via The Globe and Mail | September 6, 2013
Mel and Melanie have a home in Quebec, three rental properties and a mountain of mortgage debt.
But Canadians love their real estate, so now that Melanie is back at work, they want to buy more. He is eyeing a commercial property, while she wants a vacation home in Florida that they can rent out when they are not using it.
He is 39, she is 37. They have two children, ages 4 and 2.
They both work in the sciences, earning a combined income of more than $150,000 a year. Their rental properties roughly break even.
Mel’s job comes with a defined contribution pension plan, to which both he and his employer contribute.
How the plan does will depend on how it is invested. Melanie, who is working on contract, has no pension plan.
Their first goal is to establish an emergency fund. Mel wonders if they should take out a home equity line of credit (HELOC).
As well, they want to speed up the repayment of their home mortgage and RRSP loan.
“Should we refinance our home mortgage to take advantage of current rates and lower our 3.59-per-cent rate?” Mel asks in an e-mail.
“Or maybe secure a HELOC for emergency funds?”
Would the purchase of additional real estate be “advisable or possible over the next three to five years?” he asks. Or should debt repayment be their top priority?
We asked Michael Giacomodonato, a financial planner and vice-president of T.E. Wealth in Montreal, to look at Mel and Melanie’s situation.
What the expert says
As long as interest rates stay low, Melanie and Mel’s income is sufficient to maintain their comfortable lifestyle and cover all their debt payments, thanks also to $4,400 a year in child tax benefits, Mr. Giacomodonato says.
But if interest rates rise one percentage point, their annual interest expense will rise about $8,000. “Should any tenant not pay the monthly rent, then they could be in financial distress.”
Their income is not sufficient to meet unforeseen major expenses, he says, something they appear to recognize, which is why they want an emergency fund.
To emphasize how stretched the couple is, Mr. Giacomodonato looks at their debt-to-income ratio – debt service payments as a percentage of personal disposable income. The average Canadian has a ratio of 162 per cent (high enough to prompt words of caution from the federal finance minister); Mel and Melanie’s is 206 per cent. That does not include the mortgage payments on their rental properties.
“The ratio jumps to 426 per cent if the rental properties are included, which in my opinion is excessive,” he says.
With mortgage rates still relatively low, he suggests Mel and Melanie consider negotiating a lower interest rate with their lender, extending the maturity of all their mortgages and taking out a line of credit to provide emergency funds.
“I don’t recommend that they purchase an additional rental property solely because interest rates are low.”
If they do decide to add to their property portfolio in future, they could consider it only after their total debt has been cut by about $200,000, the planner says.
Savings should go to pay down the mortgage loan on their principal residence and to pay off the (zero interest) credit card debt before the March, 2014, deadline, when they would begin paying interest. They could use the funds in their savings account to pay off their registered retirement savings plan loans.
The planner recommends they contribute $2,500 a year for each child to a registered education savings plan for post-secondary education. If the children study in Quebec, the RESPs will accumulate enough capital to cover five years of college and still leave them with a comfortable surplus for higher studies, Mr. Giacomodonato says. His calculations are based on a federal government education grant of $1,000, a provincial grant of $500 and an average annual return on investment of 5 per cent a year.
Melanie and Mel should also take full advantage of their RRSP contribution room.
“The option to buy a condo in Florida should be considered only if they sell one of their current rental properties.”
Mel, 39, Melanie, 37, and their two children, 2 and 4.
How best to use their higher income now that Melanie is back at work: Pay down debt or buy another property.
Put debt repayment first. Consider renegotiating mortgages to improve cash flow and establish emergency fund. Take advantage of savings plans.
The resilience to weather a rise in mortgage rates or a drop in rental income.
Monthly net income
Bank deposits: $26,300; GICs: $1,230; his RRSP: $69,150; her RRSP: $28,670; his pension plan: $18,105; children’s RESP: $6,595; residence: $509,000; rental real estate: $652,000. Total: $1.3-million
Residence mortgage $1,610; property tax $390; utilities, maintenance $400; home insurance $95; car lease $710; other transportation $475; food and household goods $1,300; child care $605; clothing $220; loan payments $470; vacation, travel $200; dining out, entertainment $400; other personal $100; dentists, drugstore $ $100; life insurance $105; telecom, cable, Internet $165; RRSPs $500; pension plan contribution $265; group benefits $220; Total: $8,330. Surplus: $355
Residence mortgage $292,715 (3.59 per cent); rental property mortgages $472,000 (3.15 per cent to 3.34 per cent); interest-free credit card $18,405; RRSP loans $13,045. Total: $796,165
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