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Oct. 6, 2006
Steps to financial security
Debt doesn't have to be a four-letter word if you handle it right.
JORY SIMKIN
There are few people in this world who are lucky enough to never
experience the stress of debt in their lifetime. Debt has a way
of sneaking into our lives and taking control if we are not careful.
As the cost of living increases, people are taking on more and more
debt just to get by.
Most people consider debt to be just another four-letter word, but
it doesn't have to be. There are easy action steps you can take
to optimize debt and change it from a negative stress in your life
to a positive contributor. Instead of working for your debt, you
can learn to have your debt work for you.
Debt optimization is a very important initiative that could save
you hundreds, if not thousands, of dollars a year in interest costs.
By optimizing debt, you can stop the erosion of your hard-earned
money.
The first step in taking control of your debt is to realize that
not all debt is bad debt. It is important to distinguish and categorize
your debt into three categories: bad debt (high interest, non-tax
deductible), acceptable debt (low interest, non-tax deductible)
and good debt (low interest, tax deductible).
The next step is turning your bad debt into acceptable debt and
then your acceptable debt into good debt. An obvious example of
bad debt is the all-too-common high-interest credit cards run up
to the limit and then paid down slowly, if at all. According to
David Bach, author of The Automatic Millionaire, approximately
two in five Canadians have a credit card balance of $3,000. To pay
the balance off an 18 per cent credit card using a $50 minimum payment
will cost $4,732 and take 155 monthly payments (12 years, 11 months)
- assuming there are no late fees and no annual fees and you do
not charge anything further on the card. Eighteen per cent interest
on $3,000 is $540 a year.
To change bad debt into acceptable debt, pay your credit cards off
with a line of credit (acceptable debt). On a go-forward basis,
spend only what you can afford and make sure that the limit of your
credit card is adjusted to a level that you are able to pay off
in full every month. A good tool to consider might be a hybrid product
that combines a personal line of credit with a no-fee VISA card.
Some of these cards are charging as low as prime for a secured rate.
At the current prime rate of six per cent, the interest charge on
a $3,000 balance is $180 a year instead of the $540 mentioned above.
Just by changing credit cards, you could save $360 a year in interest.
Pay your bad debts first; the rest of the debts should be paid at
their minimums until the bad debt is paid in full. If you can consolidate
all of your non-tax deductible debts under one low-cost line of
credit, do it. It will save you a significant amount of interest
payments.
After paying off the bad debt, you can use the freed up money to
further pay down your acceptable debts, such as your mortgage, line
of credit and RRSP loans (non-tax deductible). This is the point
at which you should consider converting acceptable debt to good
debt. Fraser Smith, author of The Smith Manoeuvre, pioneered
the concept of converting your mortgage into tax-deductible debt.
Your mortgage is usually the largest debt that you will have in
your life. If you are in the 40 per cent tax bracket, a $200,000
mortgage at seven per cent for 25 years will require $700,402 in
order to pay it off. Income tax will cost $280,161, plus there's
original loan of $200,000 and $220,241 in interest.
Converting your mortgage to tax-deductible debt helps you create
interest deductions and the possibility of a tax refund. By applying
the refund back against your mortgage, you are able to accelerate
the paying down of your non-deductible mortgage debt and build an
investment account at the same time.
Here is how it works: you set up a re-advanceable mortgage of 75
per cent of your home. Every time the principle is paid down, it
is borrowed back to purchase investments.
Let's say you have a mortgage of $200,000. At seven per cent, it
would cost you approx $1,400 a month. In the first month, approximately
$1,150 goes to interest and $250 goes to paying down the principle.
In a separate account, usually a line of credit designated only
for investment loans, you borrow back the available principle up
to the 75 per cent level and buy investments with the money. You
collateralize (have the interest accumulate in the loan account)
the investment loan, so there is no increase in monthly cash flow
obligations and the interest on the interest becomes deductible.
At the end of the year, you can deduct the investment loan interest
from your income and then use the tax refund to further pay off
your non-tax-deductible mortgage - thus giving you more room to
buy more investments and further increase your tax deduction. This
program gives you the ability to build investments that can enjoy
the advantages of compound interest at the same time as paying for
your home – and you're not spending another penny.
This cycle continues until your mortgage is paid off, at which point
you will have a substantial investment account that will continue
to enjoy compound growth. Smith estimates the account to be worth
more than $500,000 after 25 years if you were to achieve 10 per
cent returns. You will also have a $200,000 tax deductible loan
that continues to return large tax refunds until you decide that
you want to pay it off.
The fact that you are getting money back from the government and
putting it down on your non-tax-deductible mortgage means that you
will have your mortgage paid up sooner. At the same time, you are
growing an investment account that has a tax-deductible loan attached
to it that gives you more after-tax dollars to make more investments.
By turning bad debt into good debt, you are able to optimize debt
and change it from a negative stress in your life to a positive
contributor.
Even though this is a debt conversion strategy, borrowing to invest
is not always suitable for investors, depending on your risk tolerance.
You should speak to a financial advisor in order to determine whether
borrowing to invest is the best thing for you. Make sure you are
fully advised of the risks and benefits associated with investment
loans, since losses as well as gains may be magnified.
Jory Simkin is a financial adviser with Simkin Financial
in Vancouver.
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