Home equity loan at 4% costs $9,000 a year for interest alone, with rates likely to rise. The loan could ultimately cost Hazel her home or her future
Situation: Woman has to pay a big debt left over from a failed investment before she can retire
In Alberta, a woman we’ll call Hazel, 58, works as a consultant in the chemical industry. She earns $115,000 per year. She lives in a $600,000 house that is almost fully paid for, but has $250,000 of home equity loans outstanding, an overhang of debt she incurred to buy an investment that collapsed. That debt is an anchor preventing her from retiring.
“I did well on some raw land deals several years ago,” Hazel recalls. “That lowered my threshold for risk. I took out my home equity loans, bought into the deals and was able to pocket the spread between the dividends and the loan’s cost. But in 2009, it became clear the company was over-leveraged. It went into receivership. The banks took over the properties and I lost everything in the quarter million dollar investment. But I kept the huge debt and have to pay it off. My dilemma and fear is that I am not going to be able to do it and still retire.”
Hazel had put too much of her money into a single investment with risks she did not anticipate in the volatile Alberta property market.
Traumatized by her loss, but with retirement in sight, Hazel has to decide how to deal with the debt. Her home equity loan at 4 per cent costs her $9,000 a year for interest alone and interest rates are likely to rise. The loan could ultimately cost her her home or her future. She has to decide and act.
Family Finance asked Eliott Einarson, a Winnipeg-based financial planner with Ottawa-based Exponent Investment Management, to work with Hazel to find a solution.
The facts of the case are clear. Hazel can’t afford to pay off the principal unless she downsizes her house, keeps her job or sells her $600,000 RRSPs. The RRSP asset sale and cash payout would incur taxes at a prohibitive 48 per cent marginal rate. Downsizing her $600,000 house would leave her an estimated $320,000 after 5 per cent selling fees and other expenses and use of $250,000 to eliminate her debts. Gains on the sale of her principal residence would be tax-free. So selling the house seems the best choice, Einarson says. Moreover, her cost of living might decline if she had no more home repairs and the high heating costs that go with detached homes, the planner notes.
The renting scenario would cost her an estimated $2,300 monthly for rent plus utilities. The downsizing would generate enough cash to pay off the HELOCs. Her total living costs would be about $4,500 per month. She would have no home mortgage, tax or maintenance costs and she would stop contributing to RRSPs. She thinks she would be able to cover expenses with $6,000 of monthly after-tax income.
Hazel’s home has a current value of $600,000. If sold for that sum less costs, say $570,000 net and the $250,000 debt paid, she would have an estimated $320,000 cash left. She could put $50,000 into her TFSA with a present balance of $7,000.
Assuming no further contributions to her accounts, her TFSA balance of $57,000 would rise at 3 per cent after inflation per year for seven years to $70,100. If it continued to generate 3 per cent per year after inflation, then with all capital and income paid out over the following 30 years to her age 95, the TFSA would generate $3,500 per year.
Hazel’s $600,000 of RRSPs with no further contributions and the same growth assumption would increase to $737,925 and generate $36,550 for the next 30 years, by which time all income and capital would be paid out.
The $320,000 left from the sale of the house with the same assumption would grow to $394,800 at her age 65 and then support an annual income of $19,600.
If she does work to 65, she could expect Canada Pension Plan benefits of $13,610 per year and $7,160 in Old Age Security benefits. Her total pre-tax income in this scenario would be $76,920. After 16 per cent average tax and addition of untaxable TFSA annual payouts, she would have about $5,700 to spend each month in 2018 dollars. Her expenses with rent to pay but no mortgage, house repairs, line of credit payments, or savings would decline to perhaps $5,400 per month plus perhaps $300 a month for a small car to replace use of her company car. She would be able to travel at her present rate of $1,000 a month and still live within her budget.
Assuming Hazel prefers downsizing to paying income taxes on RRSP payouts, timing the downsizing is critical. After all, interest rates may rise further. Residential property prices and interest rates move in opposite directions. So time is running against Hazel. If she decides to downsize, she should not postpone it too long.
“This is a sad case of a major loss and an illustration of what can be done in spite of a large loss to achieve a comfortable retirement,” Einarson concludes. “Hazel’s pessimism is understandable, but we have a solution for debt management and her future well-being. We think she should sell the house and have a clean slate for retirement. This would not be easy, but it will work and, if her investments are well diversified in equities and perhaps some government bonds, they would be fairly secure over the long run.”
