Making a return on your mortgage

ROB CARRICK
Taken from the Globe and Mail
Published Friday, Nov. 26, 2010 3:47PM EST

The 5-per-cent return on safe investments is back.

It happened last week when major banks increased their posted mortgage rates. If you were lending money out for mortgages like a bank, you could get the same return.

Here’s how: Just use the money in your registered retirement savings plan to finance your mortgage.

Mortgage negotiations Investing your RRSP dollars in your mortgage is a fringe strategy – let’s get that straight. Several financial institutions offer it, but not with much enthusiasm. It’s costly and time consuming to set up, and it locks you into returns that could be lower than what a diversified investment portfolio could earn over the long term. If your entire RRSP is invested in your mortgage, then there’s also a lack of diversification to worry about.

And yet, there’s a steady level of interest in this strategy. Mike Wise, a Calgary investment adviser, said most of the inquiries he gets are from people who want to use RRSP money as a source of funds to buy investment real estate. These people are often stretched financially and may not qualify for traditional mortgages.

The other group interested in the mortgage-RRSP strategy is made up of conservative investors who see their mortgage as a potential replacement for the low-yielding bonds and term deposits they own.

“That kind of person would be a jewel for this strategy,” said Mr. Wise, who 11 years ago put his own mortgage in his RRSP and wrote about it for Canadian MoneySaver magazine (read it here).

Charley Tsai, vice-president of wealth planning support at TD Waterhouse, offers this guideline on deciding whether it makes sense to hold your mortgage in your RRSP: “It’s worthwhile if the mortgage interest rate, net of expenses, would be greater than the investment return you would generate from your RRSP.”

Let’s deal with the “net of expenses” side of things first. Prepare yourself for a fee-for-all if you set up what banks call a non-arm’s length mortgage.

Start with the mortgage set-up fee and annual mortgage administration fee, which at TD are $250 and $225, respectively. Next, there are legal fees that can cost, in one mortgage broker’s estimation, anywhere from $500 to $1,000, depending on the specifics.

Now add mortgage insurance fees that will apply regardless of how much equity you have in your home. Genworth Financial, a private provider of mortgage insurance in Canada, says the insurance premium on mortgage amounts ranging as high as 65 per cent of the value of a home will be 0.5 per cent of the amount borrowed. Premiums rise as high as 2.75 per cent for mortgages that are up to 95 per cent of a home’s value.

You could face still another fee if you break an existing mortgage so you can move it into your RRSP. For that reason, the best time to adopt this strategy is when your mortgage comes up for renewal.

Negotiating the mortgage

When negotiating a typical mortgage, your goal should be to hammer the rate down as far as it will go. Just the opposite applies with an RRSP mortgage, because you are essentially paying interest to yourself, not the bank.

“If you’re doing this, you want to try and have as high an interest rate as possible,” Mr. Tsai said.

TD rules say you have to go with the posted mortgage rate for a non-arm’s length mortgage, but there’s still some manoeuvring room to bump up your rate high enough to make it an attractive investment for your RRSP.

Mr. Tsai said TD will allow you to select mortgage terms of one through 10 years. A five-year fixed rate would have put you at 5.44 per cent as of late this week; extending to six years put you at 5.7 per cent, seven years was at 6.09 per cent and 10 years was pegged at 6.4 per cent.

TD also allows a six-month convertible mortgage, which presents an interesting possibility if you see rates moving higher. You’d get a 4.45-per-cent rate for half a year, with an opportunity to benefit from any rate increases that happen between now and then.

But is it a wise investment?

Now to the question of whether it makes sense to put your mortgage in your RRSP from an investment point of view. If we take all the startup fees mentioned above, we end up with a cost of roughly $1,000 to $2,000 in the first year, assuming a $100,000 mortgage. Essentially, you could have a first-year fee of up to 2 per cent if you decide to pay your mortgage insurance upfront.

The cost looks more attractive in subsequent years, when the $225 annual admin fee works out to a fee of just 0.23 per cent.

These fees tell us that conservative investors earning 2 to 3 per cent in their retirement savings should not find it hard to get a better return from the mortgage-RRSP strategy.

“If you have fixed income in your RRSP and if it’s generating a very low yield, then this may be something worth looking at,” Mr. Tsai said. “The greater the difference, the more economic sense it might make to do this.”

Mr. Wise, the Calgary investment adviser, said the mortgage-RRSP strategy works best if you use the mortgage to replace the bonds and GICs in your portfolio while leaving your holdings in the stock market.

If putting your mortgage in your RRSP leaves you light on equities, take the mortgage payments flowing into your retirement plan and invest them in stocks, funds and so forth. In fact, investing each successive mortgage payment gives you a nice little dollar-cost averaging program.

Making mortgage payments into your retirement plan does not affect your RRSP contribution room. So you can further diversify your retirement savings using the money you annually add to your RRSP, separate from your mortgage.

One of the challenges in putting your mortgage in your RRSP is to find a trustee for the plan. In addition to TD Waterhouse, the online brokerages CIBC Investor’s Edge, RBC Direct Investing, Scotia iTrade and ScotiaMcLeod Direct Investing all allow this. Bank of Montreal says it no longer offers this program. If you have an investment adviser, he or she should be able to find a trust company to hold your mortgage RRSP.

Don’t forget the usual strategizing if you’re putting your mortgage into your RRSP – amortization period, biweekly versus monthly payments and so on. An interesting question arises here: Do you put the priority here on getting your mortgage paid off as quickly as possible, or on building your RRSP?

“If I can get a fixed income investment in my RRSP that will give me 5 per cent, I think I’d want to keep that as long as possible,” Mr. Wise said.

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HOW TO DO IT

Investing your registered retirement savings plan in the mortgage on your home is not for everyone, but it can generate steady returns that beat what bonds and term deposits offer.

Step One

Find a bank, investment dealer, trust company that offers this service; some investment advisers may also be able to help you set this up.

Step Two

Tally up fees – expect to pay a set-up fee, an annual mortgage administration fee, legal fees to set up the RRSP mortgage, mortgage insurance fees and possibly discharge fees if you're breaking your current mortgage.

Step Three

Pick mortgage terms. Expect rules guiding the rate you can use, the mortgage terms available and so forth.

Step Four

Use the money you're paying into your RRSP to diversify your RRSP investments, possibly by making regular purchases of stocks or equity funds and ETFs

WHAT YOU SHOULD KNOW

Four things to keep in mind about investing your retirement savings in your mortgage:

1. You can invest RRIF money in your mortgage, but you must have enough cash on hand to fund the required minimum annual RRIF withdrawal.

2. Some banks will allow you to use RRSP money to buy a residential investment property, while others allow this only for an owner-occupied residence.

3. It may be possible to invest in a mortgage on someone else's property.

4. You'll need mortgage default insurance even though you're lending to yourself and even if you have a lot of equity in your home.

Psychology of Home Investing

By Lois A. Vitt, Ph.D.
A major principle to keep in mind when considering whether to become an investor in housing is risk tolerance. To answer the question of your risk tolerance level in home investing consider the factual information: Your age, income, experience, savings, future need for cash, and investing time horizon. They are important considerations to realize about yourself.

Also give some time to consider other realities like market timing, mortgage interest rates, inflation, credit availability and rental and selling markets, over which an aspiring investor has no direct control. Like buying stocks “on sale” in a down market, a savvy real estate investor can decide whether a fluctuating marketplace in housing offers investment opportunities that are simply unavailable in a marketplace that is roaring upward.

If we listen to the experts in real estate investing, emotion should be locked out for investors in second homes. “Gee that is a gorgeous home—just look at that view,” is not appropriate, they might say, until after you’ve run the numbers and made an informed investment decision. In other words, don’t “fall in love” with your investment real estate until it has earned its way into your affections. Love of a home or other residential housing, however, does sway many second home purchasers and this type of emotion can lead to serious mistakes.

The same excitement, anticipation, and anxieties are often present when buying a second home, especially if its purpose in our lives is to bring relaxation, recreation, and social enjoyment as a place for vacationing. Still, the cautions that exist in our primary home purchases must also be present when considering a second home. In addition, lessons from the psychology of investing in the capital markets also apply to investing in real estate as written about by David Dreman in his book “Investor Overreaction,” and Richard A. Geist in “The Emotions of Risk.”

People in general are over-confident when it comes to their estimates of the earnings potential of their investments. Of course there are always nice surprises, but chances are that you will be overoptimistic about the investment potential of your second home.

In real estate, like the stock market, people forget. Not only are homeowners overoptimistic about the prospective price appreciation of their homes, analysts and other experts are overoptimistic about general market trends.

The evaluation of risk, by definition, contains important subjective elements and considerations. It is not purely rational, nor can it be if we are to be helped in our investment evaluations and decisions by our “emotional intelligence.”

Fear and greed are the psychological concepts that drive the markets it is often said, but psychologist Lola Lopes insists that most investors react less to greed and more to hope. Nowhere is that more visible than in both primary and second home investment.
“Fear induces an investor to focus on events that are especially unfavorable, while hope induces him or her to focus on events that are favorable,” writes Hersh Shefrin in discussing the theories of Dr. Lopes. The fact that a homeowner will insist that his or her home is still worth its full value, despite a decline in neighborhood prices or even the overall economy, isn’t based in greed. But is a hope as Dr. Lopes knows well. Only if and when it becomes absolutely necessary to sell a home in a down market will a homeowner finally, reluctantly, accept the fact that the value of his or her home is less than it was before.

Second Homes as Rentals

Homes held strictly for rental, and not for personal use, are diverse and defy categorizing. A rental home can be a cooperative in a big city, a duplex in an aging neighborhood, a bungalow in a suburb, farmland in a rural area, or a condo unit in a coast resort.

The owners of these properties can live anywhere. Although many investors prefer to own property they can access easily, many people who relocate choose to rent the home they are leaving rather than sell it. With enough cash flow, price appreciation and/or property management, this can be a good investment decision.

Rental property investing is a small business that can help owners gain financial independence. If you choose to hold or purchase one or more investment homes to rent, you are your own boss. You can set your own goals, make your own decisions, and work at your own pace. The return from a rented home can be in cash flow or in price appreciation or both. As long as the home is cared for and your carrying and maintenance costs are covered, you have little to worry about, except a steep decline in the housing market just when you want to sell.

Published August 5, 2010


About the Author

Lois A. Vitt is a housing expert and financial sociologist, and is the author of "10 Secrets to Successful Home Buying and Selling", the first book to demystify the psychological forces behind our housing decisions. To learn more about Lois and this book, visit www.RealtyStudies.com.