Reference no: EM132472773

Case Study: Managing Debt

Point 1: Five years ago, Lisa and Renee purchased their first home together, worth $325,000. Since then, the property value has risen to $450,000.

Point 2: Over the last several years, Lisa and Renee have built up significant debt to fund in vitro fertilization. Eventually, they adopted a child. Emily, now two years old, is their pride and joy. After the adoption, the couple made a concerted effort to pay down their debt. However, since then, Lisa lost her job. With no emergency fund, the couple began to finance their living expenses using their credit card, whose interest rate recently grew to 24 percent when Lisa and Renee missed two payments. The couple had planned to adopt a second child, but those plans have been put on hold until their finances improve.

Point 3: Renee has been offered a new job, which would provide a salary increase of $600 per month ($4,500 per year after taxes). The position is located across the city, and she would need a car. The couple has found one for $20,000, which may be fully financed at the dealership through a car loan or lease. A four-year car loan is available at a rate of six percent, with an 80,000-kilometer, four-year warranty. The lease is available at a rate of five percent over four years, with a 20,000-kilometer allowance per year, a warranty for the term of the lease, and a buyout price of $8,000. The couple finds it strange that their friends trade in their cars after each lease. Most of them have explained that they do so to avoid costly repairs, which tend to crop up between fifth and eighth year of car use. Renee and Lisa want to ensure that any repairs do not have a significant financial impact. They also live by the motto that if "it isn't broken, don't replace it".

Point 4: They have been referred to a CFP professional by one of their friends to help manage their finances better and decide whether to lease or buy a car. Lisa and Renee would like to retire debt-free in 23 years at age 60, and will need to fund $5,000 per month in income (in today's dollars) to supplement their Canada Pension Plan (CPP) and Old Age Security (OAS) income. Lisa has a locked-in retirement account with a balance of $100,000. However, after her divorce is settled, she expects it to be cut in half by the equalization payment to her former spouse. The couple feels strongly about covering the cost of Emily's four-year, post-secondary education at an estimated cost of $15,000 per year (in today's dollars). They do not have any savings earmarked for either of these goals. Renee and Lisa have been identified as investors with a high-risk tolerance, corresponding to a portfolio consisting of 75 percent in equities and 25 percent in fixed income. In the short term, Lisa would like to stay home with Emily, at least until she turns four years old and starts kindergarten.

The CFP professional has gathered the following information about their debts:

Type of Debt

                                                 Borrower                         Balance                 Annual Interest Rate                            Monthly Payment

Mortgage                                      Renee and Lisa               $261,000                      3%                                        $1,445.07

Government of Canada Student Loan      Renee                        $22,000                      8%                                        $266.92

Unsecured Line of Credit                          Lisa                        $18,000                     6%                                         $547.59

Credit Cards                                 Renee and Lisa                  $28,000                   24%                                         $570.00

Requirements:

Question 1: Evaluate whether Lisa and Renee should lease or finance their new car? Assume that the interest rates compound annually and there is no down payment.

Question 2: Compute the Loan payment and the total cost of the loan

Question 3: Calculate the lease payment and the total cost of the lease if the buy the car at the end and if they don't buy the car at the end.

Question 4: Explain to Lisa and Renee what other factors might impact their decision and explain why.

Question 5: What recommendation would you make?

Question 6: Evaluate Lisa and Renee's current debt situation. Assume that the interest rates listed are still the same.

Question 7: What amount does the couple currently pay in monthly debt payments?

Question 8: How many months would it take them to become debt free based on the current payment structure?

Question 9: What option does the couple have to reduce their total monthly debt payments?

Question 10: Based on the option above, how much would their debt cost them each month? Hint: Consider when do they want to be debt free.

Question 11: How much cash flow would now be available for their other goals?

Question 12: What other recommendations would you make to Lisa and Renee?