By Fadi Baradihi, MBA, CFP®, ChFC®, CLU, CDFA®
More often than not, the standard of living of both spouses drops in the first few years after divorce. Why? Because the same cumulative income and pool of assets now has to support two households instead of one. Unfortunately, most people do not prepare themselves financially or emotionally for that consequence. So what can you do to better prepare yourself for this inevitability? The answer is simple, but it’s not easy to put into practice.
Divorce is an inherently stressful process. To alleviate some of the stress, it’s important to be proactive and in control. Here are the “Lucky Seven” things you can do to help prepare yourself for your post-divorce financial future.
You should expect your income to drop after the divorce is final. Develop a budget based on needs—not wants—and keep in mind that your expenses need to stay within your post-divorce income. Consider all sources of income—including spousal and child support, keeping in mind that they won’t last forever—as well as investment income. To develop a budget, use a detailed worksheet so you don’t overlook any expenses. The best sources for the expense information are your banking and credit card statements, if that’s how you pay your bills. Remember that not all of your expenses are paid monthly; some insurance premiums or tax bills might be payable quarterly or annually, so make sure to account for those as well. (To help get you started, fill out the “Monthly/Annual Expenses” worksheet, which is available online at www.institutedfa.com.) The last step in preparing a budget is to ask a reasonable and critical friend or family member to review your budget and challenge the expenses that seem unreasonable. You have to agree to keep an open mind and not to get upset if he/she challenges one of your items; remember that this person is trying to help you.
Here are the traditional options for the matrimonial home:
In many cases, one spouse wants to keep the house. Though this might be emotionally satisfying, it usually makes little or no financial sense. The equity in the house is illiquid, meaning it won’t pay the bills.
If one spouse wants—and can afford—to keep the house, that spouse should pre-qualify for a mortgage before the divorce is final. Sometimes, a divorcing couple will decide that one spouse is going to keep the house. They remove the other spouse’s name from title to the house—and then the spouse who wants to keep the house gets turned down for a mortgage because he/she doesn’t make enough money to qualify to refinance in his/her name alone. The spouse who is leaving the marital home ends up being on the hook for the debt, has no reciprocal asset, and can’t qualify for their own mortgage because they don’t make enough to support both mortgages.
To qualify for a mortgage, most conventional lenders use credit and debt to income ratios. Many use a credit score system to qualify applicants; a credit score is based on payment history, amount of credit owing, length of time credit established, number of recently opened credit accounts, and types of credit established. Lenders generally use two different ratios to analyze credit worthiness. Generally speaking, here’s how they work (check with your local lender—their guidelines may differ):
In order to qualify for a conventional mortgage, an applicant must have an acceptable credit score and debt-to-income ratios.
Account statements have a way of disappearing when divorce proceedings start. When contemplating divorce, start by collecting statements for all your financial holdings and put together a list of your assets. When negotiating your divorce settlement, this step will prove helpful as a starting point. Here’s an example of items you’ll need to list on an Asset Worksheet. Remember to note the value of each asset, and who owns what portion of it:
As you work your way through the asset split negotiations, each asset can be moved to its appropriate column: “Self” or “Spouse”. To figure out the percentage split, divide the total for each spouse by the grand total.
Accounts with pre-tax contributions and tax deferred growth come with a tax liability. Know what the after-tax equivalent value is before agreeing to take an asset. Having $100,000 in an RRSP is not the same as having a $100,000 in a chequing account. The spouse with the retirement savings plan will end up with the account value minus the tax liability, and the other spouse will have the whole amount to spend.
You need to make sure that the liquidity of the assets that you’re receiving matches your needs. Let’s suppose you want to keep the marital home—which is worth $300,000 or 50% of the marital estate—as your share of the settlement. Until you take a close look at your long-term financial forecast, you won’t know whether you can afford to keep it. Suppose, for example, you’ve factored child support payments into your income; after the payments end, how are you going to pay the mortgage? If you have to put the house up for sale in a few years, you may be solely responsible for paying all of the real estate costs.
Any portion of a pension that was earned during the marriage should be included in the marital pool of assets. The pension will need to be valued by a qualified pension valuator, or in some provinces, the plan administrator, to determine the future projection of the contributions made to the plan.
Personal recommendations from a trusted friend or business associate are a great source for professionals. However, you need to do your homework before hiring anyone. Your team should consist of a family law lawyer and a Certified Divorce Financial Analyst® (CDFA®) professional at a minimum. If needed, other members or the team could include a mediator, an accountant, a business or pension valuator, or perhaps a child or individual therapist. Although you may think that the more professionals you hire the more costly your divorce will be, but this is not necessarily true. In the long run, having the appropriate help will cut down on litigation costs, and it may save you from making costly mistakes regarding your settlement.