Holding a mortgage in an RRSP needs careful consideration

“Frankly, using the money in your RRSP to pay down a mortgage sounds like a nice idea and it resonates with a lot of people, but at the end of the day it often falls apart,” says Warren Baldwin, regional vice president at T.E. Financial Consultants Ltd. in Toronto.

“The costs can be horrendous, and the financial circumstances of a lot of people are simply out of sync.”

Here’s how it works: instead of taking out a mortgage with a commercial lender, such as a bank, the client borrows the money from his or her RRSP to finance a home, cottage or any piece of commercial or residential real estate in Canada. In turn, the client becomes both the borrower and the lender, and must pay back the loan to the RRSP at posted lending rates. The payments do not count as regular RRSP contributions, and the client can continue to make maximum allowable contributions each year. As the mortgage usually replaces the fixed-income portion of the RRSP portfolio, the client earns a higher rate of return than would otherwise be earned on bonds or guaranteed investment certificates.

Sounds good. But consider the fees, Baldwin says. On top of the typical mortgage set-up fees ($200-$250) and annual trustee fees for holding a self-directed RRSP ($100-$150), there are also legal fees and — the biggest cost — mortgage insurance. Under the rules of the National Housing Act, mortgages held within an RRSP must be insured by Canada Mortgage and Housing Corp. or another private insurer (such as GE Capital Insurance Canada) to protect the lender.

As for premium rates: “We look at it the same way any other insurer would: whatever the loan/value ratio is, that’s the premium we charge,” says George Huckle, manager of home ownership underwriting at CMHC in Toronto. Premiums typically range from 0.5% for loan/value ratios of 65% or less and up to 2.75% after that, regardless of the amount held within the RRSP.

Baldwin warns this isn’t to be mistaken for life insurance. “This is loss-prevention insurance, and the rules say you have to have it to protect your retirement savings,” he says.

Another problem with holding a mortgage within an RRSP is the logistics: few people fall into the ideal category of having a sizable RRSP and a mortgage that’s substantial enough to justify the associated fees, yet not large enough to deplete the RRSP entirely.

In an ideal situation, the client may have a $200,000 RRSP and would need to borrow $145,000 against a property valued at $400,000. Unfortunately, Baldwin says, the strategy most often appeals to people whose RRSP is too small to accommodate a mortgage or to people who have a substantial RRSP but a small mortgage.

“That’s the conundrum: those who want to take advantage of it probably shouldn’t, and those who could don’t need to,” says Howard Kabot, director of financial planning at ScotiaMcLeod Inc. in Toronto. Kabot has never had a client who implemented the strategy. He says that most people don’t know it’s an available option, and those that do usually forgo the option once they learn of the fees and costs.

“Clients have to think about the mortgage rates vs what kind of money they could be making if they didn’t pull it out of their RRSP,” says Kabot. With current mortgage rates hovering between 4% and 5%, investing in a mortgage will yield higher returns than most fixed-income products, but may be more worthwhile when interest rates rise, he says.

Kabot also warns against making the mortgage a heavy component of the RRSP’s asset allocation. “I think you can argue that a concentrated position in anything isn’t a good idea, whether it’s in a mortgage or a stock or a bond,” he says.

Finally, there’s the issue of paying back the RRSP. Theoretically, it would be most profitable to the RRSP to pay the highest posted mortgage rate and opt for a long amortization period. In other words, the worst-case borrowing scenario is now the best-case scenario because the payments are going back into the RRSP holders’ pockets.

However, clients who would ordinarily use any extra income to pay off their mortgage and save the after-tax cost of interest will now probably choose not to because it effectively reduces the investment return on the RRSP.

“They’re not going to pay the mortgage down, and they’re going to continue to incur the after-tax cost of interest. It doesn’t make sense,” Baldwin says.

What does make sense, he suggests, is taking out a mortgage for investment purposes.
For instance: a client with a fully paid-for home and a $500,000 RRSP decides to buy a doughnut shop franchise worth $300,000 and needs to borrow $200,000. Because the borrowed money is being invested in a business, the interest is fully tax-deductible; so having a long amortization period would make sense in such a situation.

But regardless how clients use mortgages held within their RRSPs, they should be warned that skipping payments isn’t an option. The RRSP trustee will take the same action it would take with an ordinary mortgage in default.