YOUNG FRUGAL COUPLE STILL NEEDS TWO INCOMES
In Ontario, a couple we’ll call Esther, 23, and Mike, 27, live with their new baby. They have monthly take-home income of $5,650, a house worth about $300,000 with a $206,000 mortgage and a $240,000 rental property with a $186,000 mortgage. Their plan is for Esther, who is an office manager for a small company, to be a stay-at-home mom raising what they expect will be two children. Mike, who runs a house contracting company, will have to carry the family’s financial load. They expect that their children will go to religiously oriented private schools. They want to buy another rental property for retirement income.
That’s the plan, but there are four decades of work and saving ahead. They are aware that building so much on one income is risky. “How soon can we meet our goals on a single income?” Mike asks. “Are we stretching our finances by buying more property?” Family Finance asked Daniel Stronach, head of the Stronach Financial Group in Toronto, to work with Esther and Mike.
“Mike and Esther have done all the right things,” Stronach says. “They bought a rental property, then increased the mortgage on the property to get money for a down payment on their own home, then rented out the upstairs portion of their home. That’s creative finance.”
FINANCING THEIR GOALS
Their plan is to acquire another rental property for $240,000 with $60,000 or more down, even though that may not be the best course.
However, if they manage their living costs carefully, they can pay off some of their debt in the four years before their first child begins private kindergarten.
The problems ahead lie in diversification or, specifically, lack of it, Stronach notes. If they have just a few rental properties, loss of one tenant or interruption of rental flows could cause a liquidity crisis. They are vulnerable to drops in property values and they could have their anticipated profit margins slashed by rising interest rates.
Most of all, the properties they hope to buy will be pyramided on Mike’s income, the family’s sole source of support. They have already borrowed $40,000 on their RRSPs via the Home Buyers’ Plan and now have to pay the RRSPs $2,666 a year for the next 15 years.
The good part about their focus on real estate is that loans of 75 per cent on appraised value are usually available. Rental income as a fraction of their 25 per cent equity would be much larger than if they owned the property outright.
Yet there is risk in carrying property on long loans, especially if interest rates rise, Stronach says.
There are other risks as well: vacancy, tenant damage, injury to Mike making him unable to do some of the manual work for his rentals and, most of all, lack of diversification if their investments continue to be concentrated in residential property. As well, residential property rents may be rent controlled and, even where not constrained by law, leases prevent quick adjustments to rents charged. Finally, returns on directly owned property cannot benefit from the dividend tax credit available for stocks.
With so many drawbacks to a portfolio mainly based on rental apartments, a strategy to get diversified is important. Mike and Esther have just $1,600 in their RRSPs after taking into account their HBP loans. They currently contribute $222 a month. Their TFSAs have $38,000 in total.
There is no life insurance in place even for external liabilities, excluding the RRSP loan, of almost $400,000. Yet they can’t diversify until their properties are paid off. For now, therefore, just buying life insurance on each parent’s life is vital.
COSTS OF CHILDREN
The couple’s pre-baby take-home income dropped by $2,200 a month after tax when Esther stopped working. Parental benefits will temporarily boost income and the Canada Child Benefit should pay them about $360 a month, based on expected income and one child.
However, the core family income stream will be Mike’s $3,400 monthly income. And that is problematic.
The couple’s current expenses excluding savings add up to $4,377 a month. Initial costs of care apart from income loss will be small, but when the children start school, tuition expenses averaging $400 per child per month for kindergarten and then $700 per month for tuition for Grades 1 to 12 will require the couple to dip into savings, Stronach says.
Mike and Esther will probably want to build savings for the postsecondary education of their children. They can add $208 a month for each child to an RESP, for savings totalling $5,000 a year.
For that, they would receive the Canada Education Savings Grant of the lesser of $500 or 20 per cent of contributions per child per year, to a maximum of $7,200 per beneficiary. If they manage to do that for 14 years, they will max out the CESG and, assuming gains of three per cent interest above inflation, have $105,600 for two children.
If they continue to contribute for three more years of growth without the CESG they would have $131,310 for the children. Split, each would have about $65,600 for college or university. However, to make these savings possible, Esther will have to return to work.
RETIREMENT FINANCE
Using projections based on ownership of their present $292,500 house and the present and one future rental property worth a combined total of $480,000, then in 2017, after buying one more property for $240,000 and taking on a $156,600 mortgage, they would have $548,600 of debt and $223,900 of equity. Their rental income based on existing rents and estimated rent for a new unit, would total $38,940 before estimated maintenance, tax and other expenses of $12,100 a year.
Mortgage interest based on total debt of $548,600 financed at four per cent for 25 years would total $29,050, leaving net rent before tax negative by $2,210 a year. We’ve allowed a fairly high rate of interest to cover the likelihood that rates will rise in the next 25 years. If property prices rise enough, the annual negative income from rentals will just be a carrying cost for profits.
Projecting retirement income four decades into the future is more conceptual than certain, Stronach says. Mike and Esther will have to save for retirement during the two decades after their children have moved out. If they save just $1,800 a year for 20 years starting in 2032 when the RRSP loan is paid and obtain an annual rate of three per cent after inflation, then when Esther is 63 and Mike is 67, they would have about $120,000 in their RRSPs.
That sum would support an annuitized income of about $5,700 a year for the 35 years to Esther’s age 98.
When Mike is 60, having earned an assumed two-thirds of maximum Canada Pension Plan benefits by his early retirement, he could receive $8,770 a year, RRSP payouts of $5,700 a year and rental income of $6,863, assuming interest is within the four per cent limit and one rental unit mortgage is paid off. It would be advisable for him to continue working.
Assuming pre-tax employment income of $65,650 a year, his income would total about $87,000 a year.
Four years later, Esther could draw CPP benefits of an estimated $2,193 a year based on a conservative estimate of only a fifth of total CPP benefits and, when both partners are 65, they could receive Old Age Security benefits totalling a combined $13,692. If Mike has retired at that point, as planned, his employment income would stop.
With that assumption, when both mortgages are paid off, income based on present rents would rise by an estimated $12,400 to make final retirement income $49,620 a year before tax or $3,720 a month after splits of eligible pension income and 10 per cent average income tax.
“These are distant, speculative numbers,” Stronach says.
“If Esther returns to work when their children start primary school, then they could have two incomes, save aggressively, and build assets, liquidity and security.”