What if you could be your own bank? Instead of forking over thousands of dollars in interest every year on your mortgage loan to one of the Big 6 banks (who earn billions in profits each year), you shovel that money straight into your RRSP. Month after month after month.
You can do this by setting up a non arms length mortgage in your RRSP. This whole scheme is actually new to me as well. I've long known of people who invest in arms length mortgages from their RRSPs. In fact, the secondary market for arms length mortgages is large and promoted quite aggressively in the inner circles of real estate agents and mortgage brokers.
But a week or two ago, a regular reader of this blog asked me to look into self-directed mortgages held within your own RRSP, better known by the banks and tax man as the self-directed RRSP non arms length mortgage.
There are important distinctions between an arms length mortgage investment in your RRSP and a non arms length mortgage in your RRSP, so I'll give a brief overview.
A transaction or contract with a party at arms length means you are dealing with someone who has no close connection to you. When you use your RRSP to provide a mortgage to someone at arms length with you, you can set the terms and rates at whatever you want. It is essentially a private loan secured by real estate. Typically this market is geared towards second and third mortgages and are higher risk. There are few restrictions involved and the loans are often managed by a third party who takes a hefty cut of the profits.
A non arms length mortgage is a loan to immediate family members and corporations where you are an influential shareholder, again secured by real estate. When this mortgage loan is made through your RRSP, there are a number of restrictions in place to protect your RRSP and prevent funny business.
This post will deal solely with non arms length mortgages through your RRSP. That is, you using your RRSP money to finance your own mortgage loan, or a mortgage loan to a child, parent, sibling, or similar close relations. I'll call it the RRSP self mortgage.
RRSP Self Mortgage
By law, RRSPs are not allowed to hold real estate directly. However, RRSPs are allowed to invest in mortgages. They can issue a loan to an individual or corporation which is secured by underlying real estate. This means, subject to a number of rules, you can actually use your RRSP to finance your own home purchase and completely cut out the banks.
To begin with, you must have enough money in your RRSP to finance the entire mortgage amount. It doesn't matter if this is a refinancing or a new home purchase. It also doesn't matter if it is a first mortgage or second mortgage on the property. However, the loan-to-value ratio cannot exceed 90%.
The home must be occupied by you as a primary home or vacation home. You can use a RRSP self mortgage to finance a multiple unit property up to four self-contained units provided you live in one of those units.
Also, you must have the regular downpayment amount, or existing home equity, from a source other than your RRSP self mortgage. This could be cash on hand, or money from a RRSP Home Buyers Plan if you are eligible. Just remember, using the RRSP Home Buyers Plan shrinks the amount of money remaining in your RRSP for the mortgage loan.
Your entire RRSP self mortgage must be administered by a third party trustee. This generally means the trust division of a handful of Canadian banks including Canadian Western Trust, TD Bank, CIBC (not confirmed), and B2B Trustco (not confirmed). Digging into this, I can tell you the documents and information regarding self mortgages are often buried in the fine print. The only provider which openly advertises non arms length mortgages through RRSPs is Canadian Western Trust. It is important to note that the trustee is obligated to act in the interest of your RRSP, not you.
Finally, your RRSP non arms length mortgage must be insured regardless of the loan-to-value ratio. This mortgage insurance follows standard rates and requirements and is provided by CMHC or Genworth Financial. Both providers accommodate insurance for RRSP self mortgages. Mortgage insurance is mandatory because the government doesn't want to have you in a situation where you default on your own mortgage and deplete your RRSP in doing so.
Fees and Set up Costs
Setting up a self mortgage with your RRSP is not a cheap process. First, you are required to obtain a professional appraisal of the value of your property which will cost a few hundred dollars. Then, you must pay set up fees to the trustee ranging from $200 to $500 depending on the trustee.
The mandatory mortgage insurance will likely add several thousand dollars to the set up costs. Even if your net worth greatly exceeds your loan value, your mortgage amount is a small percentage of your property value, and you could not possibly default, you cannot get around this.
Finally, for the duration of the mortgage you must pay annual fees to the trustee. Again, these ongoing fees vary significantly depending on the provider but in general range from around $100 to $300 per year.
Additional requests or actions made by the trustee on behalf of your RRSP are also subject to more fees. This includes mortgage renewals, discharges, payment confirmations, legal and other fees when processing arrears, and so on.
While the total cost of establishing a RRSP self mortgage depends on a few variables, it would be safe to expect the costs to be in the range of $1,000 to $5,000 in addition to the costs you would incur obtaining a standard mortgage from the bank.
These non arms length mortgages are not restricted to a RRSP account. You may also use other registered accounts such as a RRIF, LIF, LIRA, Locked-in RSP, or RDSP. However, the account must be a self-directed account, not a group plan.
As a bonus, the loan amount is not considered a withdrawal, so it could be a particularly attractive prospect for someone who has a large LIRA or Locked-in RSP but is under the minimum age to get money out of their locked account.
RRSP self mortgages are not a way to get money out of your RRSP tax free and then default on your RRSP by not making payments. If you fail to make the required regular payments according to standard industry mortgage terms, the trustee will start a foreclosure process on you. Not only will you lose your house, you will be paying fees upon fees throughout the process. While you might become homeless, your RRSP will stay intact thanks to the thousands of dollars you paid for mandatory mortgage insurance.
During the foreclosure process is the only time your RRSP can technically hold real estate as an asset. However, your RRSP must sell the property within a year and, again, the sales process is completely in control of the trustee who is obligated to act in the best interest of your RRSP, not you. For example, you have no real control over the sales price and certainly can't set the price unreasonably high and live in your own foreclosed home forever. You may also be subject to hefty tax penalties if your RRSP holds the real estate for more than a year.
You must still meet all the standard mortgage qualifiers, just as if your were applying for a mortgage with a bank. This means an appropriate downpayment or equity in your home, the ability to make payments based on current qualifying mortgage rates (including the new B-20 rules), your TDS ratio must be lower than 44% of your income and GDS ratio lower than 39% of your income, you must provide income and employment verification, have good credit scores, etc. etc.
With a non arms length RRSP mortgage the interest rate you can set is restricted to certain parameters even though you are technically loaning money to yourself. The rate you pay, and qualify for, must be approximately equal to the posted rates of commercial mortgage lenders. However, you can choose your mortgage terms whether that is a 1 year open, 3 year variable rate, or 10 year fixed rate mortgage. It's up to you but must be consistent with commercial practices.
Try avoid setting up the mortgage with very short terms like 1 year open or 1 year closed mortgages. Most trustees charge a fee of a few hundred dollars every time you renew a mortgage term.
Subject to very specific situations, don't get fooled by paying your RRSP self mortgage the highest interest rates you can to maximize your RRSP value or "investment returns". If you do this, you are in fact robbing yourself to pay the tax man. How? Well, a big RRSP is not necessarily a good thing because you pay full income tax rates on the withdrawals down the road. Also, the mortgage payments you make to your RRSP are not considered RRSP contributions. It would be like contributing to your RRSP without getting the tax deduction that makes the RRSP so valuable when you earn a moderate to high income.
In most situations, you are technically better off to pay the lowest interest rate possible (usually a 5 year variable discount rate) and invest the excess monthly cash flow by properly contributing to your RRSP and getting the deduction, using your TFSA, or investing in your non-registered account as tax efficient as possible. This way your RRSP self mortgage can be a form of transfer from a high tax retirement savings vehicle to a low tax or no tax retirement savings vehicle.
Should You Get a RRSP Self Mortgage?
All this information begs the question: are self mortgages (non arms length) funded by your RRSP worthwhile?
I think it depends on your financial situation and your individual risk tolerance, so lets look at a few scenarios from best case to worst case.
An Investor with No Mortgage
A RRSP self mortgage could be a great solution for someone who has a large RRSP, is a savvy investor, has no mortgage currently, and wants to save a lot of money on tax. It is particularly suitable for a retiree or someone with low employment income.
In this scenario you could set up a RRSP self mortgage where the interest is 100% tax deductible. By borrowing against your home for investment or business purposes, you create a loan where the interest is tax deductible from your other income. There must be a clear trail for the money from your RRSP account to a non registered investment account or business.
As you make mortgage payments back to your RRSP account, the majority of those payments, especially at the beginning of a mortgage term, will consist of interest. Just a small part of the payment is principal. This could allow you to pull most of those payments back out of your RRSP effectively tax free.
If needed, you could refinance your mortgage again in the future to access more RRSP funds. However, you would need the cash available in your RRSP and the appropriate equity in your home.
This strategy is effectively an asset swap. You don't acquire any debt, you don't technically increase your overall assets. You simply invest outside of an RRSP rather than inside your RRSP, still using your RRSP money. It is a shift for tax savings purposes only.
I will go into more detail on this strategy in a future post as there is massive potential here to save tens or even hundreds of thousands in tax on your RRSP. It is basically a way, maybe the only legal way, of getting a serious amount of money out of your RRSP tax free or at very, very low tax rates so it deserves a thorough analysis and explanation.
The Big RRSP Retiree Who Is Mortgage Free
If you need money for a large purchase, lets say a vacation home or something similar, and all your assets are tied up in an RRSP, a RRSP self mortgage could be a good way to get that money largely tax free.
Normally, if you make a RRSP withdrawal, you pay full income taxes on that withdrawal. That means a large purchase financed by a RRSP withdrawal could cost you tens of thousands in taxes alone, requiring you to make a still bigger RRSP withdrawal to pay the tax bill.
For example, to get $300,000 in spending money from your RRSP, you would need to withdraw well over $500,000 in order to pay the tax bill. If the money you need is a big enough amount, it is almost certainly better to pay the costs of setting up a RRSP self mortgage and just take the $300,000 out tax free.
You will need to make larger RRSP withdrawals over time to pay your RRSP self mortgage payments, but it's better to withdraw an extra $15,000 every year to make those payments than it is to withdraw a few hundred thousand dollars in a single year and pay taxes at 50% rates or higher on that large withdrawal.
You could also be better off self financing your big withdrawal with an RRSP self mortgage rather than getting a HELOC or personal loan. Assuming your portfolio is in cautious investments, it is likely that your loan rate would be higher than your expected investment returns. If you are a retiree, you might not even be able to get a loan at a reasonable rate because you are not employed and deemed to be a higher risk by many lenders.
The Risk Averse Saver With A Current Mortgage
If you are an extremely risk averse saver who has a large RRSP account while maintaining a mortgage, then a RRSP self mortgage is a good choice. You will certainly do better than investing in a GIC or similarly safe investment asset.
Over 25 years, at today's rates, the interest on your mortgage can easily equal 50% or more of the value of the loan. If you have a $400,000 mortgage, expect to pay at least $200,000 in interest costs over the course of the mortgage loan. Any risk adverse saver would quickly see they would rather have that $200,000 in their own pockets than ship it off to the banks.
My hesitation with this scenario is the risk averse saver part. With a RRSP self mortgage, you are putting all your eggs into a single basket: your house. Instead, get a good fee-only financial advisor or learn about self-directed investing and set up a properly diversified investment portfolio. You don't need a lot of exposure to stocks to outperform mortgage rates over the long term.
An Investor with a Current Mortgage
If you are a true investor, someone who is willing to take risk, and you have a mortgage with a bank, I don't think RRSP self mortgages are a great choice in today's market.
Current mortgage rates are barely above the rate of inflation, so why not get all the money you can from your bank and invest as much as possible for higher returns? Also, obtaining a RRSP self mortgage for your own house and giving the bank the boot means you are not obtaining the mortgage for investment purposes. That means no tax deductions on the mortgage interest.
For an individual in this scenario, I believe the Smith Manoeuvre makes more sense financially. The Smith Manoeuvre allows you to deduct the interest of your investment loan (HELOC portion) from your income at tax time. Plus you invest at preferential tax rates in a non-registered investment account. In the meantime, your RRSP is invested at an expected long term return of 6% or more and you can worry about taxes on future RRSP withdrawals later.
Use a bank mortgage and the Smith Manoeuvre to maximize your productive assets, pay the bank their low interest rate, get the tax deduction, and invest for higher returns elsewhere through a well designed portfolio.
I also don't believe the bond substitute argument is a good one for someone in this case. Bonds have an important place in your portfolio to reduce volatility; we know they do not generate huge returns.
I think it would be short-sighted for someone to establish an RRSP self mortgage and invest their entire portfolio aggressively in stocks with the argument that the mortgage is their bonds. It works great until they see a 40% or larger drawdown in their all-stock portfolio. When that happens, I'm betting the "investment return" (payments) they are making towards their RRSP because of the self mortgage will hardly be a consideration. After all, they are only seeing their investment portfolio value shrink day after day.
If a 2007-08 repeats itself, they could see the value of their home shrink together with their portfolio. However, in those years bonds did quite well with their 10% annual returns, nicely offsetting some of the losses from the stock side of the portfolio.
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