Ella and Ken will be mortgage-free in June.
The B.C. residents wonder what to do with the extra $2,000 a month they will soon have: sock it away in registered savings plans, or buy a rental property in Vancouver's popular, and expensive, Kitsilano neighbourhood.
The idea is to invest now to help finance their retirement in eight years or so. Ella is 51, Ken 52. Together, they have $158,000 in unused registered retirement savings plan contribution room.
Ken has $60,000 in a defined contribution pension plan, while Ella will collect a defined benefit pension of about $915 monthly after tax when she retires at age 60.
If they were to buy a condo in Kits or a second house to rent out in their own suburban Vancouver neighbourhood, they would take out a line of credit against the equity in their current home for the down payment.
"We are confused as to whether the property is the best way to go considering that we would most likely have to pay capital gains when we sell," Ella writes in an e-mail.
We asked Ian Black, a financial planner with Macdonald, Shymko & Co. Ltd. in Vancouver, to look at Ken and Ella's situation.
What the Expert Says
Before they consider buying an investment property, Ella and Ken should pay off their consumer debt, Mr. Black says. Interest payments on this type of borrowing are not tax-deductible.
Next, they should begin to build an emergency fund equal to three to six months of after-tax household expenses; in their case, between $11,000 and $25,000. They could use their tax-free savings accounts for this, making sure whatever investments they held were readily cashable.
Then they should consider taking full advantage of their $158,000 in unused RRSP contribution room, Mr. Black says. Every dollar contributed to their respective RRSPs will cut their tax bill and add to their savings capacity.
For example, Ken's marginal tax rate is 33.7 per cent, so every $1,000 contributed to his RRSP will cut his income tax by $337. As well, investing through RRSPs allows for greater diversification of asset classes than real estate, the planner notes.
As for the rental property alternative, Mr. Black gives it a thumbs down. The least expensive condo in the Kitsilano area would cost about $300,000, he says. Ken and Ella would borrow the $75,000 down payment against the equity in their home and take out a mortgage for the remaining $225,000.
"Regardless of how the purchase is structured, the $300,000 investment would be 100-per-cent financed," he notes.
Ella and Ken would want to have the mortgage paid off by the time they retired in eight years, which means a short amortization period. At 6 per cent, a mortgage loan over eight years would cost about $3,940 a month. Property tax could add another $100 or more and condo fees $220.
"Already, the cash flow needed is up to $4,260 a month, and there has been no consideration of insurance, maintenance, special assessments and potentially, management fees."
Rents for a one-bedroom condo in Kitsilano range from $1,500 to $1,800 a month.
"The property is cash-flow negative from day one."
Ken and Ella would have to use the money they would otherwise be saving, estimated at $2,770, to make up the shortfall of between $2,460 and $2,760 a month.
What if one of them were to lose their job?
By investing instead in a broadly diversified portfolio of fixed-income and equity-based investments, Ella and Ken could earn an average annual return of 6 per cent, Mr. Black estimates. This, together with their company pensions ($11,000 for Ella, $6,900 for Ken), Canada Pension Plan (about $10,000 each) and Old Age Security (about $6,200 each), would give them at least the $45,000 a year in today's dollars they figure they will need to get by on for the rest of their lives - and perhaps more.
Mr. Black's analysis assumes Ken and Ella save $33,000 a year after their debts are paid off from now until they retire, and an inflation rate of 3 per cent.
The planner recommends a 50-50 split between equity and fixed-income, with laddered five-year guaranteed investment certificates and government bonds and a small amount of corporate bonds through iShares or Claymore ETFs.
The equity component could be 15 per cent each of Canadian, U.S. and international ETFs or Dimensional Fund Advisors funds, and 5 per cent in real estate investment trusts through iShares Real Estate ETF.
Special to The Globe and Mail
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The People: Ella, 51, and Ken, 52
The Problem: Whether to buy an investment property to help fund their retirement or invest in the financial markets through RRSPs.
The Plan: Pay off debt, take advantage of considerable unused RRSP room and build a balanced investment portfolio to supplement their pensions.
The Payoff: A comfortable retirement without the risks attached to a fully financed investment property.
Monthly net income: $7,070
Assets: Home $450,000; Ken's defined contribution pension plan $60,000; bank account $4,400; Ella's RRSP $18,300; TFSAs $10,000. Total: $542,700.
Monthly disbursements: Food and eating out $1,000; clothing, haircuts, other personal $120; personal allowance $80; pet insurance $50; mortgage $2,050; property taxes $297; house insurance $75; utilities $400; maintenance $50; vacations $200; entertainment $50; books and magazines $50; auto loan $358; auto repair, insurance, tires $400; gasoline $300; credit card payments $200; life insurance $90; group medical/dental insurance $150; donations $75; gifts $100; Ken's employer pension plan $250; Ella's employer pension plan $275; tax-free savings accounts $200; miscellaneous $250. Total: $7,070.
Liabilities: Credit cards $17,000; car loan $13,000; mortgage $4,000. Total: $34,000.