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Editor’s note: After more than a decade in which he crunched the numbers on the finances of hundreds of Canadian families, Andrew Allentuck is hanging up his hat as the FP’s Family Finance columnist. This will be his final column. Look out for the new Family Finance, coming soon.
A couple we’ll call Ernst, 52, and Molly, 48, live in British Columbia. They have combined gross income of $178,000 per year from their jobs in technology and hospital administration, respectively, and take home $10,075 per month after taxes. They are in the process of buying a new home, but the market has thrown them a curve: Rising interest rates have driven down the price of their present home and raised the monthly mortgage cost of the one they are buying. They have spent most of their savings and now find themselves in a cash crunch. It’s a serious financial jam.
They thought their present home would sell easily for $900,000 but have no bids on an asking price of $850,000, barely above the $790,000 mortgage they are carrying. They have also agreed to pay $1,050,000 for a new home, on which they have paid a $50,000 deposit . They need $275,000 to close on the new house and will have to cover $40,000 to sell their old house including $35,000 fees if they wish to get out of their existing mortgage. That’s a total of $315,000 cash that they need to complete both transactions. They have $90,000 present cash, a drop in the bucket.
Asset cupboard is bare
Aside from the cash and the homes, their other assets are meagre: just $11,000 in mutual funds and a $27,000 car. They have no RRSPs nor TFSAs. Each will have a defined-benefit pension, but the capital behind the pensions belongs to insurance companies that will pay the pensions. It would be costly to access as commuted value and then only with hefty tax and large discounts, but it is an option they will have to consider to complete the down payment.
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Their liabilities include the $790,000 old house mortgage and the $1,050,000 new house mortgage.
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, BC, to work with Ernst and Molly. The couple’s problems are not funding retirement but, rather, paying for their new home.
“They have minimal net worth on their balance sheet, but they are not poor,” Moran explains. “There is a big difference.” The old home is not a financial disaster, he says. They paid $615,000, so they have had what amounts to free accommodation with a capital gain. However, rather than paying the mortgage down over time, they have used their equity as an ATM. It is catching up to them now.
A rental suite in their new house can be valued at $250,000. Rent they receive will make it self-financing and then produce additional cash flow.
They should have a realtor provide a written opinion of the value of the rental suite, Moran suggests. The mortgage cost related to it will be tax deductible, so they should pay it off slowly and concentrate payments on their own accommodation’s cost, which will not be deductible.
They might get a two-tier mortgage — one for their own home and one for the rental. That would keep their accounts clean for CRA reporting, Moran suggests.
If it were not for the large mortgage balance caused by overspending, they could retire early. However, to make up for it, they have agreed to work to Molly’s age 65 when she will have an indexed pension of $35,000 per year. Ernst, starting the same year (when he is 68), will have a non-indexed pension of $26,703 per year. Each partner can expect Canada Pension Plan benefits of $15,043 at 65, the present upper limit. At 68, when he retires, he will get a boost of 8.4 per cent per year, making his CPP $18,834 per year. At 65, Molly will get the base amount.
Each will have full Old Age Security, $8,000 per year with available bonuses of 7.2 per cent per year for each year they defer the start beyond age 65.
Molly’s annual pension will be $35,000 and Ernst’s will be $26,703 plus $18,834 enhanced CPP and $9,728 enhanced OAS. Molly can add her own $8,000 OAS, and CPP of $15,043 at 65. That would make total income $113,308. After splitting income and 17 per cent average tax, they would have $94,045 per year or $7,837 per month to spend.
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Resolving the cash crunch
Ernst and Molly still need to come up with $275,000 to complete the purchase of their new home. Selling their old house for $850,000 estimated price less $40,000 in fees, and paying off their $790,000 mortgage will leave them with $20,000 to add to the $90,000 they could scrape up, but they would still be well short. Commuting one of their pensions is an option, but it would permanently reduce their income in retirement. Relying on credit cards is never a good long-term solution, but in this case might tide them over. Income from the rental suite and money that used to go toward savings could be diverted to pay that debt down. Taking out a loan from a relative would be another option, or some combination of all of the above.
They are in their dilemma because rising interest rates have dealt them a double whammy — deflating the market for their old home while boosting the mortgage cost for the new home. With time, their debt will shrink and they can write off some mortgage cost for the rental suite. Molly and Ernst have a cash crunch rather than a date with insolvency.
“Provided they pay down debt within the present low to mid-single digit outlook for interest rates, they will come out of their cash crunch in good shape,” Moran says.
Retirement stars: 2 ** out of 5