Bridget a 32-year-old single mom and her 8-year-old daughter Samantha live in a 2-bedroom apartment on the outskirts of town � her rent is $3,500 per month. She owns a second hand car that is in fair working condition but chooses to use public transport to save on gas and maintenance costs. She is quite disciplined with her spending and often sticks to her monthly budget by cooking and brown bagging her lunch for work.
She has been setting aside $1,000 every month from her salary and has built up a tidy sum of $30,000 dedicated solely for emergencies. She has no major debts except a solitary credit card with a $5,000 limit used specifically to deal with unplanned expenses that pop up form time to time � she always ensures that the balance is repaid in full as soon as possible to save on interest cost.
Just in case the unthinkable happens she has also invested in two insurance policies that cover death, disability and critical illnesses. She listed Jennifer, her twin sister, as beneficiary who will ultimately take care of Samantha when she is gone. In addition to these policies her agent added an annuity 10 years ago to which she contributes $450 monthly.
In her spare time, Bridget keeps busy with her hobby of making signature hand crafted jewelry. Her work has gained popularity in recent times as more and more of her clients wear pieces at important social events. She has a modest following of about 8 customers made up friends, relatives and coworkers, who order items every couple of months. The fastest moving pieces sell for around $100 with materials costing 10% of sales.
Bridget really wants to purchase her own home but is doubtful that this can happen in light of her present financial situation and current property prices.
Nick's Assessment and Advice
Bridget appears to be doing all the right things that make for a prudent financial plan. She is practically debt free, kept expenses low, covered risk and systematically saves for the future.
The concerns she has about the prospect of home ownership under the prevailing market conditions are not unfounded. However, even though it may appear difficult, it does not mean that she cannot accomplish it - it just calls for a different game plan. It also means that she has to creatively use the resources at her disposal to close the gap.
But to know what the gap truly is, she has to have a starting point. To establish a starting point she has to know the price tag of the property she is looking for. To know this we must consider her limiting factors � in this case they are: her income, age, and level of savings.
We have not been given her income so we cannot readily assess her debt service ratio (DSR) and by extension her borrowing power. However by estimating what she currently pays towards housing and discretionary savings we may be able to gauge a possible monthly mortgage payment of $4,500 ($3,500 + $1,000).
Applying a 5% mortgage interest rate and a term of 28 years (age 60 minus 32), she should be able to access over $800,000 of borrowed funds. If this amount represents 90% of the property value, then the target house price could be approximately $890,000 ($800K divided by 90%), which is not an unrealistic value.
At this price tag, her down payment and possible closing costs could amount to $134,000 (10% / $89,00 + 5% / $45,000), which now becomes her savings target. Based on her current rate of savings it would take her about 11 years to accumulate this amount, but by that time property prices would have changed and she would have advanced in age to 43 � not exactly a more favorable position.
The question is: How do we solve the dilemma of preserving her borrowing capacity, locking in reasonable house prices and not disrupting her present and future financial stability � whilst making optimal use of her current and potential resources?
We will need to make some assumptions regarding her assets and liabilities � see table 1 for an illustration.
We assumed a market value of $45,000 for an average used vehicle in a good state of repair. We have also estimated the value of her annuity to be $40,500 by totaling her contributions of $450 for the 10-year period and deducting 25% government tax, if she were to utilize this asset before maturity � this figure does not factor in policy charges or interest additions.
We have no information on her insurances so we cannot make reasonable estimates as to what their cash values might be, but if these have accessible funds she can utilize some of it to add to her down payment.
While it is not a desirable to surrender an annuity to get cash, if we were to stack up a retirement plan next to the home ownership goal, most people would choose the latter. Assuming she makes the tough decision to convert her annuity to cash and sell her car, she could raise $90,500 - narrowing her savings gap to $43,000 ($134,000 less $90,500).
At a new monthly savings figure of $1,450 ($1,000 + $450: annuity premium) she could eliminate the shortfall in 2� years, which is a great improvement on the 11-year time frame as before. This time lapse will still impact her funding by about $30,000 because of the shortened mortgage term.
If she markets the business more aggressively she may be able boost her earnings and fast-track her savings. Table 2 shows scenarios if she were to increase her clientele form 8 to 10 to 16 customers.As a last resort Bridget could skim some money off the top of her emergency reserves to narrow the gap even further.