Using Home Equity to Finance Cottage Improvements

General Kris Krawiec 7 Aug

With interest rates sitting at “emergency” levels – low rates never before seen by your parents and even your grandparents – now is an ideal time to tap into the available equity in your home or cottage to fund your renovation or landscape needs. But these rock-bottom rates won’t be available forever – the Bank of Canada estimates fixed mortgage rates will likely begin to rise this summer.

As a cottage owner, you understand the importance of maintaining your cottage and property to ensure it ages well with the times. But you also know that it can be daunting when you think about all of the ongoing costs for renovations and maintenance required to keep your cottage to your liking – especially if you also own a primary residence.

The good news is, if you have built up equity in your primary residence or even your cottage, refinancing your mortgage is a cost-effective way to have funds available for upgrades to your home away from home.

One refinance strategy that mortgage consumers often use involves extending their amortization period – to a maximum of 30 years (with no age discrimination on this product) – so they can lock into an excellent fixed rate for their mortgage and renovation expenses.

In addition to setting you up with a new lower mortgage payment, your mortgage professional can also find a lender that offers the most flexible prepayment privileges.

If you choose to refinance, it’s important to note that there may be penalties for paying out your existing mortgage loan prior to renewal, but these penalties will be offset by a lower interest rate and, at the same time, you can access extra money to put towards your cottage renovations.

By refinancing, thanks to lower interest rates, even though you’re taking on more debt, you can pay your mortgage off faster. Most mortgage products, for instance, include prepayment privileges that enable you to pay up to 20% of the principal (the true value of your mortgage minus the interest payments) in lump sum payments per calendar year. This will also help reduce your amortization period (the length of your mortgage), which, in turn, saves you money.

Some lenders also allow consumers to pay anywhere from an extra 20% of their monthly mortgage payment to up to double the payment.

Using a line of credit

Another option to enable you to access funds for cottage renovations is to take out a home equity line of credit (HELOC) on your primary residence. Although HELOC interest rates are lower than credit cards or other high-interest means of accessing funds, a refinance at today’s low rates is your best option.

A HELOC is a good tool for those who know they want to renovate their cottage in the future but do not know exactly when they want to make the improvements. In other words, a HELOC enables you to access equity on an add-needed basis and you only pay interest on the portion of the HELOC that you use. Another benefit is that you can pay the HELOC off at any time without a penalty.

There are also combination mortgage products available that enable you to have a portion of your mortgage in a fixed interest rate and another portion as a HELOC, which mean the HELOC can be used as a rainy day fund.

By using a HELOC to fund renovations, etc, the savings are substantial versus using a credit card or loan. Just the comparison of paying 3.25% interest with a HELOC compared to 18% for a credit card or loan clearly shows the HELOC advantage.

The other savings is seen in your monthly repayment of the debt. With loans or credit cards, the minimum is typically 3% of the total balance, whereas with the HELOC you’re only paying interest on the loan.

For instance, a $50,000 credit card balance with a 3% monthly payment means $1,500 must be paid each month. With the interest-only payment on the HELOC, you’re only required to pay $135 per month.

If your primary residence does not have enough equity for a refinance or HELOC but your cottage does, you still have options depending on whether your cottage is a vacation property (year-round with road access) or seasonal.

Financial institutions will lend on year-round property up to a maximum loan to value (LTV) of 95% (which means you will only have to have 5% equity remaining in your second home).

Most mortgage financing products are available for year-round cottages as long as the property is in good shape and is marketable. Your lender will want to know they will easily be able to sell your property if you do not continue paying your mortgage or HELOC.

When looking to access home equity, it’s best to speak to your mortgage broker to find an option that suits your unique needs.

Mortgage Product Comparison

Product

Amount

Interest Rate

Amortization

Monthly Payment

HELOC

$200,000

3.25%

25 Years

$541.67 (interest only)

5-Year Variable-Rate Mortgage

$200,000

2.00%

25 Years

$846.90

5-Year Fixed-Rate Mortgage

$200,000

$3.89%

25 Years

$1040.15

 

The Smith Manoeuvre: A Canadian mortgage tax-deductible plan

General Kris Krawiec 7 Aug

Canadian homeowners do not enjoy the same mortgage interest deduction that their neighbours to the south do. Fortunately, the Smith Manoeuvre is a powerful financial method that gradually restructures the largest non-deductible debt of your lifetime (your mortgage) into a deductible investment loan.

Additionally, you’ll receive increased annual tax refunds, reduce years off your mortgage, and increase your net worth – all using legal methods reviewed by the Canada Revenue Agency (CRA).

Method
The Smith Manoeuvre does not happen overnight; it takes years to complete. Follow these steps to convert your non-tax-deductible mortgage interest into tax-deductible debt.

Step 1 Liquidate all existing assets from non-registered accounts and apply it towards a down payment for the next step.

Step 2 Obtain a re-advanceable mortgage from a reputable financial institution, which allows you to pay down the mortgage and increase the credit limit (HELOC) simultaneously.

Step 3 Withdraw the HELOC portion of your mortgage to invest in income-producing assets like preferred dividend paying shares or exchange traded funds (ETFs). Your HELOC limit increases with every regular mortgage payment applied, which allows you to invest the newly available money.

Step 4 When completing your tax return, deduct the annual paid interest amount from your HELOC.

Step 5 Apply the tax return and investment income (dividends, rent, etc.) against your non-deductible mortgage and invest the new HELOC money available.

Step 6 Repeat steps 3 to 5 until your non-deductible mortgage is paid off.

Consider the following example:

Tyler buys a house for $400,000 with a $300,000 mortgage at 3.25 per cent amortized over 25 years. His annual salary is $80,000 with a marginal tax rate of 38 per cent and an annual merit increase of 1 per cent. He currently has no investments, so his net worth is $100,000. His annual mortgage payments total $17,500. Tyler can afford the following amounts to pay his mortgage and invest (out of pocket cash).

•Year 1: $19,600
•Year 5: $20,600
•Year 10: $22,100
•Year 15: $23,900
•Year 20: $26,000
•Year 25: $27,100

Let’s examine the following three long-term scenarios (all assume a 4 per cent investment annualized return)

Scenario 1 – Divert annual surplus cash to increase mortgage payment, thus paying it off sooner and then start investing all available cash.

Scenario 2 – Divert surplus cash to invest annually and pay regular mortgage payment.

Scenario 3 – Apply the Smith Manoeuvre, diverting surplus cash into mortgage payments and then immediately re-borrowing from the re-advance-able mortgage at a rate of 4 per cent After 25 years:

Scenario 1 – Tyler will own his home free and clear after 22 years and will use the remaining three years investing all his annual available cash into investments. Waiting this long impedes his investments from growing year-after-year and his net worth totals $604,000 ($400,000 home plus $204,000 investment portfolio).

Scenario 2 – Although more time consuming than scenario 1, because Tyler now must ensure he receives an average annualized 4 per cent return on his investments over 25 years instead of 3, Tyler’s investment portfolio will be $10,000 more than scenario 1. The benefits of compounding are the reason for this.

Scenario 3 – Tyler will no longer have a mortgage after 22 years, just like scenario 1, but he will have a $300,000 tax-deductible investment loan. Despite borrowing the money to invest, Tyler begins year one with an investment portfolio approximately equal to year five of scenario 2, which compounds his returns greatly. In year 10, his investments are worth the same as year 20 of scenario 2. His tax refunds increase annually to the point where he receives approximately $4,000 more annually in the last few years. The higher starting investment amount, coupled with compound returns and increased tax refunds to offset the interest charges of the HELOC portion of the re-advance-able mortgage (investment loan) allow him to invest higher amounts sooner. Even though he’s paying more interest than both other scenarios, his net worth after 25 years equals $641,000.

The Benefits
The Smith Manoeuvre has many benefits. For starters, your net worth will increase (as per example above) assuming you can maintain the same annualized return in your investments as your borrowing rate. Your tax refunds will continually get larger, year after year, as the interest on your investment loan is tax-deductible. Finally, mortgage debt is a fact-of-life, so why not apply the Smith Manoeuvre, pay your mortgage off faster and transfer the debt into a tax-deductible format? Well, there are some risks.

The Risks
As with any investment plan, there are risks. The Smith Manoeuvre doesn’t decrease your debt; it simply transfers it from a common mortgage, which isn’t tax deductible in Canada. In order to do this, you must follow the correct steps and tax forms to setup a re-advance-able mortgage to use as an investment loan. If you don’t, the CRA could invalidate your application and the primary benefit of the Smith Manoeuvre will cease to exist. In order for your net worth to increase, you must have a solid investment plan that will yield you more than your borrowing rate. In the example above, the borrowing rate and investment annualized return were both 4 per cent; however, even if the annualized return falls a half-per cent to 3.5 per cent, Tyler’s net worth of scenario 3 will only be $6,000 more the next highest scenario (1). At 3 per cent, the Smith Manoeuvre will be the worst of all three scenarios by over $12,000. So as you can see, the rate of return is definitely important.

Who should do it?
Canadians who own 25 per cent of their home should qualify for a re-advance-able mortgage. Good candidates for the Smith Manoeuvre are people who are comfortable servicing ‘good’ debt, want to maximize tax returns and understand leveraging their real estate assets to increase their net worth. Home owners that like to ‘set-it and forget-it’ should not consider this manoeuvre as it requires a solid financial investment plan, with regularly schedule performance checks to ensure you’re getting and maintaining an annualized return above your borrowing rate.

Those interested in pursuing the Smith Manoeuvre should obtain a copy of the book titled Is Your Mortgage Tax Deductible – The Smith Manoeuvreby Fraser Smith. After reading it, consult a licensed financial adviser familiar with it who gives free consultations and evaluations as final outsiders check to ensure it is suited for your wealth strategy.

The Bottom Line
The Smith Manoeuvre is the simple legal concept of “after every mortgage payment you make, you borrow the principle amount and re-invest it.” For those that understand that their debt level will not decrease – and are comfortable monitoring and maintaining investment returns – the Manoeuvre can greatly increase your net-worth.

 

Source: http://www.theglobeandmail.com/globe-investor/personal-finance/mortgages/the-smith-maneuver-a-canadian-mortgage-tax-deductible-plan/article12059456/