What Is a Readvanceable Mortgage?
A readvanceable mortgage is a type of mortgage that allows the borrower to add a line of credit to the loan, permitting the borrower to re-borrow any part of the principal paid down. It is essentially a primary mortgage bundled with a home equity line of credit (HELOC).
- Readvanceable Mortgages are comprised of a home loan and a line of credit packaged together.
- As a borrower repays their mortgage, the amount of credit available to them increases.
- A readvanceable mortgage may be used to make mortgage interest tax-deductible in Canada, via the so-called Smith Maneuver.
Understanding Readvanceable Mortgages
In a traditional mortgage, as a borrower makes regular mortgage payments a portion of the principal loan is repaid as well as a portion of the loan interest. Under a readvanceable mortgage, funds available to the borrower to draw from increase with each principal payment and tend to be automatically reborrowed by the same amount, usually at a significantly higher interest rate. Because 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.
The Smith Maneuver
Fraser Smith, a financial planner based in Vancouver Island, Canada, developed the Smith Maneuver and popularized it in a book by the same name, published in 2002. Smith refers to this maneuver as a debt conversion strategy, rather than a leveraging tactic, on the basis that it can potentially lead to tax refunds, faster mortgage repayment, and a larger retirement portfolio.
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 principal, which can accelerate the overall time to repay the mortgage.
Of course, because the line of credit reborrows the principal, 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.
While it is not an incredibly complicated strategy, there are some potential disadvantages to attempting the Smith Maneuver. Depending on your risk tolerance, financial discipline, investing horizon, and the general state of the economy, the Smith Maneuver may or may not be appropriate for you.
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.