December 2002
RRSP SURVIVAL GUIDE: Refuge in an RRSP
Jamie Golombek
Putting a mortgage into your client's RRSP can be a good constructive investment.
Joe Black has been a diligent saver since his first year of working full-time. He's thinking of using $100,000 from his RRSP to finance his upcoming home purchase, but he's unsure if this is a sound financial decision.
A self-directed RRSP can hold a mortgage on either commercial or residential Canadian real estate. The rules that govern holding a mortgage in an RRSP differ, however, depending on whether the mortgage is "arm's length" or "non-arm's length."
An arm's length mortgage is any mortgage where the RRSP annuitant deals at arm's length with the owner of the property being mortgaged. If the annuitant is not related to the owner of the property being mortgaged, the mortgage will probably qualify as an arm's length mortgage. The main advantage of holding an arm's length mortgage is that there is no requirement to have the mortgage insured.
A non-arm's length mortgage is a mortgage where the mortgagor (i.e., the borrower who is mortgaging his or her real property) is, in fact, the annuitant or is related to the annuitant. In this case, the mortgage must be administered by an approved lender under the National Housing Act, which includes most financial institutions. The mortgage interest rate and other terms and conditions must reflect normal commercial practice. In addition, the mortgage must be insured either by the Canada Mortgage and Housing Corporation or by a private insurer of mortgages. The mortgage insurance requirement ensures that retirement savings are protected in the event the annuitant defaults on his or the mortgage.
Choice of Rates
When seeking a mortgage, the borrower normally tries to get the lowest possible rate available. However, since Joe is making the payments to himself (through his RRSP, which is the lender) the opposite holds true. Why not simply charge, say, 15%? As noted above, unless Joe can find a mortgage lender loaning funds at 15%, this rate won't fly with the CCRA. Joe can search for the highest available commercial rate and use that rate on his mortgage. A quick scan of the commercially available rates on November 1, 2002, revealed the highest five-year closed mortgage rate to be 7%.
Annual Fees
The costs associated with putting a mortgage into an RRSP is perhaps the biggest drawback. There are the typical one-time mortgage expenses, which include set-up, appraisal and legal fees. However, since Joe will have to get a mortgage (from a financial institution or his own RRSP), these fees would have to be paid anyway.
The biggest upfront cost is the mortgage insurance premium, which can range between 0.5% and 2.5% of the mortgage. The amount depends on the loan-to-value ratio of the mortgage and is calculated on the total amount of the mortgage on the property, regardless of the amount held within the RRSP. There are also annual fees for maintaining a self-directed RRSP and an annual mortgage administration fee that many financial institutions charge.
For Joe, we will assume that the mortgage insurance fee is 1% of the mortgage amount, or $1,000, plus provincial sales tax of 8% in Ontario, which totals $1,080. This fee will be amortized over the 25-year term of the mortgage at the 7% rate. So, Joe's annual fees can be summarized as follows:
Self-directed RRSP fee $125
Annual mortgage administration fee $200
Amortization of $1,080 insurance $90
Total annual fees $415
The Analysis
To determine whether this is a good investment, Joe will need to compare the rate that he is getting on the mortgage (i.e., the 7%) to the rate a similar type of investment inside his RRSP might have earned. Probably the best comparable investment choice would be a five-year GIC. As of November 1, 2002, the typical five-year GIC rate was 4%.
Worth the effort?
Putting a mortgage into an RRSP incurs added costs, so clients and advisors alike need to ensure the returns are satisfactory.
The following chart shows the minimum interest rate a mortgage would have to charge, at varied mortgage amounts and costs for insurance, in order to break even with a GIC rate of 4%. (The chart assumes a 25-year amortization and annual fixed costs of $325 plus the amortization of mortgage insurance premium. The mortgage insurance premium is calculated as a percentage of principal amounts.)
Principal Mortgage Insurance Premium
1.00% 2.00% 2.50%
$25,000 6.13% 6.24% 6.30%
$50,000 5.20% 5.32% 5.37%
$100,000 4.73% 4.84% 4.89%
$150,000 4.57% 4.67% 4.73%
$200,000 4.48% 4.59% 4.65%
If we assume a 25-year amortization period, Joe's monthly mortgage payments to his RRSP on a $100,000 mortgage at 7% would be approximately $700 for a total of $8,400 annually. From this amount we deduct the annual fees of $415, paid from within the RRSP, which leaves approximately $8,000, which now needs to be reinvested inside the RRSP each year. If we assume that the money is invested at the end of each year in a GIC yielding 4%, at the end of 25 years, the RRSP would be worth just over $333,000.
If Joe's RRSP simply invested the $100,000 in a five-year GIC at 4%, compounded annually, and renewed at the same rate every five years, after 25 years the RRSP would be worth approximately $267,000. So, given the large spread between the commercially available five-year mortgage rate of 7% and the five-year GIC rate of 4%, the former seems like a good deal for Joe.
In this example, we have made a number of assumptions. First of all, rates do fluctuate. It is unlikely that the five-year mortgage and GIC rates would be the same in five years' time as they are today. However, as long as the spread is similar, the analysis should hold true. Second, for this to work, Joe needs to have $100,000 of liquid investments inside his RRSP to loan to himself. Third, not only is the analysis sensitive to the interest rate spread, it is also dependent on the amount being borrowed and the mortgage insurance premiums being charged.
One final cautionary note is in order. Just because the RRSP is the lender doesn't mean the annuitant can skip the odd payment. If the annuitant is unable to make his or her monthly mortgage payment, the financial institution will place the mortgage into default. It will then attempt to collect the proceeds upon a power-of-sale of the property or, if insufficient, from the mortgage insurance. In other words, holding a mortgage in an RRSP does not get the homeowner off the hook in case of default.