Monday, June 4, 2012

Mortgage Freedom!


Mortgage Freedom by Sandy Aitken is about a strategy of converting your non-tax deductible mortgage into a tax deductible line of credit. Unlike the United States, any interest paid on your principle residence in Canada is non-tax deductible. Sandy explains something called the "Smith Manoeuvre" where one converts all their mortgage debt to a Home Equity Line of Credit (HELOC). Interest paid on a HELOC is tax deductible if the money is used to purchase investments. Investments include: mutual funds, stocks, bonds, rental property, and business investments. The definition of an investment is not clear cut and should be discussed with a tax accountant before proceeding.

The type of HELOC that makes this strategy work is call a "Re-advancable Compartmental HELOC". The re-advancable part means that everytime you make a mortgage payment, the part that pays off the principle is added to the HELOC, giving you more credit. For example, if you make a $1000 mortgage payment each month and $400 goes toward the principle of the loan, than the credit in your HELOC increases by $400. This allows you to invest an extra $400 every month. The "compartmental" part is the partitioning of accounts to keep track of your HELOC and what you invest the credit in, as well as what you do with the returns you receive on the investments. This is for book keeping purposes.

By the end of this strategy you will have converted all your mortgage debt into tax deductible debt and hopefully own an investment that is worth the same amount as the mortgage you started with (given that your investment holds its value, ideally it will have appreciated in value). The two benefits of this strategy are:

1) You get time diversification on your investments, which makes your portfolio less volatile overall. Instead of waiting to pay off your mortgage entirely and then investing, starting earlier by borrowing to invest will allow you to ride out more of the ups and downs of the market. Trying to invest over a shorter time period will leave you susceptible to the short term volatility of the markets.

2) You get a tax deduction.

The things to keep in mind in order to make this strategy work and the downsides are:

1) You need at least 20% equity in your home to start a re-advancable compartmental HELOC.

2) Your investment must provide income frequently (monthly or quarterly) so that you can keep up with the interest payments on the HELOC.

3) The return on the investment must be equal to or greater than the interest rate being charged on the HELOC.

4) The interest rate on the HELOC will be likely higher than the interest rate that you are getting on your mortgage.

If you are earning more on your investments than the amount your paying in interest on the HELOC than the extra money is suppose to go towards paying the mortgage, freeing up more credit. This will accelerate the rate at which you pay off your mortgage. Once the mortgage is paid off the investment income and your mortgage payments go towards paying off your HELOC. With all this in mind it sounds like a risky proposition. This strategy isn't for everyone but it's an interesting alternative to tap into the equity in your home.

 Check out this video for more information:

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