A mortgage is often the largest debt people incur. The stress associated with its size often sets people on a mission of trying to pay it off as quickly as possible. While not without merit, this goal is often previous generations well intended guidance that actually lacks financial wisdom and often has negative results.
Advice is one thing that is freely given away, but watch that you take only what is worth having. Statistics Canada tells us that 10% of the population control over 50% of the wealth. The publication by Fraser Smith entitled The Smith Manoeuvre, provides instructions and quantitative proof showing the benefit to re-think paying down the mortgage, and to re-consider debt’s place in a financial plan.
The concept is quite simple: borrowing to invest in non-registered assets, unlike borrowing for a family home, allows interest to be tax deductible (according to CRA - providing there is an expectation of profit). According to Canada Revenue Agency rules governing interest deductibility for investing are set out in IT-533 Interest Deductibility and Related Issues - October 31, 2003, and represents the most current reference at the time of writing. Using a CRA calculator will determine your eligibility.
The change in reason for borrowing lowers after-tax borrowing costs as the interest creates a refund at your marginal tax rate. At a 40% tax rate interest cost is 40% less. To put this in perspective, a 5% mortgage becomes 3% after interest deduction. As an investor, if the after tax rate of return exceeds 3% you are getting rich with someone else’s money.
Each mortgage payment is a blended portion of principal and interest – interest incurred to borrow for the home (not tax deductible), and principal that is paying off the total mortgage balance outstanding. At the start, a mortgage payment goes mostly to interest and less to principal – this reverses over time. As the mortgage is paid down the home equity can be re borrowed to invest. Using the equity to invest, the interest on this borrowing is tax deductible and unlike unused home equity, able to grow and compound.
The homeowner who puts $100,000 of equity into an income producing asset with an ‘expectation’ of profit can write off the associated interest cost. At a 40% tax rate the investor’s real cost to borrow is actually 60% of the face rate of interest as a result. At the 3% prime rate of today, the real cost to borrow is 1.8% (60% of 3%).
In other words, to be gaining the after tax return need only be above 1.8%, which is actually pretty easy to do with a competent advisor. While interest rates vary, probability for gain is clearly strong with numerous investments in the long run. As the strategy points out, since the house is the security, the investment portfolio is free and clear and provides liquidity if ever required along the way.
Using home equity responsibly is a powerful tool for asset accumulation. While you may always have a mortgage - a six figure mortgage with a seven figure investment account gives little concern. For advice on this strategy can be found at www.smithman.net. While what you owe is important, what you are worth after tax is what ultimately fulfills most financial goals. Remember that this is not a strategy to use without advice, but great advisors in Canada should easy to find in any market.