Her issue — pay off the mortgage or invest in financial assets?
At the age of 31, a woman we’ll call Autumn, is a veteran of the hospitality industry. Currently a server in British Columbia, her income is substantially dependent on tips. Over a period of a year, she averages $4,500 per month after tax. That is modest even for a single person, but Autumn is frugal. Moreover, she has a plan to invest for retirement during her working years — and with three decades to go, she has plenty of time to compound her gains.
Autumn has not been aggressive in seeking employment income and so we will not assume her income will change much over the years to age 65. She has, however, been wise in her property investments, so we’ll focus on what those assets can do for her future wealth.
She has a $180,000 investment condo she rents and $47,000 in various financial assets, and a $42,000 balance on a mortgage that started at $70,000 two years ago. Her problem now is to anticipate what funds she may have for retirement. Currently, Autumn rents an apartment for $750 per month and is very economical in her budgeting. She eats at work for no cost, drives economically in a gently aged SUV, and chooses low-cost options for her web and phone service. Her issue — pay off the mortgage or invest in financial assets?
Family Finance asked Derek Moran, head of Smarter Financial Planning Ltd. in Kelowna, B.C., to work with Autumn.
Investments and a plan
The rental condo is a good investment. It generates annual rent after costs of $12,600. She pays annual property taxes of $408, condo fees of $2,376, and $1,177 in mortgage interest for total annual costs of $3,961. That leaves her with net annual rental income of $8,639, which is a 6.26 per cent return on her $138,000 equity.
Her goal is to buy a nice house. She wants to accumulate a down payment, but the best path to that is a question.
“With no kids or spouse, her situation is wonderfully simple,” Moran says. “She is correct that she must rely on the person in the mirror to build a comfortable retirement nest egg and the sooner the better.” But she has options on how to pay for a house with a rental unit.
She could sell her condo and take a modest gain based on current value less the mortgage, say $135,000 after expenses, and use that money for a down payment on a house with a rental suite with a price tag of about $450,000. Or keep the rental and use the mortgage as leverage so that her net rental income provides greater return on equity? Keep the mortgage for now, Moran advises.
Her mortgage would be $320,000 on a new property if she sells her present unit. She could find one with a basement suite and use the rent to defer her own costs, which might include $1,183 per month based on a two-per-cent interest rate and a 30-year amortization. Charging her tenant the going rate of $1,200 per month would cover that cost and a bit more. She could, in the alternative, live in a basement suite and rent the upstairs for appreciably more. It would be her house. She would be a renter no more.
Asset management
The problem in doing two transactions — sale of her condo and purchase of a house is that she will have double transaction costs. She might be able to negotiate some fee cuts, Moran suggests.
British Columbia allows for deferral of property taxes for persons over 55 subject to a very low interest rate and a lien on the property in question with the lien removed when deferred taxes are paid. That’s 24 years in the future and rules and qualifications could change.
This plan for accumulation of a down payment and management of a house with a rental suite depends on mortgage interest rates remaining low. That is likely for several years at least. The plan also depends on her keeping her job in the hospitality industry, which is by no means certain given the COVID-19 crisis and its effect on restaurants.
Retirement income
It is a three-decade stretch from Autumn’s present age to retirement in her mid-60s. Much could change. Autumn will need to accumulate $350,000 in 2020 dollars. RRSPs in her tax bracket where she pays an average rate of 15 per cent are not efficient. But her TFSA will be a good way to save. Assuming that with a bit of belt tightening she adds $315 per month to her present $47,000 in her TFSA, all growing at three per cent after inflation for 34 years will generate $350,000. That sum, annuitized to pay out all income and capital in the following 30 years to her age 95 would generate the required $18,000 per year. She has the present income to save $315 per month in $100 of actual savings and her untracked miscellaneous spending.
She is likely to get full Old Age Security, currently $7,362 per year, and less than maximum Canada Pension Plan benefits. We’ll conservatively estimate she gets 25 per cent of CPP or $3,528 per year. We’ll estimate rent after costs at $12,000 per year. She will have $18,000 investment income. That’s a total of $40,890 before tax. After 13 per cent average tax, she would have $2,975 per month to spend. B.C. property tax subsidies may change so we’ll not include them in this analysis.
She would have a paid up house generating rent, income from her financial assets, no debts, and costs as low as $2,000 per month. Her discretionary income, $1,975 per month, would pay for $20,000 annual travel or a new or newer car as needed.
Over a three decade time period, Autumn may face unemployment, health or other issues. Maintaining a substantial rate of saving, as she is doing, is the least expensive way of having insurance for bad luck or bad times.
As Autumn’s mortgage is paid down, free cash flow should rise. She will have the choice of investing in property or financial assets. Her savings plan will support her retirement, Moran concludes.
Written by Andrew Allentuck and published in the Regina Leader-Post on November 20, 2020
PHOTO BY GIGI SUHANIC/NATIONAL POST
