How to Stop Falling Behind

Andrew Allentuck, The Financial Post

In British Columbia, a woman we'll call Patricia, 53, is struggling to pay her expenses. It's not easy, for her debt service charges alone, $1,435 a month, consume just over half of her $2,790 after-tax income.

Her budget is spare - she spends just $240 each month on food and zero on restaurants, nothing for travel nor anything for registered savings - and yet she cannot make ends meet. Having gone from one layoff to another, her gross income has fallen by a quarter in the past two years. She is considering selling her books and one of her bicycles. Her situation sounds desperate - and it is.

"My expenses consume my income and I am falling behind every month as my credit debt grows," she explains. "Financial constraint is a hard way to live. What is the smartest way to resolve my situation?"

Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Patricia.

"Her position is less than enviable," he explains. "She has debts with interest rates as high as 12% a year. Her net worth is just $15,600. Given that earning more money is not easily achieved right now, for she has looked hard for better pay, she has to consider selling her $310,000 condo. It is her main asset, but if interest rates rise above 2.59%, which is what she is now paying, it will become a cash flow liability."

Getting Out of Debt

An alternative is to rent the condo out. If she got $1,200 a month and had to pay out $913 for her mortgage, $52 for taxes, and $300 for condo fees, she would actually be at a loss even before maintenance costs. Sale, on the other hand, would let her pay off the $248,000 mortgage and leave perhaps $50,000 cash after an estimated $12,000 selling costs and moving expenses.

That cash would let her pay off $36,000 on two lines of credit, a $12,700 credit card bill that costs her 12% a year, and another $600 credit card bill. She would walk away with just $700, but her debts, other than a $1,100 balance with the Canada Revenue Agency, would be eliminated.

With the condo sold, Patricia would be able to rent an apartment near her place of work. She has to commute at present, for which she owns and maintains a car. However, if she lived closer to her job and could bike to work, she would save $200 a month or more on gas and incidentals. Her total savings would be $912 on her mortgage, $52 on property tax, $300 on condo fees and $200 on her car plus eliminated debt services.

That adds up to $1,464 a month. If her rent was $1,000 a month, her net savings would be $464 a month on direct living costs plus another $423 from elimination of debt services charges. Total savings: $887 per month. She could bank whatever cash she gets from selling her old car with an estimated value of $2,000. She could pay off her income tax bill, but she needs the liquidity, after all. She can pay the tax as she is doing at $100 per month.

Eliminating debt will reduce Patricia's problems but not solve all of them. She is her sole support and will be at risk from illness, future job layoffs and the other hazards of life. Long-term care insurance and other risk mitigation strategies are too costly. The paradox of having little money is that she has to self-insure many risks, as wealthy people often do. The solution is to grow her financial assets to provide the cash she may need if serious illness curbs her ability to earn money.

Retirement is coming into Patricia's view. She will receive Canada Pension Plan benefits at an estimated $12,150 a year at age 65 or $14,191 if she works to 67, benefiting from a 0.7% a month bonus for delaying benefits from 65 onward to as late as 70. She will also receive Old Age Security benefits of $6,600 a year at 67, all in 2013 dollars. She can cut taxes by putting money into her RRSP. She will get a 21% tax refund in her bracket.

If Patricia saves $1,000 a month liberated from debt service and condo fees, she could save $12,000 a year for 14 years to age 67. Her employer would provide 100% matching funds of her RRSP contributions up to 2% of her $48,000 annual gross salary. That's $960. Her RRSP refunds would be approximately $2,520 a year in her tax bracket. If she puts the refunds into a Tax-Free Savings Account and gets a 3% return after inflation, she would have $44,350 in the account at 67. TFSA money could be withdrawn without tax or restriction. If she takes 3% a year, she could add $1,330 to retirement income.

Strategy For Growth

If Patricia contributes $12,000 a year plus $960 from her employer and gets a 3% annual return after inflation, then at her age 67, she would have $228,100 in her RRSP. That money, if converted to a RRIF, could generate payments beginning at 4.35% at 67 rising to 7.48% at 72 and climbing to 20% in her mid-90s.

Using a 6% average figure for early RRIF payouts beginning at age 67, Patricia would have $13,686 from her RRIF. She could add $14,191 from Canada Pension Plan, $6,599 from Old Age Security and 3% after inflation or $1,330 from her TFSA for total pretax income of about $35,800 a year in 2013 dollars. If she paid an average tax of 10% on her income (the rate allows for no tax on TFSA payouts), she would have $2,685 a month to spend. That would be almost equal to her present take-home income but, with all debt service payments eliminated, she would have 50% more purchasing power, Mr. Moran notes.

"Patricia has had some tough breaks, particularly a slide in income from jobs that paid her appreciably more than her present work," Mr. Moran says. "My concern is that a rise in interest rates drives her borrowing costs up and her condo value down, which would be devastating to her finances. But this analysis shows that she can gain financial stability if she sells her condo and uses the proceeds to pay off all debts, then contributes savings to RRSPs. Along with the employer's match, she will have a stronger base for her future."

How to Stop Falling Behind

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