Mortgages and RRSP alternatives

RRSP season brings out the best and the worst in clients. Many have old questions — wondering if they should top up their RRSP or instead put the money towards their mortgage, save for a down payment on a house or pay more to their children’s education funds. In the current interest rate environment, others could be weighing more “unique” investment opportunities.

Given Canada’s ongoing housing boom, many clients might be saving money outside of their RRSPs, in anticipation of the moment when they too jump on the real estate bandwagon to lock in before interest rates rise again.

Mortgage broker firm Invis says first time homebuyers have a unique opportunity to use that money more efficiently by making an RRSP contribution with the lump sum they intend to use for a down payment, then withdrawing the money after the 90 day waiting period under the Home Buyers’ Plan and combining those assets with their tax return to make an even larger down payment.

First time home buyers are not the only ones considering RRSP and mortgage concepts. With interest rates rising, those with larger registered plans might be considering alternatives like holding mortgages inside their self-directed RRSPs.

“It is possible to have a [self-directed] RRSP hold the mortgage on your home. That can be a qualified investment. To do that, you’d have to swap current RRSP assets for a specific mortgage,” says Dave Ablett, Investors Group’s manager of advanced financial planning support. “It can be useful if some individual already has a mortgage on their home and a fair number of assets in their RRSP that they would like to take out, say, for a business opportunity. They realize that if they collapse their RRSP they’re going to be hit with taxes. If they did a swap and took the assets out of the RRSP so that the RRSP now owns the mortgage on the home, they would gain access to this cash for business purposes. That would be one example of where this might be of interest to a client.”

For the most part the strategy hasn’t been popular in recent years since the low interest rates have considerably limited returns on this type of investment. With more favourable conditions however, clients holding mortgages in their RRSP can reasonably predict the rate of return those assets would earn, as long as they can afford to make payments.

The strategy, though, is not without a significant number or rules, and risks.

Mortgage investments generally fall into two categories — non-arm’s length, where clients lend the money to themselves or a family member, and arm’s length where the client loans their RRSP assets to someone not related by blood or marriage.

Non-arm’s length transactions

In a non-arm’s length transaction, clients lend the money to themselves or a family member out of their self-directed RRSP. In this arrangement, clients must pay the same interest rates they would normally pay on a bank-issued mortgage, get approval from the Canada Mortgage and Housing Corporation (CMHC) and pay high-risk housing insurance premiums to cover the loan, plus pay administration costs normally associated with self-directed RRSPs.

Clients may not artificially pay a higher interest rate to their RRSP, nor can they skip mortgage payments. “You need to qualify income wise and credit wise. There needs to be insurance on the property and the property needs to conform to all normal lending regulations,” says Invis mortgage consultant York Polk. “You need to charge the same rates that the bank is charging right now, but there is a 1% window each way. So if the best rate today was 6%, you could charge as little as 5% and as high as 7%. Those are CMHC guidelines. If you’re getting 8% or 9% on your portfolio, unless you really wanted to, it would be better to borrow the money from the bank and keep your portfolio performing at those higher rates.”

Not only do clients need to consider diversification risks, fees for this kind of transaction can be considerable. Premiums for housing insurance are based on a loan to value ratio — the loan amount to the value or purchase price of the home. These fees range from 2.75% of a mortgage with a 5% down payment to 1% of a mortgage with a 20% or 25% down payment. “Depending on the size of the mortgage it can be pretty significant,” says Polk.

Arm’s length transactions

The list of concerns that an investor needs to address before lending money in an arm’s length transaction — that is, to anyone who is not a member of the immediate family — is far more extensive.

Clients who are even able to engage in this kind of transaction, need to have a good lawyer, appraiser, mortgage broker and a good real estate agent on hand to support the investment.

“An investor lending to themselves, again, it’s covered by the CMHC. It does make sense because you’re conforming to guidelines that are very strict,” says Polk. But when lending to someone else, “the investor needs to be educated so that they understand what they’re doing. The big parts of this are understanding the value of the property, the type of property, the credit of the individual and their capacity to repay,” he says. “In an arrears situation, when lending to an arm’s length person, if the investor is not too converse or doesn’t understand what’s going on, they could lose all of their money out their RRSP.”

In this situation, clients could find themselves in a position where they need to dispose of the property themselves to recover the loan. When the loan can’t be repaid, the property must be sold. “Some think when they issue a second mortgage they can just take over the property. They can’t. They have to sell the property.” As well, if there is already a first mortgage on the property, the lenders must also keep up payments until the property is sold.

“First mortgages are usually the ones that are in arrears, not the second, because first mortgage payments are normally a lot higher than the second. You need to be in a position to keep that up to date. If not, the first mortgage will take their power of sale and dispose of the property. If there’s anything left, they’ll give you the money,” says Polk. “If not, you’re out of the picture.”

Property taxes also take precedence over mortgages in the lineup of creditors who are owed money.

Although he is quite positive on the process and says it works well for many of his clients, Polk says the strategy is certainly not for everyone. “For the inexperienced investor, don’t do it. For someone who doesn’t know real estate and doesn’t understand property values, don’t do it. For anybody who doesn’t understand the laws of mortgage financing, don’t do it. You can end up losing all of your money very quickly and you can not write off the loss as a loss because money lost in your RRSP is just lost.”

Filed by Kate McCaffery, Advisor.ca, kate.mccaffery@advisor.rogers.com

(02/16/06)

Kate McCaffery