Debt: how much is too much?
Given that interest rates are on the rise and the pace of Canada's economic recovery is uncertain, it's a good time to review your current debt obligations and determine if you should be making any adjustments. Where this is especially critical is when your personal goals and objectives would require you to take on more debt.
Here are three different scenarios that explore different objectives and discuss when taking on more debt makes sense - and when it doesn't.
Young Parents Michael & Janice: Single income, big dreams
Michael and Janice are raising two young children and would like to move up to a larger home. At the same time, they need to save for their children's education and their own retirement. Can they do it all on a single income?
With Janice now a stay-at-home parent, Michael is the sole breadwinner, bringing home $7,500 each month. Although the couple has recently scaled back their RESP contributions to $70 per month per child, they have still managed to build up $5,000 in educational savings. Michael has a generous RRSP contribution limit each year, but has neglected to contribute consistently. As a result, he has $100,000 of unused RRSP contribution room.
Objective #1: Boost educational savings
If they don't step up their RESP contributions, Michael and Janice will fall short of the amount they will need when the kids are ready to enter university. They should aim to contribute enough to qualify for the maximum $500 Canada Education Savings Grant (CESG), that is, $2,500 a year per child. Given they have more than 12 years of tax-free growth until the first funds are needed, a boost to $208 per child per month will result in a yield of more than $100,000 in savings, enough to pay for a four-year post-secondary program for each.
Here’s an idea that's a little different but may make sense. Michael and Janice could decrease their monthly mortgage payment just enough to free up the necessary cash. While it will take a little longer to pay off the mortgage, the extra educational savings topped up by the CESG funds will more than offset the added mortgage interest.
Objective #2: Get the RRSP back on track
To get his RRSP growing, Michael should look to any non-registered holdings as a source of funding. By transferring these investments as an in kind contribution towards his RRSP, Michael can generate funds in tax savings for reinvestment. Or, if the non-registered holdings were sold, the proceeds could be applied against the couple's mortgage to produce long-term interest savings, giving Michael breathing room to contribute more aggressively to his RRSP as he moves closer to retirement.
Objective #3: Trade up to a larger house
Michael's and Janice's dream of a larger home will add a large chunk to their mortgage principal and mean a hefty increase in their mortgage payments. If Janice returns to work, her extra income could cover the increased expense, and the couple could indeed have it all. Otherwise, pursuing their dream house might jeopardize the couple's retirement security and their children's future education.
Boomers Peter & Nicole: Early retirement on hold?
Peter, 57, and Nicole, 54, are looking forward to early retirement. But they have a problem: how do they maintain the lifestyle they've grown used to, while dealing with the immediate expenses of home renovations and funding their children's education?
The couple earns a substantial combined income of $240,000 annually and can look forward to solid pensions that will cover part of their expected retirement income expenses. They have only a small balance left on the mortgage of their $1-million residence in North Vancouver.
But while they enjoy a financial picture that's healthy overall, Peter and Nicole face obstacles to taking early retirement. While their pension income looks solid, the couple's personal retirement savings took a substantial hit in the market meltdown. They recently purchased a rental property for $350,000 with only a minimum down payment meaning mortgage payments will continue for some time. In diligently saving for their own retirements, Peter and Nicole overlooked saving for their children's education. With their eldest child expected to start university in the fall and their youngest next year, the couple needs to pull together savings immediately. Complicating matters, their aging home is in dire need of repairs and renovation.
To free up cash for their children's education and renovations, Peter and Nicole's could either sell the rental property for a net profit of $50,000 or cash in RRSPs. The latter is always a last resort. First, their investments have yet to fully recover from the market drop, so selling everything now would lock-in their losses. Secondly, their RRSPs are still needed to fund the retirement lifestyle they’re seeking. And finally, they would only net half of what they cash in because the proceeds would be taxed at the highest rate.
A third alternative is to borrow against home equity through a secured line of credit. This is an affordable way to fund the home renovations. The increase in their home's market value from making the improvements will more than offset the marginal increase in interest expense.
With a substantial combined income of $20,000 a month, perhaps the smartest route to helping their kids, keeping their condo and renovating their home would be for Peter and Nicole to work a few years longer. They'll be in a better position to meet their immediate challenges.
Retirees Maggie & Tom: The Sun Belt beckons
Recently retired, Maggie and Tom, both 65, want to spend more time pursuing their passion: golf.
The couple is eyeing a vacation property in Palm Springs. They feel it's a good time to take advantage of the high Canadian dollar and bottoming real estate prices south of the border. While Maggie and Tom are excited at the prospect of wintering in Southern California, there's a lot to consider before taking the plunge.
Financing the purchase is the first challenge. Maggie and Tom can use some of the significant home equity they've built up and borrow against it to purchase in Palm Springs. But do they want to be saddled with debt payments for years to come? Alternatively, they could cash in some of their investments. Not only would this have immediate tax consequences, they would lose the critical retirement income these investments deliver. Selling would also mean losing a source of funds to meet future health care needs which might arise.
The couple can consider downsizing from the home they're in now. Gains realized from the sale of their principal residence would be tax-free. The funds would greatly reduce the amount of financing required for their vacation home.
An option often touted to unlock home equity is a reverse mortgage. While it may be an appropriate choice for some, Maggie and Tom should understand the risks. A reverse mortgage can be a relatively expensive form of financing that would gradually erode the remaining equity in their primary residence.
When it comes to owning a second property, financing is just part of the puzzle. There are travel expenses and health insurance costs, maintenance costs, property taxes and insurance, and other ongoing expenses to consider that will further eat into their planned retirement income.
Owning a Palm Springs vacation property will go a long way to giving Maggie and Tom the retirement they want. But adding significant debt at this point in their lives is a proposition that carries some risks and needs to be well thought out.
There are always decisions
Every lifestyle decision at every life stage can involve decisions about borrowing. You'll constantly be asking – how much debt is too much? Just like investing, how much you borrow depends on your risk tolerance and clearly establishing the importance and priority of your various financial goals. If you are contemplating taking on more debt or are concerned with the debt you currently carry, talk to your BlueShore Financial financial advisor.