Get With The Plan: April 3, 2011

After raising three children, Peter, 59, and Joan, 58, know they’re getting a very late start on retirement savings. They also know their cash flow is too tight, and their debt too high.

“We want to pay off the credit cards and pay down the home mortgage on our primary residence,” Peter says.

When asked how the couple envisions their retirement years, Peter says, “Nonexistent.”

The couple, whose names have been changed, have saved $32,700 in IRAs and $5,000 in a savings account, and they have a minimal checking account. They receive extra income from a rental property, but that income basically pays the rental mortgage and related expenses. The couple’s other mortgages are pricey ones: the primary mortgage is an interest-only loan, a second mortgage with a 9.5 percent interest rate and a balloon payment, and a home equity loan with a variable rate. To top it off, the primary home is upside down — they owe more than the home is worth.

The Star-Ledger asked Douglas Buchan, a certified financial planner with Tilson Financial Group in Watchung, to help Peter and Joan make some improvements to their money management.

“Before we can look for a potential retirement day or year or adding to investments or savings, we have to first address debt management and good old-fashioned budgeting,” Buchan says.

Buchan says selling the rental property should be first on the list because the proceeds from the sale will free up some much needed liquidity.

“Investing in rental properties can make sense for some people, but a household’s positive cash flow must come first,” he says. “In real estate it may be about ‘location, location, location,’ but in personal finance it’s all about ‘cash flow, cash flow, cash flow.’ ”

Buchan says selling the rental should yield at least $80,000, and that money has two main purposes: to pay down debt, which will in turn free up some monthly cash flow, and to strengthen their emergency fund.

Buchan says sometimes borrowing is a necessity and it can be a good thing, but too much borrowing and the wrong kind of borrowing can really hurt. The key, he says, is to pay off the worst kind of debt and the highest interest-rate debt first. That’s usually credit cards, which are not tax-deductible and whose rates can rise at the whim of the credit card companies.

Once the credit cards are paid, Peter and Joan should pay off the 9.5 percent mortgage, which Buchan calls exorbitant. Next, the home equity loan, because the interest rate is variable and payments will rise as interest rates do.

Paying off this debt will accomplish several goals. It will save the couple over $500 a month in interest, give the couple some much-needed equity in their home and still leave about $10,000 for emergencies.

Buchan says selling the rental property is essential and cannot be passed over.

“I know it may hurt to sell at prices that are lower than they were a few years back, but think of it this way: Suppose they wait three years and sell it for $20,000 more than they could today. They wouldn’t be any better off because they’ll be paying an extra $20,000 in interest over three years because they’ve kept the place and weren’t able to pay down their debt,” he says.

If they follow this course, their remaining mortgage will be an interest-only loan at 5.65 percent.

Buchan says interest-only mortgages can make sense for some folks, but they can also be dangerous. If the homeowner is not disciplined in paying down some of the principal, it’s really no different from renting the house.

Buchan recommends the couple take $400 of the $500 in monthly interest savings and make extra principal payments on the mortgage.

“They will see that each month their mortgage interest payment will become less and less,” he says. “If they’re able to pay the same amount each month, they’ll be surprised how quickly the equity in the home will build.”

The extra $100 monthly can be added to the emergency fund, and when the cushion is soft enough, they can start thinking about adding to their IRAs.

He says it’s important to treat saving like a bill, and know you have to pay that bill every month.

Once the debt is under control and Peter and Joan begin to add equity to their home, the final step is to take a long and hard look at what they spend each month.

Buchan says without a look at spending, the couple will still be living paycheck to paycheck, although now they will be building wealth by adding equity in the house.

He says they need to look at each line item of their expenses to see if there’s fat they can trim.

“I can’t get my eyes off the $390 per month cell-phone bill,” Buchan says of the charge that is part of the utility bill listed in their budget. “I know kids can talk and text and text and talk, but $390 per month is real money. There has to be a savings opportunity there.”