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Woman must act now

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Woman must act now or drown in debt

In Ottawa, a federal civil servant we’ll call Sarah, 49, is drowning in debts of $293,000 while supporting Karen, a disabled sister. That’s approximately five times her annual take-home income of $60,132. Payments to service this debt, $2,407 per month, take an astonishing 48% of after-tax monthly income. She has to borrow for day-to-day expenses. She will eventually be insolvent if she does not act decisively.

She must make difficult decisions and tighten her belt

“I have so many goals, but the debts and what I have to pay for my sister have left me with no room to manoeuvre,” Sarah explains. “I want to travel to Spain and France, New York and the Yukon. I have family on the West Coast as well as in the Maritimes and I want to be sure that when I pass away the life insurance my job provides (twice annual salary) would take care of Karen and pay my mortgages (I don’t have any mortgage insurance) and leave something for my cousins, their children, and my brother and nieces.”

But Sarah’s situation is grave and has to be fixed before she can do any of that. Fortunately, there is time to do it, says Caroline Nalbantoglu, president of CNal Financial Planning Inc. in Montreal.

“We have to drill into the loans to understand the problem,” Ms. Nalbantoglu says. “They were consolidation loans. Her credit card is practically at its maximum and she makes only minimum payments on it. Interest rates on some of the loans are startling and she is going deeper into debt. She must make difficult decisions and tighten her belt.”

It won’t be easy: There is nothing visibly lavish in Sarah’s spending. There is a disability tax credit, but Karen, 51, disabled 22 years ago by a back injury, uses all of it for her own taxes. Sarah got a caregiver tax credit worth about $400 last year after tax is calculated and will receive a similar credit this year. She also receives $625 a month from Karen as rent, boosting her monthly income to $5,011, but that doesn’t change the fact her budget is a flood of red ink ending in a $542 monthly deficit of outgo over income.

Sarah must cut her massive debts, with interest charges as high as 19%. RRSPs and TFSAs will have to wait: These loans have the potential to force her into bankruptcy.

First step: Get rid of the monthly deficit. She has $204 every month deducted from her payroll she uses to buy Canada Savings Bonds to help family members back East. She has a monthly $54 transfer from pay to her RRSP every month. Those contributions, $258 per month, should be directed to debt reduction. The RRSP can wait until Sarah gets her cash flow under control, Ms. Nalbantoglu says.

Next, monthly expenses have to be trimmed. She spends $700 a month on food for herself and her dependent sister. She also spends $467 a month on phone and cable service that supports enough electronics and computer gear for a small business. She should trim $200 each from food and technology spending. That makes $400 in savings that should go to debt reduction, Ms. Nalbantoglu suggests.

Sarah has a $90,000 house on the East Coast in order to be near her family. She has used the house, once owned by a great aunt, for a few weeks each year for the past four years. Though its a fixer-upper, it has sentimental value.

Sadly, the house is an albatross. Her equity is in the home, which has an $82,000 mortgage, is just $8,000. It needs, she advises, $50,000 in repairs and $20,000 in landscaping. That’s $70,000 she does not have and cannot afford. The immediate beneficiary of improvements would be her lender, which “owns” 92% of the house. The house costs $568 a month or $6,816 a year in mortgage payments, utilities and property taxes. That’s 12% of take-home income she cannot afford to spend. Best move: Sell the house and stay in a hotel or with family members when she visits. Use the $568 for debt reduction. If, in retirement, Sarah wants to return to her roots, she could sell her Ottawa condo and use the proceeds to buy a nice house with a view of the coast, Ms. Nalbantoglu says.

So far, Sarah can harvest $258 from not buying savings bonds and not making her monthly RRSP contribution, $400 from food and tech spending, and $568 from her East Coast house. That’s a total of $1,226 a month. If Sarah uses this cash flow to pay off her $4,600 credit card debt with its 19% interest rate, it will be gone in four months.

Then she can direct her cash flow to paying off the $28,000 balance of the loan with a crippling 11% interest rate. It will be gone within two years.

Finally, she should address the $32,000 line of credit secured on her Ottawa condo. It costs 4%, which is not unreasonable, but she might get her bank to cut the rate a little in view of her aggressive debt repayment.

Sarah has a $147,000 mortgage on her Ottawa condo with a 7.6% rate. It comes up for renewal in summer and it should be possible to negotiate a lower interest rate on it. Her present debt load precludes a preferential interest rate, so she should seek a short loan due in perhaps two or three years when her debts have declined.

If she can get a $179,000 mortgage that consolidates her present mortgage with $32,000 of other debt, her payments with a 10-year amortization would be $2,051 a month. She would pay $356 less than what she currently pays for financing her many debts. This move would allow her to retire with no debt before she reaches age 60, Ms. Nalbantoglu notes.

At retirement at 60, Sarah could get an unreduced pension from the federal government of $45,192 per year. She can take Canada Pension Plan benefits at age 60 of $7,578 in 2012 dollars. She will be able to add about $1,300 a year from future retirement savings for total income to age 65 of $54,070 a year or $3,830 a month after tax. At 65, her federal pension will decline to $37,828 a year. At age 67, she will qualify for OAS, currently $6,481 a year. The sum, $51,887 plus retirement savings, a total of $53,187, would be subject to tax at a 15% average rate and leave her with after-tax income of $45,209 per year.

Her annual expenses, reduced by such economies as cutting food and technology spending and eliminating debt service costs, will be about $2,500 a month in 2012 dollars, Ms. Nalbantoglu estimates. “She will have a substantial surplus for travel or renting a small home on the East Coast. In retirement, she will have the security that her debts have denied her in her working life. It all depends on getting present debts paid.”