Readvanceable Mortgage

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DEFINITION of 'Readvanceable Mortgage'

A mortgage feature that allows the borrower to re-borrow the principal amount of the original mortgage that has been paid down. A readvanceable mortgage consists of a mortgage and a Line of Credit (LoC) packaged together. With every monthly mortgage payment made by the borrower, the mortgage principal is reduced by a certain amount; the funds available to the borrower under the LoC go up by the same amount and are generally re-borrowed automatically. While the borrower’s net debt remains the same, the interest payments on the LoC are tax-deductible in Canada if the borrowed amount is used for investment purposes. The readvanceable mortgage forms part of a tax strategy called the “Smith Maneuver” that is designed to make interest payments on Canadian home mortgages tax-deductible.

BREAKING DOWN 'Readvanceable Mortgage'

For example, assume a homeowner takes out a readvanceable mortgage for $250,000, with an amortization period of 25 years and a mortgage interest rate of 5%. The monthly mortgage payments are approximately $1,460, of which part constitutes mortgage principal repayment and the balance mortgage interest. If the first mortgage payment of $1,460 comprises $460 in principal repayment and $1,000 in interest, then the amount that can be re-borrowed by the homeowner under the LoC is $460. At the end of the first year, if the mortgage principal that has been repaid totals $6,000, the amount available to the homeowner under the LoC is $6,000.

The rationale for taking out a readvanceable mortgage is that the funds available in the LoC should be deployed immediately in investments. This would make interest payments on the LoC tax-deductible, unlike interest payments on mortgages that are not tax-deductible in Canada. This tax-deductibility of LoC interest may result in a tax refund when filing a Canadian tax return. This refund can be used to pay down the mortgage principal, thus accelerating its repayment.

A readvanceable mortgage has some drawbacks. First, the homeowner’s net debt remains the same after many years, rather than being paid down as it would be with a conventional mortgage. Second, use of this strategy requires investment acumen and strict fiscal discipline. The homeowner has to invest the re-borrowed amounts judiciously and not fritter it away on frivolous purchases. Third, the LoC interest rate is typically significantly higher than the interest rate on the mortgage component.