Huge debts perilous for retirement plans
SITUATION Woman with massive debts is headed toward bankruptcy STRATEGY Trim expenses, sell one home, pay off debts SOLUTION Debt burden eliminated, secure and comfortable retirement
In Ottawa, a federal civil servant we’ll call Sarah, 49, is drowning in debts of $293,600 while supporting a disabled sister. That’s approximately five times her annual take-home income of $60,132. Payments to service this debt, $2,407 per month, take an astonishing 48% of after-tax monthly income. She has to borrow for day-to-day expenses.
“I have so many goals, but the debts and what I have to pay for my sister have left me with no room to manoeuvre,” Sarah says. “I want to travel to Spain and France, New York and the Yukon. I have family on the West Coast as well as in the Maritimes and I want to be sure that when I pass away the life insurance my job provides (twice annual salary) would take care of Karen and pay my mortgages (I don’t have any mortgage insurance) and leave something for my cousins, their children, and my brother and nieces.”
But Sarah’s situation has to be fixed before she can do any of that, says Caroline Nalbantoglu, president of CNal Financial Planning Inc. in Montreal. “We have to drill into the loans to understand the problem,” Ms. Nalbantoglu says. “They were consolidation loans. Her credit card is practically at its maximum and she makes only minimum payments on it. Interest rates on some of the loans are startling and she is going deeper into debt. She must make difficult decisions and tighten her belt.”
It won’t be easy — there’s nothing visibly lavish in Sarah’s spending. There is a disability tax credit, but her 51-year-old sister, disabled 22 years ago by a back injury, uses all of it for her own taxes. Sarah got a caregiver tax credit of about $400 last year after tax is calculated and will receive a similar credit this year. She also receives $625 a month from her sister as rent, boosting her monthly income to $5,011. However, her budget is a flood of red ink, ending in a $542 monthly deficit of outgo over income.
Sarah must cut her massive debts, with interest charges as high as 19%. RRSPs and TFSAs will have to wait.
She has $204 every month deducted from her payroll to buy Canada Savings Bonds to help family members back East. She has a monthly $54 transfer from pay to her RRSP every month. Those contributions, $258 per month, should be directed to debt reduction. Despite her admirable goal of helping family members, Sarah could be forced into bankruptcy is she doesn’t help herself first.
She spends $700 a month on food for herself and her sister. She also spends $467 a month on phone and cable service that supports enough electronics and computer gear for a
small business. She should trim $200 each from food and technology spending. That makes $400 in savings that should go to debt reduction, Ms. Nalbantoglu suggests.
Sarah has a $90,000 house on the East Coast in order to be near her family. She has used the house, once
owned by a great aunt, for a few weeks each year for the past four years. Though its a fixer-upper, it has sentimental value.
Sadly, the house is an albatross. Her equity is in the home, which has an $82,000 mortgage, is just $8,000. The house costs $568 a month or $6,816 a
year in mortgage payments, utilities and property taxes. That’s 12% of takehome income she cannot afford to spend. Best move: Sell the house and stay in a hotel or with family members when she visits. Use the $568 for debt reduction. If, in retirement, Sarah wants to return to her roots, she could sell her Ottawa condo and use the proceeds to buy a nice house with a view of the coast, Ms. Nalbantoglu says.
If Sarah uses that $1,226 a month to pay off her $4,600 credit card debt with its 19% interest rate, it will be gone in four months.
Then she can direct her cash flow to paying off the $28,000 balance of the loan with a crippling 11% interest rate. It will be gone within two years.
Finally, she should address the $32,000 line of credit secured on her Ottawa condo. She might get her bank to cut the 4% rate a little in view of her aggressive debt repayment.
Sarah has a $147,000 mortgage on her Ottawa condo at 7.6%. Her present debt load precludes a preferential interest rate, so she should seek a short loan when it comes due this summer, perhaps for two or three years. By then her debts would have declined.
If she can consolidate her $179,000 mortgage with $32,000 of other debt, her payments with a 10-year amortization would be $2,051 a month. She would pay $356 less than what she currently pays for financing her many debts. This move would allow her to retire with no debt before she reaches age 60, Ms. Nalbantoglu notes.
At retirement at 60, Sarah could get an unreduced pension from the federal government of $45,192 per year. She can take Canada Pension Plan benefits at age 60 of $7,578 in 2012 dollars. She will be able to add about $1,300 a year from future retirement savings for total income to age 65 of $54,070 a year or $3,830 a month after tax. At 65, her federal pension will decline to $37,828 a year. At age 67, she will qualify for OAS, currently $6,481 a year. The sum, $51,887 plus retirement savings, a total of $53,187, would be subject to tax at a 15% average rate and leave her with after-tax income of $45,209 per year.
Her annual expenses, reduced by such economies as cutting food and technology spending and eliminating debt service costs, will be about $2,500 a month in 2012 dollars, Ms. Nalbantoglu estimates. “She will have a substantial surplus for travel or renting a small home on the East Coast. In retirement, she will have the security that her debts have denied her in her working life. It all depends on getting present debts paid.”