700, dining out $50, entertainment $100, clothing $100, RRSP $200, RESP $80, gasoline & car repairs $250, travel $100, extended health care $65, charity $475, miscellaneous $656. Total: $5,710.

Liabilities

Mortgage $435,000, loans $34,000. Total: $469,000.

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