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RRSP mortgages, pros & cons?

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[OP]
Newbie
Mar 31, 2007
10 posts

RRSP mortgages, pros & cons?

Hi all,

(this is long, thanks for reading if you make it through)

Just wondering what people thought of the pros and cons of RRSP mortgages?

We are debating whether or not to pursue this option as our RRSPs almost equal our outstanding mortgage balance on our principal residence (about $170k).

First some background -

This article provides a good overview:
http://www.canada.com/finance/rrsp/stor ... 57&rfp=dta

Another one with a pretty balanced view:
http://www.businessedge.ca/article.cfm/newsID/8243.cfm

This article provides a good description of the 'cons':
http://www.efficientmarket.ca/article/RRSP_Mortgage_2

My issue with the 'cons' article are:

1. True there may be a lack of diversification initially, however this is balanced out over time as each mortgage payment is made. Also, non-registered funds also help reduce any lack of diversification. Plus, some planners recommend having only interest bearing investments in your RRSP with capital gains and dividends in non-registered investments.

2. Rate of Return, they're saying it won't be as high on an RRSP mortgage than if you invested in, say, equities. My problem with that argument is:

a) the posted interest rate I would 'charge' myself is a close, but not quite, a sure thing. Not quite because we might somehow otherwise lose our ability to earn our current income levels for an unforeseen reason. But helped to be more secure by having property and critical illness insurance in place while the return on equities are by no means guaranteed.

b) by pursuing an open mortgage with a longer amortization, I can 'charge' myself 8.5% (still managing to keep the cash flow lower with a longer amortization period. Combined with a), it is hard to find close to risk free rate of return on a fixed income product of 8.5%.

What I like about the idea is:

1. Obviously the idea of paying interest to yourself, rather than the bank.

A $170,000 mortgage with a 25 year term would incur approximately $120,000 to $175,000 in total interest payments (depending on the average interest rates negotiated over the terms), using no acceleration and assuming it ran it's full amortization. It would be nice to see that interest going to us rather than the bank.

This is balanced out, of course, by all the fees involved in setting up and running an RRSP mortgage:

UP FRONT COSTS: one-time bank set-up fee $200, legal fees (required to use your own lawyer) $700-$1000, CMHC premium $900-$1200 (for our Loan to Value ratio & depending on amortization period), Bank Appraisal fee $295 (often waived though). Total = approximately $2,095-$2,695 give or take and less the $295 if the appraisal is waived.

RECURRING ANNUAL FEES: annual mortgage admin fee $175-$225 (depending on bank), normal self-directed RRSP annual fee $125 (until you return the account back above $25,000 in repayments) - note: these annual fees are per RRSP account, so double up for a couple pooling the funds across two self-directed RRSPs (or more if there are LIRAs involved). Total = approximately $650 for two SD RRSPs up to the point where they are back above $25k, then $350-$450 thereafter till the mortgage is extinguished (then a normal discharge fee of approx. $200 kicks in).

Total fees charged over the 25 year amortization = roughly $12,000 to $14,000

One thing that gives me pause though and this I really need some help on. If couple has $170k in combined RRSPs, $7k in combined new contributions made each year (ignore the tax refund for now) and all those funds achieve a rate of return (ignoring inflation for now) of, say, 8%, the future value in 25 years is approximately $1.7 million.

Whereas if the RRSP mortgage is done, the combined RRSPs have $0 today (cashed out to pay-off the bank mortgage), the RRSPs receive, say, $19k in combined payments made each year ($12,000 in mortgage payments to the RRSP + $7,000 in new contributions made each year - ignore the tax refund side of things) and all those funds achieve a rate of return (ignoring inflation) of, say 8%, the future value in 25 years of the RRSP funds is just under approximately $1.4 million.

On the surface, there is $300,000 disadvantage to going the RRSP mortgage route. I suspect this would be compensated for by the mortgage interest saved from being paid to the bank, but am unsure how to account for it in a time value of money type analysis. Any help or tips on how to properly account for issue in the analysis would be greatly appreciated.

Any other comments, corrections, suggestions etc. also appreciated.

Thanks for getting to the end!!!
20 replies
Deal Fanatic
Oct 25, 2002
6849 posts
6 upvotes
It is my understanding that your RRSP cannot charge a higher than normal interest rate. If the going rate for a 5 year closed mortgage is 6%, then you cannot charge yourself 8.5%. Otherwise, why not charge yourself 10%? 12%?

I think you pretty much answered your own question. The loss of the compounding power on that $170k will be huge. I won't argue with your calculations, but you'd likely see a greater than $300k discrepency because most people find a way to pay off their mortgages faster.

You might run the calculations again and do the "what if" you keep the $170k inside your RRSP and get a conventional bank mortgage. What if you only contributed the $7k to your RRSP every second year and paid down your mortgage with the extra $7k? What if you used non-RRSP investments to make your RRSP contributions?
Deal Addict
Mar 21, 2007
1075 posts
8 upvotes
Markham
My RRSP balance could also cover my mortgage, however, for me the biggest 'con' would be that I am too young for such a conservative investment in my RRSP. I'd like a higher rate of return than posted mortgage rates, and I can take the risk at this point. So giving myself that mortgage has a large opportunity cost.

"I suspect this would be compensated for by the mortgage interest saved from being paid to the bank, but am unsure how to account for it in a time value of money type analysis. Any help or tips on how to properly account for issue in the analysis would be greatly appreciated."

To calculate present value of a payment stream, look up how to use the PV() function in Excel.
Member
User avatar
Jan 11, 2007
427 posts
128 upvotes
Brampton
The mortgage inside the RRSP may sound good, but is not a good idea. While it appears you are "paying yourself instead of the bank", in actual fact, your mortgage must be administered by your RRSP institution and will have to foreclose on you if you don't make payments.

Can you imaging your RRSP foreclosing on your house and then selling it off as a Power of Sale? It is required to do that.

This strategy generally means that your RRSP probably makes the same or less than it would otherwise PLUS you pay far higher mortgage payments personally than you would otherwise.

This perception makes it sounds better than it is. Think of it as you get a 8.5% mortgage and at the same time have your RRSP invest in some fixed investment at the same rate. Even though your RRSP is receiving 8.5%, that does not change the fact that you have a ridiculously high mortgage interest rate that you have to pay.

This is an example of what we call "mental accounting" - somehow you think that because the payments are going into your mortgage that you are not actually making astronomically high mortgage rates. You trick yourself into thinking this is an RRSP contribution, when it is a high mortgage payment.

Your example misses this additional key fact - that you are paying about 3.5% higher interest on your mortgage. You can save hundreds of thousands of dollars by getting a regular mortgage and then buying a 30-year bond in your RRSP. If the bond rate is the same or higher than your mortgage, then this strategy easily beats the RRSP in mortgage strategy. The savings are in your mortgage payments. Plus you save all the tons of fees.

So, add to your calculation the loss from paying 8.5% vs. the 4-5% rate mortgage rates will likely average in the next few years.

You haven't explained how you calculate your future values, but they should be the same if the interest rate is the same. Presumably, your calculation is based on the compounding rate of the RRSP investment, while the mortgage pays a flat amount, but you have probably missed calculating the growth of the mortgage payments received in the RRSP.

Even though this $300,000 is probably not a real difference, I see 8.5% to be a low return on an RRSP properly invested and an astronomically high mortgage rate. You lose at both ends and pay high fees.

A far better strategy is to leave your RRSP properly invested and then do the Smith Manoeuvre on your personal mortgage (and get it at a good rate). The Smith Manoeuvre converts your mortgage to a tax deductible investment loan over time, and builds up a huge nest egg at the same time. The tax refunds from the interest deduction will be in addition to your RRSP tax deductions.

Because of the compounding growth and tax refunds (and the low mortgage rate), you will find (believe it or not) that if you buy a bond in your RRSP (if you are uncomfortable with equities) at the same rate as your mortgage (say 5.15% variable) and your Smith Manoeuvre investments only make an extremely low 3%/year long term, you will find this still easily beats the RRSP in the mortgage strategy at 8.5% after 15 or more years.

This may sound unbelievable, but it is true.

Abandon the RRSP in the mortgage strategy. There are many better strategies.





Ed
Ed Rempel
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Deal Addict
Jun 8, 2004
1478 posts
397 upvotes
Oakville
As edrempel indicated, it is not neccessarily a good strategy.

In addition to what edrempel already mentioned, you are still using your after-tax income to make your mortgage payments.

By having the higher mortgage rate, you are essentially, transferring more of your after-tax income into your RSP, without getting RSP contribution deductions. Your RSP will grow "tax free" by that higher rate but that grew using your own income that you already paid taxes on...and you'll pay taxes again on it when you retire and withdraw it from your RSP.
Newbie
Jun 9, 2005
35 posts
Very interesting thread. I have a couple of questions maybe people can answer:

1) I have a good pension plan so I don't have much RRSP room anymore. By using the RRSP mortgage strategy, I would be able to put money into my RRSP account to let it grow "Tax free"? (I understand that I am still being taxed on my principle, but the interest would be sheltered?)

2) You don't necessary need to go with a very high interest rate. In fact, you could go with prime or something like that, as long as your bank is charging that you their clients?

3) With this strategy, could you split up the mortgage such that half of it is your RRSP, and the other half from the bank? Assuming that you keep the same payment, it means that I am now paying only half the interest to the bank?

4) As soon as the money gets into the RRSP, could I then re-distribute it into a diversified portfolio once again? Assuming that the amortization is relatively short (~10 years), wouldn't this be a sound strategy?

Thanks!
Sr. Member
Mar 6, 2007
620 posts
9 upvotes
If you are only holding low interest GIC within the RRSP, then RRSP mortgage might be viable.
Usually from a financial standpoint; you can achieve a better return, not going the RRSP mortgage route. But I am sure, each person will have their own reasons for wanting a RSP mortgages.
Deal Fanatic
Oct 25, 2002
6849 posts
6 upvotes
Everyone keeps focusing on not paying the interest to the banks. There are ways of decreasing your interest payments (to the banks) that you wouldn't want to do inside an RRSP:

1) negotiate a lower interest rate -- some banks will knock off up to 1.5% off their posted rates
2) make small lump sum payments, increase, or accelerate your monthly payments

Don't forget that with the banks you can also negotiate away the appraisal and legal fees. We paid no appraisal fees and received $1000 towards our legal fees.
Deal Fanatic
User avatar
Aug 19, 2001
5089 posts
35 upvotes
Vancouver
Don't fool yourself into thinking your RRSP is "earning" 8.5% (or whatever ridiculous rate you set) .. it's only your own money you are shuffling around.

The "real" amount you are earning is only whatever you save by not paying interest to the bank. today that's about 5.2% for a 1-to-5 year closed mortgage.

The only possible purpose of inflating the mortgage rate is to get more money into the RRSP than your normal contributions allow... but personally i'd rather get more funds into my RRSP from outside sources (i.e., equity investments) rather than my own pocket.
Deal Addict
Jun 8, 2004
1478 posts
397 upvotes
Oakville
grant paraphrased my earlier comments well.

To actually earn real income on your RSP, the SDRSP Mortgages can be set up to finance someone else's property, and their mortgage payments would go to you. If they default, the trustee will foreclose on the property and give you the proceeds. Since the payments are coming from someone else, the interest earned is real income in your RSP.

Personally, I would rather buy a MBS instead, which effectively diversifies the risks over a few properties between a few investors than costs and risks associated with setting up an SDRSP Mortgage for one property.
[OP]
Newbie
Mar 31, 2007
10 posts
Thanks for all the view points, some great food for thought here. I don
[OP]
Newbie
Mar 31, 2007
10 posts
Correction to the TVM calculation in my post immediately above:

Re-reading the post, I see that instead of using one single yearly payment of $19,000, I should have done the calculation using a monthly payment of $1,583.33 ($19,000 divided by 12 months). This payment profile is similar to making a mortgage payment each month of $1,000 and an annual RRSP contribution of $583.33($7,000 divided by 12 months).

Doing this produces $1,505,789.60 rather than the $1,389,012 I calculated above:

PV = 0
PMT = $1,583.33
I = 0.666667% (8% per annum divided by 12 months)
N = 300 months
FV = ??? (Calculator returns $1,505,788.62)
Jr. Member
Feb 23, 2007
130 posts
6 upvotes
escompton wrote: Correction to the TVM calculation in my post immediately above:

Re-reading the post, I see that instead of using one single yearly payment of $19,000, I should have done the calculation using a monthly payment of $1,583.33 ($19,000 divided by 12 months). This payment profile is similar to making a mortgage payment each month of $1,000 and an annual RRSP contribution of $583.33($7,000 divided by 12 months).

Doing this produces $1,505,789.60 rather than the $1,389,012 I calculated above:

PV = 0
PMT = $1,583.33
I = 0.666667% (8% per annum divided by 12 months)
N = 300 months
FV = ??? (Calculator returns $1,505,788.62)

Great thread! I am going to take a stab at a few initial thoughts... Sorry it is kinda long...

It seems to me the net difference between the option of mortgage from RRsp or bank is a sum of the following:

few assumptions first: - you make regular max rrsp contributions in both options; you are going to buy a property no matter what; the options are mutually exlusive

1. the rate spread between rrsp portfolio returns that you would reasonably earn (proper asset mix) and mortgage interest rate that the rrsp mortgage is set at (locked in return of you rrsp assets given rrsp mortgage). This is the opportunity cost of forgoing portfolio returns and going with rrsp mortgage - both of which will net to be a negative. On a risk adjusted basis however, i think the spread is a large positive since you will never default (i hope), while rrsp portfolio is suffering from end/begining point sensitivity (period defined as term of the rrsp mortgage).

2.The spread between the after tax interest rate that is collected by the bank on your mortgage and rate of return achieved on RRsp assets. This has to be a big positive because instead of using your after tax dollars to give to the bank (no matter how tight you get it with SM), you will make abnormally high RRsp contributions (interest on rrsp mortgage) that will get reinvested at ROR of rrsp assets and compounded tax free. These abnormal contributions could not otherwise be achieved. What i am not sure about is if you could do SM on a rrsp mortgage?? IF you could, the difference between rrsp mortgage SM and bank mortgage SM is the saved interest cash flow that is achieved when it is advantageous to shorten the effective the life of the mortgage (bank-financed option) - and the growth of that cash flow in non-reg after tax. Given discussion on SM thread and my own thoughts, this would roughly be 7 years of interest (will vary largely on your version of SM) at the tail end of the mortgage.

My estimates of the above...
1. lets assume non risk-adjusted and go with a 12% return on your rrsp portion (debatable - insert your own) and 5% on your rrsp mortgage at the current time. I set this low since this is what you would realistically pay if you had to go with the bank at the current time. It seems you are losing 8% (12-5) here. However, by forcing 8% on rrsp mortgage, the incremental 3% (8-5) needed to service mortage is effectively transfered into rrsp and is compounded tax free, so that reduces the loss by .9% (3*.27 - to account for saved taxes on that 3% being invested in rrsp vs non reg). Overall for #1 we have a loss of 7.1% (12-5-.9)

2. I am going to assume a net net 2% cost of bank mortgage. This is unavoidable because you have to do financing no matter what - you cant get the interest back from the bank.This is given that SM can be done with both options (see assumptions above). I am going to assume the same 12% rrsp return, but that advantageous spread return shrinks to 3.6% for the last 7 years of the rrsp mortgage (effect of SM in bank mortgage - the saved cf that SM freed up in bank mortgage is being invested, but is not taxed - so 12*0.3). Lets say the the spread is 14% (12+2) for the first 18 years of the mortgages and only 5.6% (3.6+2) for the last 7 years, this benefit is roughly 11.2% per year average over the term of the rrps mortgage.

So overall benefit (additional wealth created) of all average rates is roughly 4.1% (11.2-7.1) per year that goes directly into your RRSP to be compounded tax free. It is created wealth since no additional cash flow commitment is needed between the two options (well the additional 3% out of pocket is needed, but is accounted for in #1). This bonus rrsp contribution starts at year 1.

Some other thoughts:
-It seems the scenario becomes much more attractive during years when rates are high, just like the traditional tradeoff between fixed income and equities. A very high locked-in rate on rrsp mortgage shrinks the equity premium and locks it in for the term of the mortgage.
-On risk adjusted basis i think rrsp mortgage is far superior - assuming of course you will never default on your locked in rrps mortgage rate...
-What if you used the proceeds of rrsp mortgage to buy a rental property - could you deduct the interest right off the bat??? If you could - (holy moly!) the fat deductions for the duration of the mortgage would be a nice annual cash flow!

A lot of assumptions above...Overall i think this is worthy of a good spreadsheet to test things with exact figures... I think as long as the equity premium is small throughout the life of the mortgage (thus either the prevailing prime is very low throughout the term of the mortgage, or you cannot produce extraordinary long term returns inside your rrsp) the rrsp mortgage seems to be a good choice as it allows to you increase rrsp much faster through avoidance of interest to the bank and bypassing those pesky contribution limits.

Comments?
Deal Addict
Feb 20, 2006
1174 posts
46 upvotes
Vancouver
frankal101 wrote: Comments?
I'm pretty sure your calculations are totally bunk.
1. lets assume non risk-adjusted and go with a 12% return on your rrsp portion (debatable - insert your own) and 5% on your rrsp mortgage at the current time. I set this low since this is what you would realistically pay if you had to go with the bank at the current time. It seems you are losing 8% (12-5) here. However, by forcing 8% on rrsp mortgage, the incremental 3% (8-5) needed to service mortage is effectively transfered into rrsp and is compounded tax free, so that reduces the loss by .9% (3*.27 - to account for saved taxes on that 3% being invested in rrsp vs non reg). Overall for #1 we have a loss of 7.1% (12-5-.9)
I'm a bit confused about exactly what numbers you are suggesting - I'm going to assume you mean that you'll charge yourself 8% on your RRSP mortgage and compare that to a normal 5% mortage through an FI. Then, your calculation of this .9 factor associated with having more funds in your RRSP is bunk. Where does this .27 number come from? More importantly, you are completely neglecting the fact that these excess payments are essentially non-deductible contributions - on which you will effetively be double taxed - you pay them with after-tax dollars, and will need to pay taxes again on withdrawal.

I ran the numbers for this scenario here (discussing the $2000 overcontribution limit, but the concept is the same), and assuming cap-gains and 12% returns, it may take 25-60+ years just for these extra pseudo-contributions to just break even. I don't think you ever reach a point where the compounding effects of having more money in an RRSP minus eventual tax hit will give an RRSP ROR a boost of 27%, as your .27 figure indicates.
2. I am going to assume a net net 2% cost of bank mortgage. This is unavoidable because you have to do financing no matter what - you cant get the interest back from the bank.This is given that SM can be done with both options (see assumptions above). I am going to assume the same 12% rrsp return, but that advantageous spread return shrinks to 3.6% for the last 7 years of the rrsp mortgage (effect of SM in bank mortgage - the saved cf that SM freed up in bank mortgage is being invested, but is not taxed - so 12*0.3). Lets say the the spread is 14% (12+2) for the first 18 years of the mortgages and only 5.6% (3.6+2) for the last 7 years, this benefit is roughly 11.2% per year average over the term of the rrps mortgage.
This whole part is pretty boggling to me. Putting aside the SM part for a moment, how are you adding 12+2 to get some hypothetical 14% benefit for the RRSP mortgage? You already calculated, in 1 above (incorrectly, though) the oppotunity cost of changing an equity investment in your RRSP to a mortgage investment. What are you trying to calculate here?

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