Debt-Heavy Couple Liable to Fall Victim to Interest Rate Squeeze


Andrew Allentuck

In Ontario, a couple we'll call Oscar, 40, and Nancy, 33, are raising two children, ages 6 and 8. The parents are both in real estate sales and bring home about $120,000 a year after business expenses and income tax. They are thriving in their commission sales work and have three rental properties of their own worth $320,000. With their home, two cars, one RV and other property investments, their assets total $732,700. But acquiring those assets has been expensive, for they owe $634,000, nearly four times their $160,000 annual gross income. Their debt-to-income ratio could put them into a serious squeeze as interest rates rise. In effect, they are living a bet that bricks and mortar will one day yield a big capital gain that compensates for the time, risk and effort of holding real estate.

Oscar wants to add more properties. "Our plan is to build our real estate business to its maximum potential over the next 10 years, to acquire eight more rental properties and have all of them paid in 15 years and to be able to retire, if we want to, by the time I am 55."

Outlook and Risks

Family Finance asked Derek Moran, RFP, who heads Smarter Financial Planning Ltd. of Kelowna, B.C., to work with Oscar and Nancy. "The amount of debt this family holds is scary," he says. "They are coping for now. An interest-rate squeeze or a run of vacancies could be devastating and their plan to build a real estate fortune could collapse. At present, the business is solid and very profitable. They know their market."

Oscar and Nancy collect $3,148 in rents each month from their three properties. From that gross revenue, they pay $1,161 for mortgage interest, $60 for utilities, $238 for property insurance and $414 for property taxes, total $1,873, for net rental income of $1,275 a month, or $15,300 a year, before depreciation. They put down only $8,000 for all three properties, giving them an annual net return on initial equity of 192%. It is the result of high leverage and it is evidence of high portfolio risk. If property prices were to drop by 10%, the rental properties would be worth less than what they owe. Oscar and Nancy could face a cash calls from lenders."

They have other interest charges that total $2,619 a month for loans for their RV, car, home renovations, line of credit and their home mortgage. Add in living expenses and their monthly cost of living totals $10,000. Their budget balances, but they plan to add to their rental properties. They should trim expenses. Interest charges and potential vacancies could decimate their savings and fortune, Mr. Moran says.

Cutting down on debt

Debt reduction should start with eliminating non-deductible interest. At the head of the list is the couple's $30,000 recreational vehicle financed at an 8.9% annual interest. That costs them $4,728 a year. Add depreciation of several thousand dollars a year and the unit becomes a luxury the family can do without. Sell it and rent when the occasion arises. Let someone else store it and take the depreciation, Mr. Moran suggests.

Then pay down other debts, like their $17,000 car loan at 3.9%. That costs $5,100 a year. It is partially deductible because the car is used for business.

Next to go should be a $30,000 home-improvement loan with interest charges as high as 10.25%. That's $6,000 a year. Money saved from the RV loan and the car loan, approximately $819 a month, or $9,828 a year, can be put into paying off this high-cost debt. At this rate, it will be discharged in a little more than three years. The balance of savings can go to paying off the $7,000 student loan that is carried at prime.

Planning for future

Retirement is very far away. Moreover, Oscar and Nancy are likely to build up their rental business quite substantially in the next few decades. However, at age 55, they would be five years from the earliest time they could draw Canada Pension Plan benefits and 10 years from Old Age Security. The cost of taking CPP benefits at age 60 is a 36% reduction of age 65 benefits, so it would be good for the couple to have sufficient savings to get them to 65.

At age 65, they would be entitled to what can be assumed to be close to the maximum Canada Pension Plan benefits, currently $11,520 a year, and full annual OAS benefits, currently $6,322 a year. It is too early to estimate what their present or future property or other assets will earn.

It is possible to suggest the amount of investment income that will be needed to support a budget of $5,000 a month, or $60,000 a year, after tax, which is roughly what Oscar and Nancy now spend after debt service and child care, RESP contributions and other family costs. If they pay an average tax rate of 20% on their pre-tax income, they would need $75,000 a year before tax.

When both are 65, two CPP benefits, $23,040, and two OAS benefits, $12,644, will total $35,684 a year. It is fair to assume that the current rental mortgages will be paid by retirement, so a further $3,148 a month times 12, or $37,776, can be added to cash flow. That's $73,460, which is almost enough to cover present living expenses dollars projected to Nancy's age 90. All figures are in 2011 dollars.

Oscar and Nancy have $23,400 in their children's registered education savings plan and should boost contributions from the present level of $167 a month to $416 to qualify for the maximum Canada Education Savings Grant of the lesser of 20% of contributions or $500 per child. If they make full contributions and the RESPs grow at 3% a year over inflation and payouts are averaged for the two kids, each would have $50,800 for post-secondary education, Mr. Moran estimates.

Achieving the goals of educating their kids after high school and retiring at age 55 is challenging but not impossible. The bigger question is whether they should take the large risks that go with early retirement. That would mean giving up perhaps a decade's worth of commission income. The property market could solve this problem for them. After all, as house prices and rents rise with inflation, the couple's rental income and pre-retirement commission income should keep pace with the growth of the consumer price index.

Lack of diversification of investments adds to their portfolio risk. They have 74% of their total assets, including their house but excluding vehicles, in property. It is hardly a diversified portfolio. Moreover, 25% of their financial assets in RRSPs and other accounts is in cash earning almost nothing. "They have, in effect, balanced their at-risk real estate assets with a small amount of cash with substantial exposure to inflation," Mr. Moran says. "The balance is, in fact, lopsided and the interest return is so low that they are in effect paying for the privilege of holding cash. Oscar and Nancy need to sharpen their non-real estate investment skills to provide the security they need."

(C) 2011 The Financial Post, Used by Permission