Make Your Mortgage Tax-Deductible!
What if, like our American friends, you could deduct your mortgage interest payments? Well, truth be told, you can - by converting your "bad debt" into "smart debt."
Accumulating debt is easy. Managing debt takes focus. Profiting from debt takes a whole different approach to financial management. You can equate it to driving in Britain: the cars move people exactly the same way they do in Canada, but everything seems to be coming at you from the wrong direction.
Debt conversion can be profitable and isn't difficult, it's simply a matter of thinking long term, keeping an open mind and knowing how.
Smart Debt versus "Bad Debt"
First, let's dispel the myth that all debt is bad. Borrowing to buy a depreciating product (car, television or sofa) will always be considered bad debt. However, when money is borrowed to buy something that can earn income, the amount of interest you pay to service that debt can be deducted from your income before you pay your taxes. Now that's "smart" debt. Smart debt may be referred to as leveraged investing or borrowing to invest but, in basic terms, it's borrowing with the goal to make money.
Converting Bad Debt into Smart Debt
The concept of not "eliminating" your debt but rather "converting" it from non-deductible debt is gaining popularity in Canada. There are a number of vocal proponents of the concept, each believing that every Canadian should be aware of their ability to convert their debt - more specifically, the ability to convert their mortgage into a tax deductible debt.
Most Canadians are oblivious to the real cost of their mortgage. In fact, a few years ago, a survey by Maritz Research2 found that over 75% of Canadians surveyed either underestimated the amount of interest they would pay on a mortgage or had no idea of the total cost. For example, a $150,000 mortgage at 7% paid over a 25-year period would cost the homeowner more than the original mortgage amount ($165,000) just in interest alone. At a 40% tax bracket, the mortgage holder would need to have earned $525,000 to pay off that $150,000 debt. That's why more and more Canadians are investigating tax-deductibility as an alternative option.
The Conversion
The first step is for the homeowner to switch to a "re-advanceable" mortgage. Essentially, it's a secured line of credit based on the value of their home. As the term "re-advanceable" suggests, every time a portion of the principal is paid down, it's borrowed back. The re-advanced money is then used to purchase investments.
As an example, a $200,000 mortgage at 7% would cost the homeowner about $1,400 a month. In the first month, approximately $1,150 would go toward the interest and $250 towards the principal. To convert that debt to tax deductible borrowings, the homeowner would then take that $250 back out of their home equity and invest it.
By the end of the first year, the homeowner will have re-advanced and invested about $3,000. Borrowing back the money and investing it creates an investment loan, the interest on which may now be tax deductible. This process is repeated year after year.
Although the debt level remains at the original $200,000, more and more of it is being systematically converted to tax deductible debt. In addition, increasing tax refunds received by the homeowner could also be applied against their mortgage, and then re-borrowed and invested.
At the end of 25 years, assuming an interest rate of 7% and an 8% rate of return, the value of the investment portfolio would grow to over $530,000. If the value of the portfolio is offset by the $200,000 loan still in place 25 years later, the net value of this strategy would be $330,000. As long as the loan remains, the interest on the loan is tax deductible.
There are three significant advantages to applying this strategy:
- The homeowner is accumulating an investment portfolio much sooner, and enjoying compound growth.
- Interest deductions are generated, providing the possibility of tax refunds.
- By applying any tax refunds back into the their mortgage, the homeowner is able to accelerate the paying down of their non-deductible debt.
Should Everyone Have a Tax Deductible Mortgage?
There is no question that if you must have debt, having tax deductible debt is preferential to having non-deductible debt. However, there are risks involved and it should be remembered that the program is based on the current Canada Revenue Agency (CRA) rulings, which can change over time.
As you have seen, debt does not decrease at all when this strategy is employed - it remains level. The careful selection of investments is a key component of the strategy. Risks should be carefully examined before implementing this strategy.
Speak to a Professional
The best thing homeowners can do is to speak with their Bick Financial advisor. We understand risk tolerance and can assess the appropriateness of the strategy to the client's specific situation, and most importantly, will be able to implement the necessary investment component of the program.
There is an adage in the financial planning world that states: "The first step to wealth creation is the elimination of non-deductible debt." Canadians are now beginning to understand that they have alternatives to living with their bad-debt, non-deductible mortgages.
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