Condo can be an asset in retirement
At the age of 38, Lisa, as we’ll call her, finds herself in the vise of wage compression and rising living costs. Her salary has declined in the last year and mortgage payments, fees and taxes for her downtown Vancouver condo now cost her $2,149 a month, which works out to 57% of her $3,758 monthly take-home income. Lisa is able to make her mortgage payments and to afford some pleasures, but on her balance sheet, she has negative net worth. The problem will soon be resolved, for with just a few more payments on her mortgage, her equity will grow and her net worth will turn positive.
“Buying my condo was a big risk,” Lisa explains. “I want to work toward paying it off. Is it possible for me to retire at 65 or maybe a little later after I have paid off the condo?”
Family Finance asked Graeme Egan, a financial planner and portfolio manager with KCM Wealth Management Inc. in Vancouver, to work with Lisa. He sees the condo, which has an estimated market value of $335,000, as a foot in the door of the Vancouver housing market.
The problem now is that the condo’s high-ratio mortgage, $321,052, is 96% of its equity. She borrowed $25,000 from her RRSP through the Home Buyers’ Plan and has to pay that sum back over the next 15 years in equal payments of $1,666 a year. If she fails to do that, the annual payments not made will be considered income and will be included in her taxable income. The total of the two loans, $346,052, exceeds her total assets of $345,567.
DEBT MANAGEMENT
Lisa has to deal with her high leverage. According to rules set by the federal Department of Finance, her 25-year amortization is the longest anyone can have with a high-ratio insured mortgage. Lenders cannot lower and stretch her payments further. She has little choice but to pay down the mortgage quickly, then use her cash flow to resume retirement savings that will be suspended while she deals with debt.
She does have a way out. Lisa could sell the condo, pay off her loans and walk away. She would be free to rent equivalent space and save perhaps $500 a month. She would be mobile, could easily take jobs in other cities and would be free of debt. However, she would have given up a good asset in valuable real estate. Moreover, unless she can get $350,000 or more for the condo, she would be in a deficit position after selling and moving costs.
If she decides to stay, mortgage debt should be her focus. That means increasing monthly payments to cut her leverage and to reduce her risk. She has the cash flow to do it. She could take $100 a month from her $200 allocation to dining out and entertainment, suspend contributions to her RRSP, $217 a month, and those to her TFSA, $542 a month.
If she then directs these savings, a total of $859 a month, to her mortgage and Home Buyers’ Plan loan, she can cut the amortization from 25 years to 14 years, at which time she would be 52. She would save approximately $65,800 of interest. If she adds $200 more from her present miscellaneous spending, her monthly mortgage and HBP payments would rise to $2,815. She would cut her amortization to 12 years and three months and her total interest paid by $73,000. She would be mortgage free at age 50. She would be debt free and able to use her cash flow to prepare for retirement. Indeed, she would now be able to catch up. Her HBP loan would continue for about three more years, but the sum involved, $139 a month, is relatively small.
For most people, deferring retirement savings for 10 or 20 years as middle age approaches would be foolhardy. Yet Lisa is in a special situation, for debt service and savings make up a very large part of her spending. Cash going to service debt will become an advantage once the debts are paid.
At age 65, she could take Canada Pension Plan benefits at an estimated $12,150 a year. At age 67, she could begin Old Age Security at $6,612 a year, both in 2013 dollars. The total, $18,762, after income and age credits, would leave her with $1,564 a month with little or no tax to pay. That substantially exceeds her present spending net of savings and debt service.
Frugalness has given Lisa an opportunity to have what will be an unencumbered asset, her condo, after it is paid off by age 49 or 50. If the condo, with a present market price of $335,000, appreciates at just 2% a year over inflation, it will have a theoretical market price of $595,000 in 2013 dollars at her age 67. Every year she pays down the mortgage, her equity will grow.
The irony is that if she does nothing to change her allocation to real estate, which is virtually her entire asset base, she will bear an unusual amount of market risk. Therefore, when her mortgage is eliminated, even if she still owes several years of payments on the Home Buyers’ Plan, she can direct some or all of her $2,815 a month debt payments to investment in diversified financial assets. At 49, with that cash flow, she could resume TFSA and RRSP savings, a total of $33,870 a year. She would have a lot of space to fill.
Lisa could generate approximately 18 years of growth on top of her present $10,568 of financial assets to retirement at age 67. If she obtains a 3% return after inflation, she would have $830,000 in her accounts in 2013 dollars. If she continued to obtain 3% after inflation from $830,000 in financial assets, she would have a pre-tax income of $24,900 to add to her government pensions for total pretax income of $43,662 a year or about $3,100 a month after 15% average tax.
If Lisa were to withdraw money from her investments beginning at age 67 so that all funds were gone by her age 95, she would have $42,950 from her capital and total pretax income, including government pensions, of $61,712 in 2013 dollars. That’s $4,115 a month after 20% average income tax. On her balance sheet, at age 67, her portfolio would have a future value of $1,425,000. Real estate would constitute about 40% of her net worth. Note that a 3% property growth calculation would raise her property value to $766,500, her total net worth to $1.6-million and property would then be about half of her assets. She would have a paid-up home and a solid financial base.
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