What is a Readvanceable Mortgage
How Line of Credit Works
BREAKING DOWN Readvanceable Mortgage
Readvanceable Mortgages are comprised of a home mortgage and a line of credit packaged together. As a borrower makes mortgage payments, a portion of the principle loan as paid as well as a portion of the loan interest. Under a readvanceable mortgage, funds available to the borrower increase with each principle payment and tend to be automatically reborrowed by the same amount, usually at a significantly higher interest rate. Because of of this, the net debt of the borrower remains the same, which makes this type of loan unattractive to many investors.
Under Canadian law, interest payments on reborrowed funds under a readvanceable mortgage can be tax-deductible so long as the reborrowed funds are used for investment purposes. This is a crucial mechanism of a Canadian tax strategy known as the Smith Maneuver, which exists to make home mortgage interest payments tax-deductible in Canada.
While the borrower is usually free to spend their line of credit as they choose, the Smith Maneuver strategy tends to be the recommended rationale for taking out a readvanceable mortgage in the first place. By reinvesting the line of credit funds and taking advantage of Canadian tax-deductions on the interest, a savvy borrower can profit from those investments, while simultaneously deducting interest when filing taxes, increasing the potential tax refund for that year. That refund can then be used to pay down the loan principle, which can accelerate the overall time to repay the mortgage.
Of course, because the line of credit reborrows the principle, the net debt of the homeowner does not decrease over time in the way it would in an ordinary mortgage. The borrower entering a readvanceable mortgage will usually need to be an engaged and attentive investor in order to make smart investments with the reborrowed funds and mitigate the impact of the higher interest rates on the line of credit.
Example of a Readvanceable Mortgage
If, for example, a homeowner were to take out a readvanceable mortgage for $250,000 with an interest rate of 5 percent and an amortization period of 25 years, the monthly mortgage payments might come to approximately $1,460. Of this payment, imagine that $460 is applied to the loan principle, while $1,000 is applied to the interest. Under a readvanceable mortgage, the borrower may reborrow $460 per month. At the end of a year, the borrower has $5,520 in funds available under their line of credit.
The homeowner can reinvest that $5,520, and even if the interest rate on the line of credit increases to 10 percent, that interest is tax deductible at the end of the year. Funds from the tax return can then be used against the loan principle, reducing the overall principle at a greater rate.