Two years from retirement, widow wonders whether she can afford to buy a house
SOLUTION: SELL INVESTMENTS TO BUY THE HOUSE, USE HOUSE FOR COLLATERAL FOR INVESTMENT LOAN, DEDUCT INTEREST
In Ontario, a woman we’ll call Margaret, 58, was recently widowed. She has two children in their early 30s with independent lives. She has a civil service job that pays $9,720 a month before tax plus a $560 Canada Pension Plan Survivor’s Benefit and $1,000 of non-registered investment income. That’s a total of $11,280. Taxes and workplace deductions reduce her income to $6,437 a month. Secure for now, she worries that her retirement, which she expects to begin at age 60, will be financially insecure.
“I am renting now at $2,000 a month, but I would like to buy a home in my area,” Margaret says. “I would then be a retiree with debt. Will taking on a mortgage cripple my retirement?”
Family Finance asked Guil Perreault, head of G. Perreault Financial Inc. in Winnipeg, to work with Margaret.
A mortgage would not be her only debt, Perreault says. She has an outstanding balance on her car loan and a pension buyback payment option that would cost her $ 15,408. She can pay these off with cash she holds from the settlement of her late husband’s estate. The question of whether it is beneficial to buy a home depends in part on how these obligations work out, Perreault says.
PREVIOUS OBLIGATIONS
Prepaying the car loan is the right thing to do, Perreault says. The current amount outstanding is $ 17,529 with a 4.9 per cent interest rate. She has $ 200,000 in cash earning about one per cent a year and she saves $ 2,017 a month after expenses. Spending one per cent to save 4.9 per cent is a good deal. Pay off the loan, he advises.
The pension buyback will boost her pension by $ 1,254 a year with a tentative start date early in 2017. If her life expectancy is 25 years, the implied rate of return is 6.5 per cent. If she lives 20 years, the income stream of the pension i mplies a 5.3 per cent rate of return. Either one beats the one per cent return on her savings account. Do the buyback, the planner says.
BUYING A HOME
Buying a home is a good i dea, but t akes creativity to do it well, Perreault says. Margaret has nonregistered investments of $ 383,302. So, her best bet is to use an investment loan to make the interest on a mortgage deductible.
If Margaret cashes in all her non- registered investments to buy a home outright, she would lose the potential return of t hat money — say, $ 11,500 a year at three per cent after inflation but before tax. However, if she were to buy a home, then use her equity as collateral for an investment loan to replace investments she sold, the interest cost of the loan would be a deductible expense. She should ensure t hat any mutual funds that she sells from her non- registered account and which she bought with deferred sales commissions have been in her account for at least four years to avoid high penalties for early sale. With the typical terms of deferred sales commission funds, she might pay a few per cent after four years of ownership or she could wait six years to avoid penalties entirely.
Going by the numbers, using cash after the car loan is paid and some cash from her high rate of savings, if Margaret makes a 50 per cent down payment on a $ 400,000 home, then on a $ 200,000 mortgage she would have to pay interest of $ 1,134 a month based on a 20- year amortization of a 3.25 per cent loan. She could pay $ 350 a month for property taxes, $ 50 a month for home insurance and $ 400 a month for utilities and maintenance or fees.
That adds up to $ 1,934 a month compared to current rental, which costs her $ 2,000 a month plus utilities and insurance. However, $ 1,134 of interest on the mortgage would be indirectly deductible via a line of credit used to buy repurchase investments. In this example, purchase of a home is the winner: After the tax adjustment, her outof- pocket costs would be about $1,600 a month.
If mortgage interest rates or other costs were to rise dramatically, the advantage of buying over renting would be reduced. But deductibility of the interest portion of monthly payments makes the cost increase of higher interest rates less severe. Higher interest rates would accompany higher inflation and, probably, higher prices of Margaret’s mutual funds and other investments. In other words, a rise in rates of a few more percent would be affordable, Perreault says.
FINANCING RETIREMENT
Assuming Margaret has done her pension buyback, her income if she retires at 60 will consist of a $ 55,000 basic pension with no indexation plus $ 1,254 from the buyback and the CPP survivor benefit of $ 6,720, for $62,974 year.
Her f i nancial assets would be $ 200,000 lighter after her down payment f or a house and $ 17,529 for prepayment of her car loan. The remaining assets, $ 421,722, invested to produce three per cent a year after inflation, would generate $ 12,650 a year before tax. That would bring her annual, pre- t ax i ncome between age 60 and 65 to $ 75,624. If she pays 20 per cent tax, she would have about $ 5,040 a month to spend. That would more t han c over anticipated monthly expenses of $ 3,760 — present expenses and allocations less present rent, car loan payments and savi ngs, but accounting for $ 1,600 of mortgage payments, utilities, insurance, etc.
At 65, Margaret could add her CPP retirement benefit, $ 13,110 at present rates, and Old Age Security at $ 6,846 a year. Margaret’s CPP benefit will replace the survivor’s benefit she currently receives.
That would push her t otal pre- t ax i ncome to $ 88,860. She would have exposure to the OAS clawback, which currently begins at $ 72,809 a year. After 20 per cent average income tax based on age and pension credits and $ 2,400 clawback tax, she would have about $ 5,800 to spend each month.
The risk in this strategy of incurring debt late in life is dying with a hefty sum due to the lender. Sale of the home should clear the debt, of course. She could buy a 20- year term insurance policy f or t he $ 200,000 debt but at her age, premiums would be $ 900 a month or even more. That would make the venture into ownership uneconomic, Perreault says.
The costs of unexpected events, which are often part of home maintenance, are easier to manage with higher income. At present, Margaret is invested in a variety of well-known mutual funds with high management fees that reduce her return.
If she has $ 420,000 of financial assets in mutual f unds, her management c osts would be al most $ 11,000 a year. Margaret has no training in financial management, so she needs help.
She could get that by paying a fee- only adviser an annual fee of one per cent to 1.5 per cent of assets under management and modest costs for trading or exchange- traded funds of perhaps 0.25 per cent a year. That would be $ 3,600 of savings.
With what is likely to be a cash surplus each year and an end to income that qualifies for RRSP investment, Margaret should build up her t ax- f ree savings account. She has only $ 6,512 in the account now, Perreault notes.