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Gobeil's Strategic Financial Planning Study Aid - Constructed-Response Question - Volume 1, Question 2

Posted by David Gobeil on

There was a calculation error in Part F of this question. Their monthly expenses would be $3,378, not $2,460. They could not afford a $400,000 home.

I have rewritten the question to be more realistic about home prices; and fix the calculation. I also increased interest rate to 5%, which is not realistic.

(12 minutes – 6 marks) You have just obtained new clients, Collin Trane and his wife, Maria, who are respectively 35 and 32 years of age. They have two children who are 6 and 8 years of age. Collin is employed as financial analyst and Maria is a college professor. Collin's salary is $120,000 and Maria's salary is $100,000. Maria is a member of a 2% defined-benefit pension plan.

They have been renting a house, but would like to purchase their own home. They have been discussing this with Maria’s brother, Andrew, who purchased his home a couple of years ago. Andrew’s home is worth about $800,000. Andrew’s property taxes are $9,850 per year and his heating costs are $6,950 per year. Andrew’s bank required a maximum total debt service ratio of 42%. He is paying an interest rate of 5% monthly.

They want to purchase their own home, but would like to avoid having to purchase mortgage insurance and want to be sure that they can afford their own home. Their only debt is from their credit cards, which they pay each month as the payments come due.

Their current annual housing costs for rent and heating are $40,000. While $150,000 of their cash flow is committed to various expenses and savings, in addition to making contributions to their RRSPs and TFSAs, they currently save an additional $32,000 per year. They have $112,000 in their TFSAs and $108,000 in their RRSPs. They have no debt.

Prepare a strategic plan for the Tranes with the rationale for the plan.

Solution

A. You have $74,000 in your TFSAs and $108,000 in your RRSPs. In pursuing your objective of home ownership, you have opportunities to:

  • borrow $50,000 from your RRSPs under the Home Buyers’ Plan; and
  • use $110,000 of your savings in your TFSAs to provide a downpayment of $160,000, calculated as (20% of purchase price of home of $800,000).

B. You would have to consider potential problems of:

  • you need to ensure that you can afford the additional costs for home ownership; and
  • you would be purchasing a home after there has been a very substantial increase in the market value of residential real estate and interest rates are expected to increase after being at historical lows.

C. If you were to purchase a home comparable to Andrew’s and the mortgage company was to require a maximum total debt service ratio (TDSR) of 42%, you could afford a maximum monthly mortgage payment of $6,300, calculated as:

  • ((TDSR × gross income) - (property taxes + heating costs + 50% of condo fees + payments on other loans));
  • (((42% × $220,000) - ($9,850 + $6,950 + (50% × $0) + $0)) ÷ 12); or
  • (($92,400 - $16,800) ÷ 12).

D. If you could afford a maximum monthly mortgage payment of $6,300, the interest rate was 5% monthly and you amortized the loan over 20 years, you could borrow an amount of $955,000, calculated by entering:

  • P/YR = payments per year = 12, N = (amortization period in years × 12 months per year) = (20 × 12) = 240 months, I/YR = interest rate monthly = 5%, PMT = ( - maximum monthly mortgage payment) = ( - $6,300), FV = balancing owing at end of amortization period = $0, MODE = payment at end of month; and
  • solving for PV = amount that you could borrow = $955,000.


However, this is the amount that you could afford to borrow based upon a total debt service ratio (TDSR) of 42%. The amount that you can really afford to borrow should be based upon an assessment of your income and expenses.

E. If you were to make a downpayment of $160,000, take a mortgage of $640,000, arrange an interest rate of 5% monthly and amortize the loan over 20 years, your monthly mortgage payment would be $4,224, calculated by entering:

  • P/YR = payments per year = 12, N = (amortization period in years × 12) = (20 × 12) = 240 months, I/YR = interest rate monthly = 5%, PV = amount of mortgage = $640,000, FV = balancing owing at end of amortization period = $0, MODE = payment at end of month; and
  • solving for PMT = monthly mortgage payment = $4,224.


F. Your current monthly housing costs are $3,333, calculated as:

  • (rent and heating expense); or ($40,000 ÷ 12).

If you were to borrow $640,000 and have a monthly mortgage payment of $4,224, once you begin your repayments of the loan under the Home Buyers’ Plan, your cash outflow for your expenses and debt repayments for home ownership would be $5,902 per month, calculated as:

  • (monthly mortgage payment + property taxes + heating costs + repayment under Home Buyers’ Plan);
  • ($4,224 + (($9,850 + $6,950 + ($50,000 ÷ 15 years)) ÷ 12));
  • ($4,224 + (($9,850 + $6,950 + $3,333.33) ÷ 12));
  • ($4,224 + ($20,133.33 ÷ 12)); or
  • ($4,224 + $1,677.78).

Your monthly cash outflow for accommodation would increase from $3,333 to $5,902, and you would also have $160,000 of your savings invested in your home. This increase in your costs of accommodation of $2,569 per month, calculated as ($5,902 - $3,333); or $30,828 per year, calculated as ($2,569 per month × 12 months per year) could be covered by your cash flow.

While $150,000 of your cash flow is committed to various expenses and savings, your cash flows include other savings of $32,000 per year. So, you can purchase an $800,000 home.

G. A strategic plan to meet your objectives is:
borrow $50,000 from your RRSPs under the Home Buyers’ Plan; and

  • use $110,000 of your savings in your TFSAs to provide a downpayment of 20% or $160,000.

H. The rationale for this strategy is:
you can each borrow up to $25,000 from your RRSP under the Home Buyers’ Plan; and

  • with a downpayment of 20%, you do not have to purchase mortgage insurance and you would have significant equity in your home.

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