Big house dream out of reach for now

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Colleen and Cal have big plans for the future - children, a family home - but they are concerned about overextending themselves financially. And with good reason.

Cal is a jazz musician, working when he can, so Colleen, who is a nurse, has the larger income by far. This means the family's income and saving capacity will tumble when she is on maternity leave.

Recently, the couple bought a triplex in the Toronto area. They live in one unit and rent out the other two, bringing in enough money to cover the $471,000 mortgage - at least for now. They chose a variable rate mortgage that's currently at 2.25 per cent.

"Our plan is to eventually move out of our current house and keep it as a rental, and purchase another property as our family expands," Colleen says in an e-mail. She figures they'll have to pay $600,000 to $800,000 for the family home.

As always, there are conflicting claims on their money. Cal, who is in a lower tax bracket, has $20,000 of unused registered retirement savings plan room.

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"Should we be prepaying the mortgage or should I be contributing to his RRSP to lower my taxes?" Colleen wonders.

We asked Jane Cheong, financial planner with T.E. Mirador in Montreal, to look at Colleen and Cal's situation.

What our Expert Says Because they are living rent free, the couple's saving capacity is substantial, Ms. Cheong notes. Net income of $8,050 less living expenses of $4,355 leaves a surplus of $3,695. She subtracts from that the $200 a month they already are contributing to Colleen's RRSP.

But there are costs beyond the ones they have included in their monthly budget. The planner adds $250 a month for vacations "because people need balance in their lives."

Interest rates are likely to rise over the forecast period, Ms. Cheong points out. When rates start to rise, borrowers tend to lock in for a fixed term. If Colleen and Cal were to lock in at 5.14 per cent for a five-year, fixed-term loan, their monthly mortgage payment would rise to $2,777 from $2,050. Add another $727 to the expense column.

That would leave them with $833 a month for their tax-free savings accounts and $1,685 for savings in non-registered accounts.

Suppose Colleen takes maternity leave next year. Their surplus shrinks to $1,108 a month, the RRSP contributions are shelved, $200 is added for child care expenses and $100 for life insurance. Their saving capacity falls to negative $169 a month.

The following year, 2012, Colleen goes back to work again, so their surplus of income over expenses bounces back to $3,695. The RRSP contributions of $200 a month resume and $415 is added for daycare expenses. That would leave them with saving capacity of $1,803, divided among their tax-free savings accounts ($833), registered education savings plan (which they would open for their child ($208), and non-registered savings and investments ($762).

As for the rental property, the planner does not recommend prepaying the mortgage because the interest on it is tax deductible, at least for the portion that is rented out. Two-thirds of the property's operating expenses would be tax deductible as well. As joint owners, the couple will share the income and expenses equally.

The dream home will have to wait. Although Colleen and Cal will be able to save $106,000 over the next five years, they still won't be able to afford a house costing $600,000 to $800,000 - their target range - without stretching themselves to the limit and beyond, Ms. Cheong says.

Five years hence, their equity in the triplex is estimated at $280,000. If they were able to refinance the property for 80 per cent of its value, they could raise $150,000 for a down payment on another house, she notes. But that wouldn't be a good idea. Even if their banker agreed to the higher loan, the new mortgage would not be tax deductible because the money would be going to finance a personal residence.

If they were to liquidate Colleen's investment portfolio, which in five years might have climbed to $200,000, refinance their triplex to raise $150,000 and get a $250,000 mortgage loan to buy a $600,000 house, it "would be too much," Ms. Cheong says.

"This means that there is no additional savings going on, and everything is going to an illiquid asset not earning anything."

And if repairs and renovations were needed on the rental property, "no cash flow is available." And there might be vacancies.

The couple could look to the suburbs for a lower priced house, or just continue "living rent free for some more years with their children," Ms. Cheong says.

Colleen has a defined-benefit pension plan at work, leaving her with only $2,500 a year in RRSP contribution room. She should contribute the maximum to her own plan and the same amount to a spousal RRSP for Cal so that when they retire they can split their RRSP income.

Cal is in a low tax bracket, so he should put off contributing to his own RRSP until his income is higher. Ms. Cheong recommends they both open a tax-free savings account and contribute $5,000 each annually.

Client Situation

Special to The Globe and Mail

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