Financial Jungle

Yikes! I just discovered that the new 5-year fixed mortgage rate had risen sharply to 5.69%. Wasn’t it only 5.25% just two weeks ago?

Readers are aware that I’m increasingly leery of Vancouver’s housing prospect. I still remember those cheap mortgage rates at 4.55% back in 2003. Since then the market advanced 60%, but that’s not the whole story. When you throw in the effect of rising mortgage rates, Vancouverites are actually paying twice as much mortgage interest.

Here’s a comparison. For simplicity, I assume an 80% loan-to-value mortgage.

If a house was worth $400,000 in 2003, the mortgage interest would’ve been $400,000 x 80% x 4.55% = $14,560. Today, the same house appreciates to $640,000. With the prevailing 5-year mortgage rate at 5.69%, the new mortgage interest becomes $640,000 x 80% x 5.69% = $29,133.

Ultimately monthly mortgage payments matter, not the sales price. Even if we assume prices remain idle, affordability is still deteriorating due to rising mortgage rates.

Related to this, Statistic Canada revealed some grim numbers on provincial weekly earnings:

Average weekly earnings for B.C. payroll employees are the third-highest in the country, according to Statistics Canada, at $755.70. That’s about $40 behind Ontario and $70 behind Alberta. But B.C. recorded the lowest percentage increase (2.4%) of all provinces when comparing the first quarter of 2007 to the same period last year.

As Vancouverites are facing the worst affordability measure (68.5%) in Canada, our solvency is in jeopardy unless we see a meaningful boost in wages accompanied by falling rates. Otherwise we’ll literally run out of cash, and possibly endure the “inconceivable” outcome of stagnating prices or even a broad correction.

Canadian Capitalist is graciously hosting the third Canadian Tour of Personal Finance Blogs. There is no way I am passing up this opportunity to be mentioned in his blog. This will be my second participation to this tour. Enjoy!

Organizing your portfolio into neatly divided asset classes appears to be the sensible thing to do, but what if your financial advisor is offering you only a half-baked solution? Take my friend, Mel, for example. He and his wife walked in to a bank seeking an optimal way to invest a $10,000 windfall. The advisor had them fill out a Know Your Client form to learn their financial goals, risk tolerance, investment knowledge, time horizon and financial position. Based on his assessment, the advisor recommended a 70/30 split between equity and bond funds commanding a hefty 2% in management expense ratio (MER.)

What’s wrong with this picture? Like typical young couples, Mel and his wife still owe an approximate $200,000 worth of mortgage. Since homeowners pay mortgage interests with after-tax money, a 5% mortgage rate is costing Mel 7.14% of pre-tax income - assuming he’s in the 30% tax bracket. None of these bond funds could have guaranteed that rate, especially after MER. Why lend his money to a bond fund, only to borrow it back in his mortgage at a higher rate? He may as well pay down the mortgage instead of buying bonds.

The problem with the financial industry is that it’s not in their best interest if you pay down your mortgage. It’s a double-whammy for them:

• They stop collecting mortgage interests from you.
• They stop collecting MER on the bond fund.

A better solution – in my opinion – is to reduce the scope of your portfolio. Instead of investing $3,000 in bonds, pay that toward the mortgage. A dollar saved is a dollar earned. Paying down your mortgage is equivalent to earning 7.14% guaranteed. The net result is a reduced $7,000 portfolio invested 100% into equities. Sounds scary at first, but simply imagine the other $3,000 is invested in your mortgage. 7.14% guaranteed is a yield on steroid, that no one else can match.

I just learned homebuyers are finally getting some relief in the overheated real estate market. Effectively immediately, buyers with at least 20% down will not longer pay a dime for the CMHC insurance premium.

“We believe that a great number of home buyers will benefit from this change and we are delighted to be able to take a leadership position in making this new option available immediately,” said Cid Palacio, Vice President, BMO Bank of Montreal.

Ms. Palacio noted that based on an average home price of $300,000, a home buyer with only a 20 per cent down payment can now save an average of $2500 in insurance premiums.

To the best of my knowledge, the new fee structure will look as follow. Since the news is so recent, I can’t find official confirmations of these numbers. Not even CMHC’s own website is updated as of this writing. I’ll update this post as I learn more.
[Edit: Just gotten words from my mortgage broker that the only change is the elimination of 20-25% bracket. Everything else stays the same.]

The intention is obviously to alleviate the burden to come up with 25% down, but I’m not convinced that it will be the buyers who reap the benefit. The market has a way of offsetting any money left on the table. I believe the cheaper premiums will drive up demand, causing buyers to bid up prices in the mist of an already tired real estate boom. Consequently, what you gain on the insurance savings, you give back in higher prices. I guess we will have to wait and see.

On a related note, existing home owners can now access up to 80% of their home equity instead of 75%. This is good news for owners looking to tap into their equities for such things as the Smith Manoeuvre or renovations.

“Now, with refinancing at 80 per cent, we’re making an extra five per cent equity available to our clients for their financing needs,” said Catherine Adams, RBC Royal Bank’s vice-president, Home Equity Financing.

Resources

• Down payment rule change won’t alter much
• Banks applaud lowering of mortgage threshold
• BMO Takes Lead
• Mortgage insurance change makes home buying easier: bankers
• 20% down to buy home has just gotten cheaper

If you want to get overview of banking system you can consult many journals or websites relating to banks. The bank charges on the credit card vary from bank to bank. The bank closing information is normally provided on the banks website you can also get other bank related information from there. Now online credit card application forms are available and you can apply for the travel credit card through the websites.

A lot has been said of asset allocation, but can we do better than bonds or GIC’s for our fixed-income asset class?

The best current 5-year GIC rate is 4.40%. After paying for taxes, you only keep 3% depending on your tax bracket. That’s barely above inflation! A better option may be to pay down your mortgage. The going rate for a 5-year fixed mortgage is 5.1%. Since a dollar saved is a dollar earned, saving 5.1% on your mortgage is a better deal than earning 3% from bonds or GIC’s. After all, why lend your money to the financial industry just to re-borrow it back at a higher rate?

A growing number of Canadian homeowners are making their mortgage interests tax-deductible.  Last year alone, my wife and I received a $1,613 tax refund, simply by following the Smith Manoeuvre to rearrange our financial affairs.

Our US cousins down south have it easy; not only do they benefit from lower income taxes, but their mortgage interest is also tax-deductible.  This is significant when you consider a typical person pays 72% of the first year’s mortgage payments toward interest.  Unfortunately, Canadians do not receive this tax advantage.  We do get a break on investment loans.  To remedy this tax drag, Fraser Smith popularizes a technique to convert mortgage debts into tax-deductible investment debts. 

The gist of it is to actively pay down your mortgage via cash surplus, and re-advance the principal to fund your investments or businesses.  The benefit is the interests on the converted loan are now tax-deductible, which means you’ll receive tax refunds each year, enabling you to pay down your mortgage even faster. At least this is the high level goal. The nuts and bolts of the Smith Manoeuvre are different depending how your finances look today and your investment risk profile.  Picture the Smith Manoeuvre as going from point A to point B. We know point B is to make mortgage interests tax-deductible, but everyone has a different starting point A.  I’ll go over some common scenarios later on, but first, a little background on Home Equity Line of Credit.

In almost all situations, the Smith Manoeuvre works best by opening a Home Equity Line of Credit (HELOC) secured by your home. A HELOC gives you the flexibility to re-advance your mortgage principal, therefore making your debts more tax-friendly. In our case, we used the President’s Choice just because we have a joint account with them. I have yet to find one lender that offers less than prime.  If you know one, feel free to post it here.

Alas, there are a few caveats with HELOC. Firstly, the homeowner must cover the legal and appraisal fees.  Secondly, to qualify, you must have more than 25% of equity in your home.  The equity over and above the 25% is your credit limit.  For instance, if the market value of your home is $400k, and you have $250k left on your mortgage, then you can qualify for ($400k-$250k) - ($400k x 25%) = $50k.

Below, I’ll outline a couple of common scenarios:

Flintstone Flip

This is the situation that we were in several years back.  We had a lump sum of investable cash, but needed to deploy it in the most tax-efficient manner. Suppose you have a $50,000 investment portfolio.  Assuming it has little embedded capital gains, you can unload the portfolio, pay down your mortgage, re-borrow $50,000 from your HELOC, and re-purchase the same investments.  At the end of the day, nothing really changed.  Your overall debt level remains the same, and you still hold the same investments. The only difference is you’ll start receiving tax-refunds, because the interests on the $50,000 are now tax-deductible.  You have just transformed $50,000 of bad debts into good debts.  The actual refunds depend on the loan interest rate and your tax bracket.  Assume the interest rate is prime rate or 6%, and you’re in the 40% bracket, the tax refund works out to $50k x 6% x 40% = $1,200. 

Cash Flow Dam

Similar to investment loans, converting your mortgage debts into business debts means more money in your pocket. This applies to homeowners with an existing unincorporated business that has revenues and expenses.  It works with an unincorporated business, because the tax department treats the business and you as one entity.  Consequently, the tax department treats revenues from your business identically as your employment salaries. If you can make mortgage payments with your pay cheques, you can make mortgage payments with your business revenues.  The next step is to withdraw cash from your HELOC to pay the business expenses.  Since you’re borrowing the money to pay business expenses, you’ll receive tax deductions on the HELOC interests.
For a more in-depth look at cash flow dam, check out this document from Fraser Smith.

As some of you already know, I’m a die-hard dividend investing fan.  Although I don’t remember Fraser Smith mention this specifically, I should be able to apply the Cash Flow Dam concept against a leveraged dividend paying stock; the revenues are the quarterly dividends, while the expenses are the loan interests.  Say I borrow money to buy BMO today, the dividend yield is 3.7% and loan rate is 6%. Every year, I pay down the mortgage with my 3.7% dividends, then re-advance 6% to cover the interest expense, provided that the HELOC account has available credits.  Since the 6% is tax-deductible, I’ll get 2.4% back if I am in the 40% bracket.

As always, don’t take advice from a guy on the Net.  Talk to your accountant if you’re interested in the Smith Manoeuvre. You can read more about it here:

• www.smithman.net
• Jonathan Chevreau, Dec 2004
  
• Jonathan Chevreau, Sept 2006
• IE Money: Manoeuvre money from your house
• National Post: Making your mortgage tax-deductible
• National Post: Borrow your way to tax freedom
• NewsPoint: The $500 billion mortgage opportunity
• 50Plus: Mortgage Manoeuvring
• Western Investor: Tax-deductible mortgages
• Fraser Smith, July 2004
• TheTaxDeductibleMortgage.com
• John Chow on the Smith Manoeuvre
• MillionDollarJourney
• The Cen-Ta Group, David Ingram

I don’t know about you, but I’m frightened by universal life insurance. Once you sign the dotted line, it becomes a life-long commitment that comes with a hefty early termination fee. The existing term insurance policy which we currently hold is pretty flexible, since we are free to adjust the insurance premiums in accordance to our needs.

For instance, if we allocate $400 per month of spare cash, we can purchase a million dollar policy with $100, and invest the remaining $300 into any securities of our choice. Should we be lucky enough to self-insure later on, we can cut off the insurance premiums, and invest the full $400.

Insurance can be too complex of a topic to explain over the dinner table by an insurance agent. I recommend taking the materials home, and spending some time doing a little critical and independent thinking. Since insurance agents are generally commissions driven, it is in your best interest to consult an independent financial advisor to verify if this is the right product for you.

How does a universal life insurance policy work?

When you buy universal life policy, not only are you paying for your insurance premium, you’re also contributing to an investment portfolio. In effect, the insurance company is underwriting your insurance and managing your retirement nest egg simultaneously. For instance, the company takes your $400 spare cash, and split it between the insurance premium, administration fee, and investment contribution. The company then offers you a limited list of investment vehicles. Sounds like a rip off if they charge you the extra administration fee and reduce your investment options, but …

What are the benefits?

1. The portfolio grows tax-free. This is similar to RRSP and RESP, where you can switch between different mutual funds without triggering capital gain taxes. This is different from a taxable account where capital gain tax can cut into your capital. The smaller the capital you have, the less it will compound.
2. The portfolio and the face value of the insurance policy go to the beneficiaries tax-free when you pass away.
3. Unlike taxable accounts, there are no probate fees. This can save as much as 5% of your total assets.
4. The portfolio is creditor proofed. This is useful for anyone concerned about lawsuits. (Does anyone know if RRSPs are creditor proofed too?)
5. The portfolio can be used as a collateral for loans. The loans can be repaid by the policy, but that will reduce the death benefits.

What are the key drawbacks?

1. Again, the investment options are limited, and often expensive.
2. You are committed to buying insurance for life even when you have no more dependents.
3. Early termination fee is steep.

Am I better off with universal life insurance?

To find out if universal life is better, we need to explore the alternatives. Most Canadians don’t max out their RRSP. If you still have RRSP contribution room, then I think you’ll get better bang for your bucks by contributing your free cash flow into RRSP. Since the $300 is after-tax money, the pre-tax equivalent is $400 if you’re in the 25% tax-bracket. Most payroll departments let you deposit pre-tax income directly into your RRSP brokerage account. Next step is to pick an investment vehicle, and what’s a better way to show off your patriotism by investing in the Canadian TSX index. Since you’re investing on your own, you’re able to shop around for the cheapest index fund or ETF. The cheapest Canadian index fund that I am aware of is the TD Canadian Index e-series fund with an MER of 0.31%, while the cheapest ETF is iShares’ XIU with an MER of 0.17%. Since XIC trades like regular stocks, you’ll have to pay transaction fees to buy. Refer to my previous post on Interactive Brokers.

As a comparison, Sun Life universal life insurance policy offers their version of the Canadian index fund with MER of 1.50%.

Let the race begins

If you invest pre-tax $400 worth of TD Canadian Index fund (MER = 0.31%) inside RRSP and assuming the market compounds at 10% over the next 30 years, your portfolio balance will grow to $6,413 before tax. The highest marginal tax rate for British Columbia is 43.7%. If you liquidate the entire RRSP account at once, you’ll receive at least $3,636 after-tax. This is the worst-case scenario, since the RRSP can be transferred to the surviving spouse tax-free. The freedom you enjoy with a term life insurance is you can terminate the policy once your dependents leave the nest. By then, you won’t need supplemental insurance. This unleashes bonus cash flow to excel your RRSP portfolio further. I have not factored in the probate fee, since it depends on the lawyer and if your beneficiaries are willing to handle the paper work.

If you invest after-tax $300 worth of Sun Life Canadian index fund (MER = 1.5%) over the same 30 years, you portfolio will grow to $3,467 tax-free. Based on my understanding, this is on the optimistic side for two reasons. First, I’m ignoring the administration fees. Secondly, the insurance company withdraws portions of the portfolio to offset your rising insurance premiums. Please feel free to complete my math if we have an insurance expert here.

What if I have no more RRSP contribution room?

If you’re in a high tax bracket, pay down your mortgage. This strategy saves you in the neighbourhood of 5%, or 8.33% before-tax assuming your marginal tax-rate is 40%. Although this not as sexy as Sun Life Canadian Index fund’s 8.5%, it is a guaranteed return instead of a projected return.

Is universal life good for anything?

My opinion is that universal life is third in line after RRSP and mortgage. It cannot be emphasized enough. I’m not a certified financial planner nor an insurance expert. Materials are presented here for discussion only.