I recently did a post on leveraging your home equity to invest and building the taxable account of a lower income spouse. That strategy is part of intermediate-term income splitting. Whether using an investment loan against your home to fund investing is a good idea or not depends on multiple factors including:
- Whether a taxable account is needed as part of your investment plan.
- A risk/benefit analysis.
- Structuring the loan and payments to avoid triggering the attribution rules.
- Investing to make the interest paid deductable against income.
We examined each of those points in detail in my last post, but today we are going to look at a real life example. Ours. I made the classic doctor mistake of buying a bigger house than necessary. It is castle-like and marginally smaller than the one in the photo, but it feels about that size when it comes to cleaning, heating, and maintenance. On the other hand, we do use pretty much all of our space, and having multiple washrooms is handy more often than you’d think.
This was not our first home and we had been aggressive savers for a number of years before we bought it. We did take out a mortgage for about half of the house value when we bought. Having an ingrained abhorrence for debt, we aggressively paid that down. Back then mortgage rates were about 6%, so it was like a 6% guaranteed tax-free return on investment.
However, we reconsidered this approach when our mortgage came up for another renewal a couple of years ago. With the low interest rates, our registered accounts filled up, and the threats of “making rich professionals pay just a little bit more” looming on the federal election campaign trail – we decided to revisit our approach.
Is a taxable account helpful to us?
We max out our TFSAs with growth investments & our RRSP with the “fixed income” portion of our portfolio each year. We have also have significant retained earnings in our CCPC and under the upcoming changes to passive investments in professional corporations, we are likely surpass the allowed threshold before I retire. Other than our castle, we live beneath our means and prioritize saving to have extra money to invest each year. My wife makes a fraction of what I do and with spousal income splitting via dividends coming to a close, income splitting in other ways is important to us. We also plan to scale back and retire well before age 65 when income splitting of investments becomes much easier. All of these factors mean that having a taxable account was a useful part of our investment plans and to have it in her hands was the most efficient way to diversify our accounts and accomplish that.
What was our risk/benefit analysis?
At the time when we were considering our approach, we had paid down our mortgage to about 1/3 the value of our home. This meant that we had built up considerable “home equity“. We all need a place to live and home equity makes you feel rich. However, until you access that money, it doesn’t do you much practical good. We examined three options.
- Renew the mortgage at the same balance and continue to pay it down.
- Renew the same mortgage and open a home equity line of credit (HELOC) on top of that.
- Get a new mortgage for a higher amount and take the difference as cash.
The interest rates at the time for mortgages was 2.396% for a five year fixed term. We figured that we could easily beat that with investment returns, so decided to tap some home equity for investing. We decided to remortgage rather than use a HELOC since we could get a low fixed rate and felt interest rates were likely to rise over the next five years.
We remortgaged for $340K above the remaining balance. Even though we could have taken out an even larger mortgage, we decided not to. This amount gave us plenty to invest. Further, if mortgage rates were higher at the time of renewal and it was a poor time in the markets, we would be able to manage our exit from the loan in a more controlled fashion if needed.
How did we structure the loan?
When we took out the new mortgage, the difference between our previous balance and the new mortgage was paid by the bank as a cheque in my wife’s name and deposited directly into her personal account. Even though our mortgage was a loan to both of us, with our house as collateral, that portion went straight to her directly. This is functionally the same as having a joint HELOC (a loan accessible to both people with the house as collateral).
For the purposes of attribution of income earned by the investment loan, the key factors are who actually takes the money and who actually pays the interest on it. So, in this case, the money went directly to my wife and she pays her portion of the interest ($687.10) every month from her personal account for an annual interest cost of $8245. She made her first interest payment one month before we started making mortgage payments from our joint account. So, there could not be a case made that I loaned her money for the few days lag between her payment and our mortgage payments each month. We have kept records of the initial deposit and all of the payments to have a clean paper trail.
How did we invest the money?
My wife transferred the money directly from her bank account to her taxable investment account and purchased investments that pay some eligible dividends and are expected to make capital gains. Capital gains are generally the most tax efficient investment returns to have in a taxable account, but you need some investment income via dividends or interest to be able to deduct the loan interest as an expense. She purchased a mixture of ETFs:
So, she would make ~7K/yr in eligible dividends and ~4K/yr in foreign dividends. She can deduct the loan interest of $8245/yr against her combined investment and earned income. This made for a net increase in her income of $2855/yr after taxes. With the eligible dividend tax credit and her marginal bracket, her tax bill is actually reduced by $800/yr. She invests all of her income while I pay for our other living expenses from my income. I also pay any tax owing that she may have (paying someone’s taxes does not cause attribution problems). This allows us to maximize the growth of her taxable account.
The above growth of about $3700/yr (investment income and tax refund re-invested) also does not account for capital gains growth. We try to avoid triggering tax events by deferring realization of capital gains. So far, in the one and a half years that we have had the loan, we have total capital gains of ~57K.
So, with a $344K loan, we have reduced our household tax bill by $800/yr and increased our household net worth by $65K in less than two years. Having a high net worth is mainly useful for the fact that you can access the money; however, when you access it you usually have to pay tax. Having this built in my wife’s hands means that it will be taxed at her lower rates when we do access it.
For comparison, if we had invested the same amount in the same securities in an account attributed to me, then our household tax bill would have risen by $550/yr ($1350/yr more than with her investing). Plus, any realized capital gains would be taxed at 27% in my hands instead of 15% in hers.
We have had an incredible stock market run the last couple of years, making our results to date atypical.
How could this strategy compare to other strategies over the long run as more typical returns and interest rates take hold?
To figure this out…. I made an Excel-based Investment Loan Calculator with built-in tax calculators for all provinces etc. Please, hold your applause until the end – I know you are as excited as I am. [insert nerdy laugh and snort here]
I plugged in our salaried incomes, loan amount, estimated investment returns based on the longer-term historical performance of the above securities (or similar ones).
I also estimated average inflation over the next 25 years at 2% to convert everything to “current dollars”. Getting results in “current dollars” does not have the wow factor of huge “nominal dollars” amount. However, I have an easier time understanding current dollar buying power rather than the seemingly huge “nominal dollars” that actually have less buying power in the future.
I think that interest rates are likely to rise back to a more normal range, so I also put in different rates in 5 year blocks. The inputs are illustrated in the screenshot below.
A couple of interesting points from the above initial data:
- The average investment income (not even counting the capital gains) more than pays for the loan interest.
- Even with interest rates doubling in about 5 years (years 6-10 in the above scenario), there is enough growth in the annual investment income to almost completely absorb that increased interest cost.
- So, getting a head start while interest rates are low makes this strategy more viable than waiting until they are already back to the longer term normal. If you were to start this strategy when mortgage rates are at 5%, then you would need to pay about $5K in interest above the investment income. That would be easy to do by realizing some of the $18K/yr capital gains or using some of her earned income. It would take almost 25 years for the investment income to cover the interest cost completely. That may still be worthwhile for some people, but not nearly as good as starting with lower interest rates and is a higher risk maneuver due to the increased leverage costs.
So, what could this look like after 25 years?
I am assuming in our example, that we make interest only payments during the 25 year period and then pay off the loan after 25 years.
Over that longer period of time, a number of things happen:
- The loan never gets bigger, but it becomes easier to pay off down the road since inflation erodes it away. At 25 years at 2% annual inflation, the $344K loan would be equivalent to $208K in “current dollars”.
- The interest drag on returns from the loan becomes less over time as the loan stays the same in size while the portfolio increases in size. It starts as 2.4%/yr drag on returns and is 1.8%/yr by the 25th year.
- The portfolio increases in size due to the compound gains. At the end of 25 years, it would be worth >$1M in nominal dollars or $550K when adjusted for inflation. After we pay back the loan, that would be $343K that we not otherwise have if we had simply let our home equity sit without putting it to work for us.
- As the portfolio income grows, so does my lower income spouse’s income. That could bump her up tax brackets. In this example, since my wife is in the middle of a wide tax bracket, it actually does not happen and the tax drag on returns in her hands is ~0.5%/yr.
- For comparison, if the same loans and investments were in my highly taxed hands, the account would only be worth $112K after adjusting for inflation and paying back the loan balance.
When we go to actually access that money, the fact that it would be taxed in my lower income spouse’s hands makes the difference even greater. Let’s say that we draw down on our accounts with accessing some RRSP for her and corporate dividends for me as per below.
After taxes, we would have an extra $13K/yr retirement income because we used this strategy compared to if we did not leverage our home equity to invest. In terms of income splitting, using this strategy with my lower income wife gives us an extra $9K/yr income compared to if I had invested and then accessed the funds in my own name.
How could this investment loan income splitting strategy apply to your own situation?
Hopefully going through my own case was illustrative by attaching some real numbers and the considerations in our case. I realize that we are very fortunate financially and that this would look different for different people. You can try using your own income, interest rates, province, and guess at investment returns and inflation in the investment loan calculator to get a rough idea like I did. Of course, it would also need to fit with your overall financial situation and comprehensive financial plan.