Canadian homeowners often have two critical financial goals: pay off the mortgage and save for retirement. It is conventional practice in Canada to approach these two goals sequentially as most Canadians have a fixed amount of income each month and there is a contractual obligation to make monthly mortgage payments. No one will come knocking at your door if you do not invest, but someone certainly will if you do not make your mortgage payment.
The sequential approach is costly
The approach of first paying down your mortgage and then starting to save for retirement means losing the potential of compound growth. Compound growth is the concept of making money on your accumulated growth so that earnings accelerate every year. For example, if you invested $10,000 and made 5% of interest growth annually, you would have accumulated approximately $16,300 altogether ($10,000 principal plus $6,300 of accumulated interest) after the tenth year.
But it takes time to compound your income, and if you have to forego investing because you have to make mortgage payments for the next 25 or 30 years, then you may find yourself short on retirement savings.
You do not have to choose one over the other
There is a tax-reduction strategy called The Smith Manoeuvre that can reduce your tax bill, eliminate your mortgage debt quicker, and enable you to start investing in your future regularly.
According to the Income Tax Act, you are restricted from deducting the interest from a loan unless the borrowing was used for the purpose of generating income (in addition to some other complex rules). On the other hand, if you borrow to purchase consumption items (i.e. cars, vacations, or your home), you cannot deduct the interest from these borrowed funds when doing your income tax return.
While the interest on residential mortgages in Canada are, by definition, not tax-deductible, you can refinance your home into a readvanceable mortgage. This is a type of mortgage that allows you to access any reduction you have made on the principal balance of your mortgage as part of a line of credit.
Assume you regularly make a $2,000 monthly payment against a $400,000 mortgage, with $1,125 of this monthly payment going to the bank in the form of interest and $875 going towards reducing the principal balance on your mortgage. A readvanceable mortgage will let you re-borrow the $875 you pay off every month to invest. By continually reusing the space available in your line of credit to invest, you will be able to grow your investment portfolio each month without having to access other personal funds or credit lines that may charge higher interest.
If you were to continue with the above example, after a year you would still owe $400,000 on your mortgage, but approximately $10,500 of it would have been borrowed to invest. When tax season comes around, you can receive some tax relief from these reinvestments, as the interest on the re-borrowed funds will be tax deductible. If you receive a tax refund, you can choose to pay it towards your mortgage balance, which of course will help you pay off your mortgage quicker. If you wish, you can then re-borrow the amount you paid off on your mortgage to continue with your investing.
There are a number of risks that need to be considered
If the investment you have made with your re-borrowed funds into declines in value, then you might have borrowed more monies than the current value of your mortgage. Some readvanceable mortgages have interest rates that are floating, so an increase in the prime lending rate could result in higher interest costs.
Lenders of readvanceable mortgages could also either lower their credit limits or demand repayment at any time as readvanceable mortgages are not subject to the regular terms and conditions as typical term mortgages. Also, individuals who re-borrow funds from readvanceable mortgages should be cautious of not using these funds for declining assets or personal expenses.
Depending on your risk tolerance and your income level, the readvanceable mortgage may be a good way to start growing your retirement savings earlier. Consider consulting a Chartered Professional Accountant (CPA) or a financial advisor for more information on the implications of readvanceable mortgages.
Bilal Kathrada, CPA, CA is a partner at Clearline Chartered Professional Accountants specializing in income tax and succession planning for Canadian owner-managed businesses in various industries. Bilal is a member of the CPABC Taxation Forum.
Robinson Smith, MBA, is an author, speaker, financial educator and president of Smith Consulting Group Ltd. His new book, Master Your Mortgage for Financial Freedom, was released in late-fall of 2019.