In the first few years after divorce, more often than not, the standard of living of both spouses drops. Why? Because the same cumulative income and pool of assets now has to support two households instead of one. Unfortunately, most people don’t 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.
1. Expect your income to drop after the divorce is final.
Develop a budget based on needs, not wants. 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 source for the expense information is your check register, if that’s how you pay your bills. Remember that not all 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, make a complete list of all your monthly and annual expenses.)
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 mad if he/she challenges one of your items; remember that this person is trying to help you.
2. Consider whether you can afford to keep the house.
In many cases, one spouse — usually the wife — wants to keep the house. Though this might be extremely 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 it makes sense for one spouse 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, then they take the other spouse’s name off the deed. Later, 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 his/her own mortgage because he/she doesn’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. Here’s how they work:
(1) Housing Ratio = Total Monthly Housing Payments divided by Total Gross Income.
This ratio must be 28% or less.
(2) Total Debt Ratio = Total Housing + Other Debt divided by Total Gross Income.
This ratio must 36% or less.
In order to qualify for a conventional mortgage, an applicant must have an acceptable credit score and debt-to-income ratios.
3. Know what you have.
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:
- Retirement Assets
- Liquid Assets
- Real Estate
- Personal Property
- Cash Value Life Insurance
- Business Interests
As you work your way through the asset split negotiations, each asset can be moved to its appropriate column: “Husband” or “Wife”. To figure out the percentage split, divide the total for each spouse by the grand total.
4. Consider the after-tax values of your assets.
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 IRA or RRSP is not the same as having a $100,000 in a checking 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.
5. Understand your financial needs.
You need to make sure that the liquidity of the assets you’re getting matches up to your needs. Let’s suppose you want to keep the marital house, 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 the capital-gains taxes from the time you and your spouse acquired the property until you sold it — which could be bad news indeed.
6. Don’t overlook the value of a future pension.
Any portion of a pension that was earned during the marriage should be included in the marital pool of assets. Pensions can be handled in three different ways:
- The non-employee spouse can receive his or her share of a future benefit;
- The pension can be present valued and offset;
- A combination of 1 and 2.
Your particular situation should determine which option makes the most sense for you. For example, a 32-year-old wife with two young children and limited resources will have different needs than a 55-year-old wife with a career and her own pension. Make sure you’re not the divorcee who has a great pension that will pay in 15 years and have no money to pay the bills today.
7. Hire a good team.
Recommendations are a great source for professionals. However, you need to do your homework before hiring anyone. Your team should consist of a divorce lawyer and a Certified Divorce Financial Analyst (CDFA) at a minimum. In addition, if needed, an accountant or valuator can be retained to value a business or do some forensic work. Although you may think that the more professionals you hire the more costly your divorce will be, this is not necessarily true. In the long run, having the appropriate help will cut down on litigation costs, and may save you from making costly blunders regarding your settlement.
Fadi Baradihi (DBA, MBA, CFP®, ChFC®, CLU, CDFA™) is the former president and CEO of the Institute for Divorce Financial Analysts (IDFA). For more information about how a Certified Divorce Financial Analyst can help you with the financial aspects of your divorce, call (800) 875-1760, or visit their website at www.InstituteDFA.com.