Below you will find a real life case study of a couple who are looking for financial advice on how best to arrange their financial affairs. Their names and details have been changed to protect their identity. The Globe and Mail often seeks the advice of our VP, Wealth Advisor, Matthew Ardrey, to review and analyze the situation and then provide his solutions to the participants.
Special to The Globe and Mail
Published October 4, 2019
Chelsea and Chad are earning big and saving mightily, but with a second baby on the way, Chelsea is mulling a possible career change that would cut her income substantially. They are both 34 with a toddler, a mortgage-heavy house in Toronto, and two rental condos.
Chelsea earns $250,000 a year in sales, Chad $115,000 a year in technology. Their condos – their principal residences before they got together – are both generating positive cash flow. With the “main breadwinner” taking a year off and big mortgage payments, they are wondering how to “make it all work.”
They ask whether they should continue paying down their home mortgage aggressively, and whether they should borrow against their rental units to invest. “There is a lot of money coming in and out of our accounts monthly, with property tax, condo fees, and so on,” Chelsea writes in an e-mail. They wonder whether they are managing it optimally.
“We just keep saving but with no clear goal in mind or understanding if our planning is sound,” she adds. They have a “strong desire to maintain a safety net,” and to have a “sound strategy for retirement.”
We asked Matthew Ardrey, a vice-president and financial planner at TriDelta Financial in Toronto, to look at Chad and Chelsea’s situation.
What the expert says
Mr. Ardrey started by running the numbers Chad and Chelsea provided for their income, savings and expenses. To his surprise, his software showed the couple had a $45,000 a year surplus – even after accounting for savings and tax refunds from RRSP contributions. “I believe this is significant leakage in their spending that they have not recorded,” he says.
“Because most people know what they earn and what they save, I can only assume this is being spent,” the planner says. He has included an additional $45,000 worth of expenses in their plan to account for the discrepancy. This takes their adjusted spending to $205,000 a year, including mortgage prepayments.
“This is the primary issue that Chelsea and Chad need to address before any others,” Mr. Ardrey says. “A material change in expenses will affect all financial projections and analysis, including making sure they have sufficient life and disability insurance,” he adds. “I recommend that they go through a detailed budgeting process as soon as possible.”
Both Chelsea and Chad have defined contribution pension plans or group registered retirement savings plans at work to which both they and their employers contribute. As well, they both make maximum contributions to their tax-free savings accounts.
In addition to the registered savings, they make an extra payment of about $12,000 each quarter ($48,000 a year) on their mortgage, and tuck away $2,000 a month ($24,000 a year) in a non-registered savings account. In the past, they have used this money for RRSP top-ups, TFSA contributions and mortgage payments. More recently, they have been setting it aside to help offset the drop in income during Chelsea’s mat leave. Chelsea will get 60 per cent of her salary for the first 16 weeks and employment insurance benefits thereafter.
Their rental properties bring in an additional $19,800 a year for Chelsea and $14,820 for Chad after expenses, but before taxes.
Chelsea and Chad have a $719,000 mortgage on their principal residence and a $42,000 mortgage on one of the rentals.
It is unfortunate that Chelsea and Chad have so little debt against their rental properties and so much against their principal residence, because the rental mortgage interest is tax deductible, but interest on their principal residence mortgage is not.
Although a common thought would be to leverage the equity in the rentals to pay off the principal residence, the Canada Revenue Agency has recently disallowed a similar strategy. For interest to be tax deductible, the use of the borrowed money must be to produce income, the CRA says. The intention of the transaction and the assets pledged for security are both immaterial in this determination. The agency is reviewing tax deductibility on a case by case basis.
Chad and Chelsea ask whether they should use their surplus cash flow to pay off the mortgage or invest. They might be better off financially investing, Mr. Ardrey says. That’s because the after-tax cost of the mortgage interest is low: 2.54 per cent based on the current mortgage rate on their principal residence.
“To break even on investing instead of making extra mortgage payments, assuming a 50 per cent tax bracket and earning interest income, they would need to earn 5.1 per cent on their investments,” he says. This would be even more appealing if they engaged in tax-efficient investment planning and had more of their returns coming from dividends and capital gains, Mr. Ardrey says.
For their children’s education, the annual RESP savings of $2,500 for each child will fall short of the future costs by about 50 per cent, the planner says. The current average cost of postsecondary education is $20,000 a year. Historically, these costs have outpaced inflation, so he assumes the education costs rise at the rate of inflation plus two percentage points. If Chad and Chelsea want to fully fund their children’s education costs, they will be in a position to do so at the time simply by redirecting the surpluses from their non-registered investing to the education expenses, he says.
Next, Mr. Ardrey looked at how Chelsea’s lower income would affect the family finances. If Chelsea changes careers, earning $125,000 a year, they will not be able to make extra payments to their mortgage for the time being. As well, they would not be able to add to their non-registered savings. They would have to reduce their spending by a significant amount: $20,000 a year after-tax, to $137,000 a year. That’s a reduction of the $48,000 for the extra mortgage payments and $20,000 of actual spending. This would continue until their first child is 12, in 2029. If they are both working full-time with good income, they will likely have to have some form of before and after school care, the planner says. By the time the older one is 12, most agree that they can be responsible enough to babysit.
The reduced savings would affect their retirement, but they would still be able to retire comfortably, Mr. Ardrey says.
Finally, Chad and Chelsea would benefit from having a full financial plan prepared, Mr. Ardrey says. “A comprehensive financial plan will create a road map for them to follow.” In their case, it is not the retirement that is unclear, it is the next 10 years, he adds. “Having a plan will help them make the right financial decisions for both today and tomorrow.”
The person: Chad and Chelsea, both 34, and their children.
The problem: How to prepare themselves financially for the career change Chelsea is considering. Should they keep paying down the mortgage, or should they borrow to invest?
The plan: Draw up a budget that tracks their actual spending to determine where the leakage is. If Chelsea changes jobs, be prepared to cut spending and halt the mortgage prepayments for a few years.
The payoff: A clear road map across the next decade or so when their cash needs will be greatest to open roads later on.
Monthly net income: $22,900
Assets: Bank accounts $100,000; her TFSA $69,000; his TFSA $71,000; her RRSP (including group RRSP) $233,000; his RRSP $83,000; his DC pension plan $8,000; RESP $9,500; principal residence $1-million; her rental condo $700,000; his rental condo $350,000. Total: $2.6-million.
Monthly outlays: Mortgage $3,820; property tax $695; home insurance $160; utilities $160; maintenance, garden $75; extra mortgage payments $4,000; transportation $455; groceries $350; child care $1,300; clothing $200; gifts $50; vacation, travel $1,000; dining, drinks, entertainment $380; grooming $75; subscriptions, other personal $60; drugstore $10; life insurance $275; disability insurance $225; phones, TV, internet $70; RRSPs $3,500; RESP $210; TFSAs $835. Total: $17,905. Surplus: $4,995.
Liabilities: Residence mortgage $719,000 at 2.54 per cent; rental mortgage $42,000 at 3.15 per cent. Total: $761,000.
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Some details may be changed to protect the privacy of the persons profiled.