Al’s 45, two kids, wife. Townhouse in Oakville worth maybe $425,000, paid off six years ago. “Shoulda moved up then,” he says. “But we fell in love with exotic vacations instead of paying mortgage interest. Now would be an ideal time for our family to move up, but I know this is a market peak so we must wait it out for a few years.” That’s the thing about houses. People with homes want trophies. It’s then a short step to gold chains and a Corvette.
So Al asks me a question about what financial strategy to use in the meantime, since he’s got $200,000 sitting in his RRSP doing nothing. “I had a lost decade.” So here’s the plan he cooked up: “Would it make sense to get RRSP loan against my house, fully open, at market rates let say 7%, invest in low risk diversified portfolio yielding 5% while I am waiting for correction to get my “dream home” down to a reasonable price? Since I am borrowing to invest, I think the 7% interest I have to “pay myself” back to my mortgage would be even tax deductible, so in essence I would get CRA to pay me to pay myself. Sounds sweet, am I missing something?
“Do you know any Bank, Trust which would structure this kind of mortgage without too much fuss? Do I need to insure RRSP mortgage if my LTV is below 75%?”
I get variations on this a lot, so let’s review the basics. Yes, you can hold a mortgage on your own home inside your RRSP. That means you make mortgage payments to yourself, not the bank. The loan must be at market rates and insured by CMHC (no matter how much of the home’s value it represents), plus it has to be administered by an arm’s-length outfit like a trust company.
No, this is not the Smith Manoeuvre (which I wouldn’t touch with tweezers), and yes, it has helped some people squirrel away a lot of money. But not in times like these. After all, with five-year mortgages at 5.5%, why spend scads of money on legals, a trustee and loan insurance when you can get the same in dividend payments from bank preferreds? Besides, a mortgage is a mortgage. You have to pay it back – missed payments can trigger default. And you must retire the debt when you sell the house.
But Al’s plan is just weird. Normally people with lots of cash sloshing in their RRSPs use it when their mortgage comes up for renewal to pay if off and replace it with an RRSP mortgage. But when your home is already debt-free, using retirement funds to create a new home loan just means you blew up a chunk of your equity. And if Al is planning on borrowing against his equity to raise new RRSP funds to create a mortgage, then use his existing funds to invest in other stuff inside his tax shelter, he’s smoking really good stuff.
Money borrowed to put into a tax shelter is not tax-deductible. And any RRSP mortgage cannot be larger than the money already in your retirement plan, which is dictated by your allowable contribution room.
So here is a simpler plan: Get a secured HELOC for $200,000 (a line of credit backed by your residential real estate) at prime – 3% – and invest it in a balanced portfolio (my fav is 40% fixed, 60% growth) making 8% or so. That’s a spread of 5%, which is sweet. Set up the HELOC with interest-only payments because then 100% of what you spend is deductible from your taxable income.
This means $200,000 costs $6,000 a year to carry. In the 40% tax bracket, that drops to about $3,600 net. Meanwhile the portfolio earns $16,000 a year. If most of the returns come in the form of capital gains and dividends, that should be about $11,800 after tax. So, spend $300 a month in debt charges and receive almost $1,000 a month income – and have $200,000 worth of securities, secured by your equity.
This is called diversification. It mitigates against having the bulk of your net worth in one asset alone. It lets the government pay for a big chunk of your borrowing. It takes non-performing real estate equity and turns it into income-producing capital. It takes advantage of generationally-low interest rates to create your own carry trade. It builds up the critically-important non-registered side of your investment portfolio, since RRSPs are destined to become tax bombs.
And it’s something nine in ten Canadians would never dream of doing. Which is why only one in a hundred of us have a net worth of a million, while seven in ten own houses.
Real estate is not the goal. Not the answer. It’s a tool.
The holy grail isn’t living in a place your friends covet. Then they’re not friends. The object is to posses enough wealth with liquidity to give you options. Freedom, choices.
And a Vette. While you still have chest hair.