Reader Mail: $1M House – Should I Downsize my Home?

The personal finance questions via email keep rolling in. Recently, Heather inquired about her financial situation and how would she go about reaching her goals. She is recently divorced and raising a child. While married, she worked in the family business, but now her only income is spousal and child support payments. She has a significant real estate asset – her principal residence in Vancouver.

Background

Hi, I own a home in Vancouver. It’s half paid for. It’s my future retirement fund, I’m 42, currently divorced on spousal support for five more years. I’m concerned the housing market is going to take a financial downfall soon, should I get out and buy a town home, have no mortgage and then do what with the balance of the remaining money? Can you confidentially give me your gut instinct on whether real estate is worth holding?  If I sell, I would buy a home in a different area, but the quality would not be the same, the lot half the size, the neighborhood is ok, but not upper class. I’m guaranteed 7,000 per month for the next 5 years, ( spousal) , my home is worth $1,000,000, remaining mortgage is 435,000 @ 3.48% fixed 5 year term.

Given a stable financial situation for the next five years, would you sell and downsize and have no mortgage, invest the rest in the stock market, or conversely, ride it out with the real estate for five years but then have to sell once that time is up?

I’m not working yet, studying part time at UBC, raising a child. I expect to work full time (@$50k/yr) within five years but cannot count on a predictable income amount then, it is an unknown.

Car is paid off.

I’m not currently contributing to my RRSP’S in favor of the TFSA.

I can get a nice new home for $670,000 and be mortgage free. Town homes are around $300k – $400k.

The goal is financial independence by 50.  I think I’ll need at least 40,000 a year to retire.

The new home I looked at I. A different location us 670,000. Big, new, nice. Half the size of the lot but may have an upside as a school, park and mall are being built right around there now.

Summary of Numbers

Net Income: $84k/yr

  • Spousal/Child Support: $7,000/month ($84,000/year) for the next five years.
  • Occasional help from family to balance expenses.

Expenses: $91k/yr

  • Car insurance: 1,600 year
  • Home taxes : 1,800 year
  • Cable, phone: 1,200 year
  • Utilities, 1,100 year
  • Electric, gas: 2,000 year
  • Maintenance : 2,000 year
  • Vacation: 2,000 year
  • Entertainment: 700 year
  • Gas: 4,000 year
  • Child expenses: 3,000 year
  • Home insurance: 1,600 year
  • Groceries: 10,000 year
  • Mortgage: 60,000 year (overpaying by  $18,000/yr)

Assets:

  • TFSA: $15,000
  • RRSP: $197,000

Liabilities:

  • Mortgage Balance: 435,000
  • Credit card balance: $16,000 @ 1.99% (being paid off $1,500/month with help from family)

Divorce is tough and certainly a wealth killer but good on Heather for seeking advice on how to get her financial house in order.  In her first email to me, her main question was about if she should sell her house now and lock in her equity because of the rumours of a real estate crash.  To answer that question, I don’t have the foresight or experience in real estate to call a crash, however I don’t think a real estate crash is the main issue here.

The main issue is cash flow and the 5 year time limit on spousal payments.  Right now, Heather is receiving about $84k per year (after tax) in spousal/child support but although this is more income than the average family, it is not enough for the lifestyle that she is living right now.   Housing costs are eating up 75% of her net income, which doesn’t leave a lot for her and her son to live on.  In fact, she is running monthly deficit which is evident in the credit card balance.

The good news is that Heather is currently overpaying on her mortgage, thus she can reduce her payments back to $3500/month which will free up $18k per year and bring her to cash flow positive.   I would then take that cash flow and pay off any credit card debt and sever the family payments she is receiving.

The next step, and perhaps the hardest, is that she will need to downgrade her lifestyle.  I understand that Heather is used to a certain lifestyle, but times have changed, especially with significantly reduced income on the horizon.  I feel that Heather should sell her $1M house to either rent or use the equity to purchase a $300k-$400k townhouse free and clear.

By purchasing a townhouse, she will be left with about $100k cash lump sum in addition to reducing her annual expenses from $90k to $30k per year.  If she sells her $1M home in the next year or so, it will leave her with $60k per year in excess cash flow or $240k over four years.

This will leave her in good shape as her potential $50k salary ($36k after tax and deductions) should be enough to cover her annual expenses once her spousal support runs out.

By following this plan, after five years she will have about $340k in the bank and a career that pays her enough to cover her annual expenses.

In the longer term, Heather is going for financial freedom by 50, or 8 years from now.  This is very aggressive considering the financial situation she is in right now.  Assuming a full annual TFSA contributions and 5% return, after 8 years the balance should be around $75k.  Assuming no other RRSP contributions, the value of the account should grow $260k.  If the $60k in mortgage payment savings over 4 years is invested for the 8 year term, the balance should be about $400k.

With these assumptions, total investable assets grow to $730k.  The problem is that the time frame is only 8 years, and although the market has never lost money over any 20 year or longer period, the market can be very volatile over an 8 year period.  In addition, with retirement at age 50, the portfolio would need to last 40 years or so.

Due to potentially long retirement time frame, I would invest in income producing investments that have a history of increasing their dividends (for inflation protection) and live off the distributions only.  However in this case, even the portfolio managed to obtain a generous 4% yield, it is still not enough to cover her required $40k budget.  On the bright side, if she stays invested for another 5-7 years and keeps maxing out her TFSA annually, she should be in good shape.  Canada Pension Plan along with Old Age Security when she turns 65 will be icing on the cake.

Final Thoughts

I realize that this post was a little wordy, so here are the highlights of my thoughts on Heather’s financial situation.

  1. Reduce mortgage to minimum payment, use freed up cash to start paying down credit card debt;
  2. Sell the $1M house;
  3. Buy a town house for $300k-$400k;
  4. Put any cash left over ($100k) into TFSA (up to maximum amount), then the remainder into a non-registered investment account (avoid RRSP at this point);
  5. Invest old mortgage payment to add to non-registered portfolio ($60k/yr for 4-5 years); and,
  6. Start career ASAP, and create an aggressive budget so that TFSA can be maxed out every year without taking on any more credit card debt.

What are your thoughts about Heather’s financial situation?

Do you have a personal finance question? Contact me here!

Disclaimer:  This post is for informational purposes only.  Contact a financial professional before acting on anything written in this post.

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FT

FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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KC
7 years ago

The post says spousal support then spousal/child support. Keep in mind that a lot of people tend to interchange these terms. If it’s spousal, then it’s 100% taxable. If it’s child support, it’s tax free (must still be reported). If it’s a combo of both, then obviously a percentage of it will be taxable depending on the court agreement. Since she said that support will run out in 5 years sounds more like child support.

Your advice was spot on. That’s exactly what I would have said to her. She needs to sell the while she still can and use the money wisely. The fact that her family is supporting her while she’s making overpayments on the mortgage is a sign of poor cash management. That very generous support payments should be used to the max to ensure the well-being of both her and her child.

The mortgage penalty for breaking it early is something else that must be considered into selling the house.

Bottom line, it’s a lifestyle change that must be done. She will be in a very good position as soon as she sells house and downsize to a smaller one and save the leftover.

Annie Craven
7 years ago

Great Advice! She definitely needs to sell and cut back on expenses as per @Dwilly. Vancouver is not a cheap place to be and people tend to get caught up in expensive lifestyles.
It’s good that she is seeking advice now and not in 5 years time when her support is about to run out.
Great post for anyone living in Vancouver right now, thanks for sharing.

SST
7 years ago

@Paul: “For nearly two decades they have seen 8% to 10% annual increases on their homes. That’s one hell of an investment return.”

A principle residence is not an investment.
Even if it was, the increases are completely moot, as demonstrated in this thread, unless:
i) the seller is taking the money into a less expensive market (eg. PEI)
ii) the owner is using the equity in the house to buy other assets.

http://vreaa.files.wordpress.com/2013/01/van_house_price_1960_2012.png

vmty
7 years ago

Advice: get out of that s.. hole that is Vancouver. Thanks to our outdated laws, Vancouver’s real estate is a money laundering tool for Asians.

Jennifer
7 years ago

@Paul, I agree with you so much. Maybe I’m getting away from Heather’s situation a little in adding this, but Vancouver residents, including suburbia here, have been enjoying nice returns. It’s hard to walk away from that given how unaffordeable new property is and smaller lots, etc. I have been wondering when the overseas money will end and if it will stop at all. A social geographer at UBC, Daniel Hiebert, projects that Ethnic Chinese numbers in a city of 2.2 Million will double to 800,000 by 2031. There may be a substantial body of wealth coming in that may just not run out. Those arriving are not only wealthy but extremely intelligent, often with Doctorates etc. That’s why Heather and I also wonder when the right time is to get out of this extraordinary market that conventional wisdom escapes due to very particular if not peculiar circumstances. We in Vancouver are in what someone called a “Bizarre Land”. Thanks so much to everyone weighing in, I know I’m not alone in trying to figure things out here.

Paul
7 years ago

@SST… “The North American stigma of being a renter (and obsession with ownership) is absurd.”

The thing is SST; buying has served Vancouver residents exceptionally well. For nearly two decades they have seen 8% to 10% annual increases on their homes. That’s one hell of an investment return.

Jennifer had a great post regarding houses in her area being bought by wealthy foreign buyers as soon as they hit the market, and many of those buyers do not move in.

I have your concern too though – what if the market corrects, if so, then when and by how much.

But the hot money from Asia is hugely distorting the picture here. From a Canadian salary perspective, house prices in Vancouver are HUGELY overvalued.

But the $$$$ from overseas keeps on coming… At what point will these (often very wealthy) buyers decide prices are too high in Vancouver?

It looks like the government will not intervene despite housing now being unaffordable for young Canadians here in Vancouver.

Dwilly
7 years ago

@SST: Agree certainly that in a place like Vancouver (and many large cities), land value drives the pricing more than the value or square footage of the structure itself. And so in that regard, comparing a house on a 25′ lot to a house on a 35′ lot is apples to oranges. The building is absolutely a depreciating asset. The land historically hasn’t been, but as we’ve already discussed can be volatile and is probably expensive today.

But in this case, that largely does not matter anyway. Whether it’s a 25′ or a 25 acre lot, you shouldn’t be paying $700k for it if your net worth is $700k. Not if you hope to retire in 8 years. That’s just the reality of the situation, IMO.

Jennifer
7 years ago

@Dwilly, I agree that trading to the 700K is a mistake. The 300K more affordable homes do exist in areas within 30 to 40 mins out if Vancouver DT. Town homes in some areas are priced within the affordability range. That town home purchase will now provide a place to live but no longer is an investment in that there are so many town homes being over built now in the Vancouver outskirts. But it’s the reality of the current RE market here and you are right that one needs to live where the price/ rent ratio makes most sense. And btw, lol, I can’t stop laughing at the comment that yes you can’t live in stocks but you can’t eat your house either….so very true! touché

Jennifer
7 years ago

@SST, I slept on your comments and common sense. You are right! Light bulb flashed. Half the size lot is indeed what she said and what is available for many new homes here these days. A good piece of land, that’s what’s rare. It would be a mistake to over pay for less land, worse location. Thanks for making sense of it for someone like Heather and myself as well.
Thanks to FT for the article, I’m sure many can benefit. Cheers.

SST
7 years ago

Take a look at the numbers (and language): one of her options is not for “a smaller home”, but “big…half the size of the lot…” for $670,000. Thus, Heather is selling for $1 million but would essentially be buying for $1.34 million (Heather is confusing “downsizing” with size of lot — remember, it’s not the structure that’s worth the money, it’s the land).

In stock terminology, that’s a 1:1.5 reverse split.

Don’t get sucked in — again.