September 5, 2017

Now we are not suggesting that you should plan to go bankrupt but if you are struggling with debt it may be a good option and here’s why.

Many people experiencing debt problems make the mistake of self-liquidation.  While that appear to be the proper moral remedy it isn’t always the most sensible.  After all the morality of lending is questionable at best, and this is particularly evident with credit card repayment terms extending over four lifetimes.

Imagine the following scenario:

We have a typical couple who have two young children each have jobs and have seen their incomes marginally increasing.  Rob works in a factory and earns about $50,000 per year with a take home pay of $3,300 a month and Julie works in an administrative position making $45,000 per year with a monthly take home pay of $2,700 so between them life is pretty good.

The couple have been able to put a little bit of money aside for RSPs some of it from RSP loans they have obtained to reduce their income liability at the end of each tax year.  They also have been putting some money into RESPs and TFSA’s.

When they went to the bank to see what they would qualify for a house mortgage as first time home buyers the bank advised them that based on a Gross Debt Service Ratio (GDS) they qualified for a mortgage with payments of up to 32% of their gross annual income, less heat and taxes which would look something like this:

Rob’s salary is $50,000 plus Julie’s salary of $45,000 equals a gross family income of $95,000.  Therefore $95,000 x .32 = $30,400.  So according to the bank’s formula the couple can afford to pay $30,400 each year (or $2,533 per month) for mortgage payments, property taxes and heating costs.

Using the GDS formula the bank has determined that the couple is allowed $150 per month for heating costs and $350 for property taxes leaving them with $2,033 for monthly mortgage payments and base on a qualifying rate of 6% the banker told them they can afford the monthly payments of $1,919 on a $300,000 mortgage.

Like many young people they talk to their realtor about a house based on that information.  Eventually settling on a house that is close to their children’s school and is selling for $300,000 – right on budget!  They sign the deal and take it to the bank for final approval, after all they did qualify.

But the bank reminds them that they need a down payment of at least 5% of the house value to qualify for the mortgage.  Ooops!  But their friendly banker has a great solution – as first time home buyers they can get a RSP loan of $15,000 which will help them out with their taxes at the end of the year.  If they use $15,000 from the money already held in their RSP accounts they can convert that to a OHOSP and use it as a down payment on the property without a tax penalty, the RSP just must be repaid over the next fifteen years.

So Rob and Julie sign the deal and happily move their children into their new home.  Along the way they had to pay 4% of the purchase price to CMHC to insure the bank (not them) in case of default.  Then of course they had the usual legal and other conveyance costs but it doesn’t matter they have their home and their $300,000 mortgage.  They are so focused on the excitement of their new home they weren’t thinking about the $15,000 RSP liability that must be repaid over the next 15 years to avoid the tax consequences of withdrawal and they weren’t really paying attention to the $15,000 RSP loan they now owe to the bank – collectively leaving them $330,000 in debt for the purchase of the property, or maybe even closer to $470,000 if the future interest payable on the mortgage loan is considered.

Life is good for the first year but they did accumulate a whole bunch of debt on their line of credit and various credit cards furnishing and maintaining their home and doing all the normal stuff families do; taking the kids to dance and karate lessons a modest vacation and so forth.  All the bills were being paid on time even though sometimes they had to go into overdraft at the bank and occasionally use the line of credit to pay out higher interest credit cards.

Then it happened, Rob was laid off from his job working in a manufacturing environment and found himself on the dole bringing home $400 per week or about $1,600 per month.  The couple remained optimistic for the first few months and continued using their credit cards and lines of credit to make up the shortfall while Rob was looking for work.  Unfortunately with so many jobs leaving the country for cheaper labour markets the best he could find was paying a little over minimum wage at $12 per hour.  So with a take home pay of $1,650 per month they simply could not catch up and were getting further behind on their bills.

At this point they should meet with a Licensed Trustee in Insolvency and Restructuring (newfangled name for Trustee in Bankruptcy) to discuss their options.  Some of their investments (RSPs and pensions for example) are exempt from seizure in a bankruptcy subject to claw backs.  But instead they embark on a self-liquidation – perhaps it is a case of pride – and collapse their RSPs to make minimum monthly payments to all of their creditors – possibly not thinking of the tax consequences they will face at the end of the year.

By the time they eventually present at the trustee’s office they have nothing left, the house is under a power of sale, they have no RSPs and have liquidated everything else they possibly could in order to make minimum payments.  Now let’s be clear bankruptcy is no panacea but when appropriate filed it could have saved this couple a lot of money in terms of RSP and pension funds at the very least.  And if they spoke with a trustee when they were thinking about buying a house they may have had some sound advice on what is really affordable – after all trustee see the highs and lows of family finances and are well positioned to advise people on the costs and risks of incurring long term debt.