Big-house Dream Comes With Big Debt

In British Columbia, a physician we'll call Donald, 33, and his wife, a corporate manager we'll call Ellen, 28, are moving into the affluence of professional life and planning a family of three kids. They will need a larger home than their current 1,100-square-foot apartment in a house they own, for which they lay out $5,500 a month in mortgage payments.

Donald spent 11 years in university and medical school, financing his education with student loans. Ellen, a management specialist, put in seven years in university. They have a combined monthly after-tax income of $14,508 and expect that Ellen's annual after-tax income of $37,056 will rise to perhaps $60,000 within a few years before she takes maternity leave.

"We have focused on debt repayment," says Donald, speaking of the couple's student loans. "We have a 19-year old car. Now we want to build up our RRSPs and eventually get a bigger house."

What our expert says

Facelift asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with the couple. Much of their problem is timing a move to larger quarters, he says.

"B.C. property prices may come down," he explains. "A 5-per-cent drop in prices would cost $25,000 on a $500,000 house, and $50,000 on a $1-million house. That seems to favour the buyer, but the bargain is less than it seems. There would be higher taxes, upkeep and finance costs on a bigger house. They would need to boost after-tax income to cover higher expenses."

Donald and Ellen have a $550,000 house, $91,000 in RRSPs and $10,000 in their Tax-Free Savings Accounts. Their only remaining liability is a $230,000 floating-rate mortgage that they carry at prime plus 0.5 per cent (or 3 per cent at today's rates).

The couple has to avoid taking on too much debt, Mr. Moran advises. B.C. property prices may decline, but interest rates should rise within a few years, the planner notes. Thus the couple could find themselves paying 5-per-cent annual interest on a $1-million mortgage loan with a 25-year amortization. That would cost them $5,816 a month. They are now paying $5,500 a month, so the deal would be feasible.

But if interest rates were to rise to 10 per cent, the monthly payment on a $1-million loan with a 25-year amortization would climb to $13,417 or $161,000 a year, a sum that would be unsupportable on the couple's foreseeable income, Mr. Moran says. How high interest rates might rise is difficult to predict but, to be safe, the couple should avoid taking on more than $1-million in mortgage debt, he says.

The couple could capture value in their current home by renting out all of it. By not selling, the couple would lose a potential down payment on another house, but retain a good asset. If total rents on the whole house were $3,000 a month, or $36,000 a year, the house would yield 6.5 per cent of its estimated $550,000 market price before expenses. That would be an 11.3-per-cent return on $320,000 equity. The couple would also avoid selling commissions. The idea is worth considering, Mr. Moran says.

The couple can also increase their after-tax income. Donald had taxable income of $200,000 in 2008. His marginal tax rate, 43.7 per cent, is the top bracket in B.C. He could save money by having Ellen increase the work she does for his practice. She already receives $12,000 a year from the company. She could double or triple that salary, provided that the actual work she does justifies it. That would shift more of the corporation's income to Ellen. She pays tax at 29.7 per cent, saving them 14 per cent (the difference in tax rates) or $1,680 just at a salary level of $12,000, Mr. Moran says.

Donald and Ellen should have a comfortable retirement. Ellen has an indexed defined benefit pension plan that will pay a third of her salary, assuming she receives a promotion to a job that pays $90,000 before tax and works for 30 years. Her annual pension would then be about $33,120 a year in 2009 dollars plus a bridge to age 65 - should she retire before then - of $9,240.

If the couple continue to add $2,200 a month to their current $91,000 RRSP balance, and if the portfolio grows at a real rate of 3 per cent annually, they will have $1,005,000 when Donald is 55, and $1,662,000 when he is 65, Mr. Moran estimates. If Donald works to age 65, he could withdraw $82,324 a year for 30 years.

Each spouse should qualify for maximum Canada Pension Plan payments, currently $10,905 a year. They will each qualify for full Old Age Security, which currently pays $6,204 annually. Their total income in 2009 dollars at age 65 would therefore be $149,662 a year. With careful pension splitting, they should be able to avoid most of the OAS clawback that currently begins at $66,335, the planner notes.

"Donald and Ellen can't have their mansion, their kids and an early retirement," Mr. Moran says. "They have to make strategic choices."

"We'll stick with our present house as long as we can," Donald says. "But we recognize that we have to choose between living well in a big house, or living well in retirement."

Client situation

The People

B.C. physician 33, and wife, a corporate manager, 28

The Problem

Managing expenses to buy a larger house that they need for children

The Plan

Restrain overspending on bigger house, consider renting out all of current home

The Payoff

Avoidance of debt trap, building funds for retirement

Monthly net income: $14,508


House $550,000; RRSPs $91,000; TFSAs $10,000; Car $3,000; Total: $654,000

Monthly disbursements

Mortgage $5,500; Property tax $165; Food & restaurants $750; Entertainment $100; Clothing $250; RRSP $2,200; Car fuel, repairs $125; Travel $500; Car, house insurance $147; Life insurance $331; Charity, gifts $100; Miscellaneous $400; Savings $3,940; Total $14,508


Mortgage: $230,000

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