Personal Financial Planning Executive Summary Further to our recent discussions, the following is a detailed analysis of your current financial position and recommended action plan for achieving your stated financial goals. Key findings are summarized below and detailed supporting financials are provided in Appendices I thru VI. As at March 31, 2011, your total net worth/equity is estimated at $22,090. In reviewing the details of your assets and liabilities, with all other personal assets fully leveraged, this net worth is comprised primarily of the value of your household contents.
While these household items are valued at a replacement cost of $25,000 on the family balance sheet, these items could not be sold for this amount to service your current debt obligations, which today total $22,078. With your financial assets totalling $2,000, your liquidity, that is, your ability to meet your financial obligations in the short term, has been significantly impaired. At the same time, the family’s solvency, which means your ability in the longer term to pay your debt, could also be seriously compromised.
In preparing the detailed cash budget for the preceding 12 month period, I could readily identify the factors that have compromised your liquidity and potentially, your long term solvency. With cash outflows exceeding inflows each month by approximately $850 from April 2010 to February 2011, you have had to fund this shortfall each month by increasing the outstanding balance on your credit cards and line of credit.
While I recognize your recent efforts to consolidate some of this outstanding debt, reduce interest charges and lower your monthly payments by taking out a second mortgage with ABC Financial, this second mortgage has your current Total Debt Service Ratio at 47. 4%, well in excess of the 40% threshold that the large Canadian financial institutions use as criteria when extending credit to clients. With a 20% interest rate, it will be several years before you begin to pay down the principal on this mortgage.
Despite the efforts to consolidate and reduce your monthly payments, in reviewing your projected cash flows for the month of March, 2011, your outflows still exceed your net monthly income by $545. Without a plan of action to close these gaps, the only way to fund this shortfall will be to continue to increase the balances owing on your credit cards and line of credit – both considered demand loans that can be called by the bank at any time. When we first met to discuss your short and long term financial goals, one of your primary short term goals was to own a home.
Three years ago, you were successful in achieving this objective, purchasing a home for $240,000 and financing 75% of the purchase price with a conventional mortgage and a down payment of $60,000. However since that time, not only has the housing market declined, thereby reducing the equity in your home, your spending patterns have significantly increased your short term and long term debt obligations and further eroded the equity you had. At the same time, you have not been able to contribute to your other long term financial goals i. . , saving for retirement and your children’s education. This is why a detailed review of your current financial position, with the goal of developing an action plan to remedy the situation, is so critical. Once you have had the opportunity to review the attached analysis and recommended plan of action, we will meet again at your earlier convenience to discuss the next steps. Regards M. Smith Certified Financial Planner Key Assumptions and Supporting Backup
Below is a summary of key assumptions supporting the current Chang Family Balance Sheet, 12 Month Cash Budget, as well as the Pro Forma Cash Budget that has been developed based on the recommended action plan. 1. Min Family Balance Sheet as at March 31, 2011 (see Appendix I) • A key assumption underpinning the current balance sheet is that the $35,000 received from securing the second mortgage with ABC Financial was used to pay down debt and therefore there is no corresponding asset on the balance sheet.
Other assumptions include: o The TDS ratio prior to the second mortgage well exceeded the 40% threshold, which is why RBC or similar large banks would not extend any further credit to the Chang family o Combined balances owing on the credit cards and line of credit (e. g. Other Debts) were an estimated $55,000; this included the amount for the renovations of $10,000; the balance was reduced to $20,000 in February 2011 with the funds received from the second mortgage o Cash Outflows for payments for Other Debt were an estimated $850 each month prior to securing the second mortgage (i. , April/10 to February/11) o Chang family funded the cash shortfall each month by using credit cards and their line of credit Assets • Cash and Investments – current balances in TD chequing account and mutual fund investments of $1,000 respectively o Given their current financial situation, this family would have only a minimum amount of liquid assets; if they had anything substantial they would have used it to pay down a portion of their outstanding debt • RRSP, RESP, Company Pension Plan – nil As noted above, given the family’s current financial position, they have not had the cash flow for any investment for retirement or children’s education fund • Car – asset of $12,000 o Reflects current market value for a 2007 Honda Accord purchased 2 years ago for $22,000 financed with a loan of $18,000; market value reflects current black book value • Condo – as at March 31, 2011, asset value of $219,000 o Condo was purchased 3 years ago for $240,000 Conventional mortgage with RBC at a rate of 6%; RBC would have financed a maximum of 75% of the market value of the home and therefore with a mortgage of $180,000, the market value at the time of purchase = $180,000/. 75 = $240,000; Chang family had a deposit of $60,000 o Family has lived in the condo for 18 months before making upgrades/ renovations o The current value of the home of $219,000 assumes ABC Financial financed 90% of the family’s equity in the home at the time of the second mortgage after estimated disposal costs.
ABC Financial advanced $35,000 therefore family had at least $40,000 of equity in the home ($35,000/. 90) o Given the outstanding mortgage balance of approximately $170,000 and an estimated $40,000 of equity remaining in the home, ABC Financial would have valued the home at $170,000 + $40,000 + an amount for disposal costs of $9,000 = $219,000 o While Sylvia Chang does not believe the market value of the condo is more than $180,000, several facts support a higher asset value on the balance sheet.
ABC Financial advanced a second mortgage of $35,000 and would not have done so if they did not believe there was value in the asset over and above the outstanding balance of the first mortgage with RBC. Also, the family invested $10,000 in upgrades (new furnace, air conditioner and carpet) and housing prices in the area are up 5% year over year. • Household – replacement value of family’s personal assets/household contents of $25,000 • It is assumed the family has no other personal assets or luxury assets
Liabilities Current Liabilities (include all demand loans and current portion of long term debt) • Credit Card and Line of Credit outstanding balance of $20,000 (information provided in the case) • Car Payment – $332 per month o Original loan of $18,000; financed car in March 2009 with first payment in April 2009 and therefore 24 payments have been made to date. Interest rate of 4% with monthly compounding so EAR = 4. 0742%; N = 60; I = . 395; PV = 18,000 and calculated PMT = $332 per month; after 24 months have paid $1,206 in interest, $6,764 in principal and now $11,236 balance remaining • RBC Mortgage Payment – $1,152 o 1st mortgage of $180,000; with a combined gross family income of $77,000 and two young children, assume a 25 year amortization as it is likely this family would want to minimize their monthly mortgage payments o Family purchased the house 3 years ago; interest rate of 6%, five year term with semi-annual monthly compounding so monthly effective rate = . 939, N = 300, PV = $180,000 and calculated PMT = $1,152 • ABC Financial Payment – $594 o Case stated this second mortgage was recent so assume the loan was made in February 2011 with the first payment due in March 2011 o 15 year amortization as the family did not want to carry this debt beyond this period given the high interest rate of 20% o With semi-annual compounding, interest rate of 20% equates to an effective monthly rate of 1. 6%; PV = $35,000, N= 180, PMT = $594 Long Term Liabilities • Car Loan – outstanding balance of $10,904 24 payments made to date – interest paid to date of $1,206 and $6,746 paid in principal (total car loan liability = $332 + $10,904 = $$11,236) • RBC Mortgage – outstanding balance of $168,526 o 36 payments made to date – $31,140 paid in interest, $10, 321 paid on principal (total RBC mortgage outstanding = $1,152 + $168,526 = $169,678) • ABC Financial Mortgage – outstanding balance of $34,402 o First payment made in March 2011 and therefore negligible amount paid on principal (total ABC mortgage outstanding = $594 + $34,402 = $34,996) 2.
Min Family Cash Budget – February 2010 – March 2011 (see Appendix V) Cash Inflows • Assume the only source of income is employment income and the family does not have any material investments that would yield dividend or interest income; David does receive an annual Christmas bonus which nets $1,000 after tax • See Appendix IV for a detailed calculation of net income from employment after deducting taxes, EI, CPP and group life and health insurance premiums for David; assume neither David or Sylvia are making monthly contributions to their employer pension plan given their current cash flow situation
Cash Outflows Discretionary Expenses • Food, Health and Hygiene, Clothing, Entertainment and Dining Out based on a family of four • Transportation costs assume both David and Sylvia use the car and public transportation to travel to work • Gas costs assume car is used to commute part of the way to work and for errands on the weekend • Utility costs of $90 per month are for telephone and internet; the costs for cable and hydro are included in the monthly condo fees, which is typical for newer condos • Day care costs are assumed to be $68. 5 per week for two children • Condo fees and property taxes – information provided in the case • Car insurance – assumes an annual premium of $600 to insure the car for both drivers and monthly premium = $600/12 = $50 • Condo insurance – assumes an annual premium of $300 or $300/12 = $25 per month • Annual spending on Christmas gifts is $500 and funded primarily with David’s year end bonus paid in December Non-Discretionary Expenses See above for details supporting monthly car and mortgage payments • $600 per month for credit card and line of credit payments – information provided in the case • Assume no other fixed loan payments in March o However, prior to March 2011, Other Debt payments averaged $1,500 per month. In February, the family realized the need to consolidate the balances outstanding on credit cards and their line of credit to reduce their interest charges and lower their monthly payments.
In March, they secured $35,000 of funds from ABC Financial, which they applied to their Other Debt Outstanding, reducing the balance to $20,000 and decreasing their monthly Other Debt Payments to $600 3. Pro forma Cash Budget – April 2011 to March 2012 (see Appendix VI) Incorporated into this pro forma budget are a number of assumptions that reflect changes resulting from the proposed action plan. • Monthly Income – Based on information provided by the client, both David and Sylvia receive annual base salary increases of 2. 5%. These pay increases are effective in April of each year.
David will receive an annual bonus of $1,000 in December, which is consistent with bonus payments received the last 3 years • Sale of the Family Home – Family home will be sold for its current market value of $219,000 (see supporting rationale for current market value included in section 1 above). After paying off the 2 mortgages totalling approximately $205,000 and deducting all closing costs and related moving expenses of $12,000, there will be $2,000 of excess cash remaining. It is assumed the house will be listed in early April with a May closing date. Extraordinary Item – Excess cash from the sale of the home. After deducting all closing costs (i. e. , real estate commissions, land transfer tax, interest penalty costs) of $12,000, there will be $2,000 remaining. This is reflected as a one time cash inflow in May. • Monthly discretionary expenses have been reviewed and adjusted where appropriate to reflect the expected rate of inflation. Price increases of 1% have been incorporated in April 2011 for all discretionary expenses except for Gas, Telephone, Internet, and Condo Fees.
Telephone and internet increases require CRTC approval and given the 2010 price increases, it is not expected prices will rise further in 2011/12. As an increase in condo fees requires Board approval and there have been no recent discussions proposing an increase, it is assumed the fees will remain flat. Gas is included in the Consumer Price Index (CPI), but has a high volatility rate due in part to geopolitical events. The price of gas has not risen commensurate to inflation, but rather substantially higher at an annual rate of 10% and this has been reflected in the pro forma amount for gas.
However with the move to the rental property in June, the family’s gas costs will decline as they will be living closer to work. • With the move to the rental property, estimated rent expenses are $1,000 a month beginning in June. However the landlord will require first and last month’s rent, for a total cash outlay of $2,000 in June. Outlays for condo fees and property taxes will cease after May. Condo insurance will be replaced with tenant insurance. Utility costs for the rental property will remain unchanged. The most significant impact on the pro forma budget will result from the transition from home owners to renters. Rent is projected at $1,000 per month, beginning in June. In addition, the last month’s deposit will also be paid in June for a total outlay of $2,000. The excess cash from the sale of the home will be used for the last month’s rent and the remaining $1,000 applied to outstanding credit card debt. Net incremental cash inflows each month resulting from the sale of the condo will be used to reduce the remaining credit card balance of $2,000.
This will be done in equal payments of $500 for a 4 month period from July to October. Paying down the high interest credit card debt is a key priority. Key Alternatives At the conclusion of our last meeting, you recognized that your current inflows were not sufficient to cover your discretionary and non-discretionary expenses. Given the high rates of interest you are paying on the 2nd mortgage with ABC Financial and on your credit card and line of credit balances outstanding, you asked that I evaluate the feasibility of consolidating your current debt into one lower monthly payment.
If this was not a viable option, you believed you would need to consider selling your home, paying off your debt and renting for a period of time so that you could begin to rebuild your equity such that you could purchase another home in the future. I have completed a detailed financial analysis to evaluate each of these options and offer a third possible alternative. A summary of my analysis and recommended plan of action is provided below. Option 1 – Consolidating Outstanding Debt into One Lower Monthly Payment
As noted in the Executive Summary and detailed in Appendix III, your current Total Debt Service Ratio is 47. 38%, which well exceeds the 40% threshold that the larger financial institutions have established as their criteria for extending credit. In fact, the reason you had to approach ABC Financial for a 2nd mortgage was because RBC would not extend you any further credit given your TDS prior to securing the second mortgage exceeded the 40% they require. And while some non-bank financial institutions such as ABC Financial and Canadalend. om would extend credit when a family’s TDS exceed the 40% threshold, they will do so at a much higher rate of interest to compensate for the higher risk of the client. In looking to consolidate your debt into one lower monthly payment in the near term, you would need to improve your TDS ratio quite significantly to meet the 40% threshold. This can be achieved in one of two ways – increasing your monthly cash inflows or reducing your discretionary expenses to accelerate the repayment of debt.
To increase your monthly inflows, one or both of you would have to secure higher paying jobs or supplement your income with part time work. Given you have two young children and are already paying for day care, I do not think this is viable in the short term. With respect to reducing your discretionary expenses with a goal of accelerating the ability to pay down your fixed loans and improving your TDS, I have reviewed your monthly cash flow statement and have not identified any areas where you could materially decrease your expenses.
Your monthly expenditures for food, clothing, transportation, daycare etc are very reasonable given you are supporting a family of four. To bring your TDS ratio line with the 40% threshold, you would have to reduce your qualifying debt payments to $30,800 a year ($77,000 * 40%). On a monthly basis, this would translate into debt payments of $2,566, down from your current level of $3,040, a decrease of $474 per month. I do not believe this can be achieved by reducing any of your current discretionary expenses. I also considered how you might increase your take home pay each month to improve your cash flow.
Other than David’s monthly premiums to his group life and health insurance plans, which are relatively inexpensive and important for managing risks to your financial well being in the event of illness or premature death, the other deductions (i. e,. taxes, CPP and EI) are mandatory. There are no other voluntary deductions that we could eliminate to increase your take home pay. In summary, given your current fixed debt obligations, monthly discretionary expenses and cash inflows, consolidating your debt into one lower monthly payment and reducing the high interest costs you are paying today is not a viable option.
Option 2 – Selling Your Home and Downsizing to a Smaller Home I have researched Oshawa’s residential market and there are a number of attractive homes available ranging from $150,000 – $175,000. However, given the two mortgages outstanding, for a combined amount of $204,674, and the estimated market value for your home of $219,000 before disposal costs, the equity in your home is $15,000. After closing costs, you would not have any equity for a down payment on another home at this time. Even considering the option of a high ratio mortgage, you would be required to make a minimum down payment of 5% (assuming you qualify).
On a home selling for $150,000, this would translate to a down payment of $7,500, which today you do not have. Option 3 – Selling Your Home, Paying Down Fixed Debt and Renting A third alternative for consideration would be selling your home, paying off the two mortgages and renting for a period of time until the family is able to save for a down payment to purchase another home. While this might be perceived by some clients as a drastic step, I know you are open to the idea because this is an option we have discussed in our meetings.
However, in evaluating any option, we need to ensure that it is not only a short term solution to your current cash flow situation but also, that we have developed a feasible set of actions that will position you to achieving your near term financial goals i. e. owning your home again, and achieving your long term financial objectives of saving for your children’s education and your retirement. This will entail developing a realistic 12 month pro forma cash budget, monitoring your progress on a regular basis and refining your financials goals and action plans as required.
In preparing your current balance sheet, I researched the Oshawa housing market and consulted with several local real estate agents. The research supports a market value for your home of $219,000. I have also provided further rationale supporting this market value in the preceding Key Assumptions section of my report. With the cash from the sale of your condo, you would be able to pay off both the RBC and ABC Financial mortgages and reduce your monthly payments by $1,746. This would be offset in part by the cost to rent but there are numerous attractive rental properties in Oshawa that are available for $1,000 per month.
In addition to lower rent payments relative to your current monthly mortgage payments, a number of properties on the market are closer to where you both work, which would allow you to reduce your gas costs. The sale of your condo would eliminate the monthly condo fees and property taxes, for a combined savings of $362 a month. This, combined with the lower rental payments, would generate an incremental cash inflow of $1,108 each month. With these net inflows each month, you will then be a position to pay off some of your remaining credit card and line of credit balances.
With the higher interest credit card debt paid off and the remaining balance on the line of credit at a more manageable level, you will then be able to begin saving each month for a future down payment. This assumes that you adhere to the proposed cash budget and be diligent in managing your spending within the constraints outlined. After estimated closing costs of $12,000 (i. e, real estate commissions, 3 months interest penalty charges to break both mortgages, land transfer taxes, moving costs etc), you would have $2,000 in excess cash from the sale of your condo.
Before saving this money, I would recommend first paying off all outstanding credit card balances, which currently represent $3,000 of the $20,000 of Other Debt you have outstanding. With the high interest charges you are paying on your credit cards, it is in your best interest to pay these cards off as soon as possible. In developing a pro forma cash budget for you (attached in Appendix VI), I have made a number of assumptions that I have outlined above in the previous Key Assumptions section. Obviously we will review in detail at our next meeting.
I have re-cast your monthly expenses to reflect the changes in your monthly cash outflows that will result from the sale of your condo. I have also taken a conservative approach and adjusted a number of your current expenses to reflect the expected rate of inflation. In addition, I have assumed you will pay off all credit card balances, using the excess cash you receive from the sale of your home and some of the incremental cash you will now have each month. Once the credit cards are paid off, you will be in a position in November 2011 to start to save for your next down payment.
In my professional opinion, I believe the third option I’m proposing – that is to sell your condo, pay off the mortgages and reduce your non-discretionary outflows such that you can begin to save for a down payment and ultimately your children’s education and retirement – is the only feasible alternative for your family at this time. Previously, you were accumulating an increasing amount of debt every month and ultimately found yourselves in a position whereby you could not meet your current financial obligations.
This option will enhance your financial stability in the short term by improving your liquidity and also enhance your solvency in the longer term and you ability to achieve your financial objectives. Based on the pro forma budget for the next 12 months, I expect you will have saved $4,000 towards your down payment by March 2012. Next Steps Once you have had a chance to review my proposal and all of the supporting financials, I would recommend we meet as soon as possible to discuss next steps.
Assuming you accept my recommendation to sell your condo, we need to discuss what steps you can take to maximize the selling price of your home and ensure the condo is sold as quickly as possible. We also need to discuss the various investment options available to you, such as the tax free savings account, that would yield an attractive return as you save towards a down payment. I would also like to look at some options for you to accelerate the purchase of your next home. For example, if you are looking to finance your next home with a conventional mortgage, you will have to save 25% for a down payment.
You could however look at financing with a high ratio mortgage, which the large Canadian banks offer at attractive rates. With a high ratio mortgage, assuming you qualify, you can have a down payment ranging from 5 – 20% of the purchase price of a home. TD is currently offering a high ratio mortgage with a fixed rate of 4. 25% for a 5 year term. This would mean you would have to have a smaller down payment and therefore we could accelerate the timing for when you could next purchase a home. I think you should also be considering a less expensive property and we can look at monthly mortgage payments assuming a range of purchase prices.
Using your combined Gross Incomes and current thresholds for both GDS and TDS ratios used by the large financial institutions, we can calculate the price of a home you can afford. Finally, while we are currently focused on the next 12 – 24 months, we do need to conduct a complete financial review so we can develop a longer term plan that includes retirement savings and contributions to a registered education savings plan for your children. A complete review of your current insurance policies would also be done as part of the review. I will follow up with you early next week to set up an appointment.