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Now that everyone, including Bank of Canada Governor Stephen Poloz, seems to be seeking ways to make the mortgage market more flexible and responsive to Canadians’ needs, how’s this for a radical idea?

Imagine a mortgage where you make payments for five years and the balance never drops.

Well, that product exists in Canada and it’s called an interest-only mortgage. As the name suggests, borrowers can buy a home or refinance into this mortgage and pay just interest. Unless you make prepayments, the balance never changes. Which means you owe the same amount on the house as you did before.

Interest-only mortgages and other so-called “innovative” financing products were the scourge of the mortgage crisis south of the border. Canadian lenders offered interest-only mortgages, too, but they all but disappeared from Canada’s prime lending market in 2010. The industry back then found them too risky under the old lending rules.

Nine months ago, mortgage finance company Merix Financial brought back Canada’s first widely available interest-only (I/O) fixed mortgage in years. (Full disclosure: Like most mortgage brokers, I do business with Merix. With the recently introduced stress test and much stricter documentation and income requirements, I believe there’s less risk in this latest iteration of the product.)

Most Canadians would balk at paying more interest and nothing in principal. And while this product doesn’t make sense for most people, there are select cases where paying just the mortgage interest can boost one’s net worth.

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Isn’t this risky if home prices decline – and for the economy in general?

Anything’s possible, but the risk is actually less than with your typical insured mortgage. With most new high-ratio mortgages, the borrower is almost 100-per-cent financed on Day 1. By comparison, an I/O borrower must put down a minimum 20 per cent. Moreover, there has never been a 20-per-cent drop in the national average home price from its peak for as far back as the Canadian Real Estate Association’s average price data go. Canada’s long-term housing appreciation rate is 3 per cent-plus, so in the long term, homeowners with this product could potentially build equity even without making a principal payment.

What are the financial penalties/conditions for making prepayments or paying off the mortgage in full?

The I/O is like a typical five-year fixed mortgage in that regard. Borrowers can prepay up to 20 per cent of the mortgage amount a year without penalty. If they pay more than that, a penalty applies on the excess. The penalty is the greater of three months’ interest or the interest-rate differential (IRD).

What happens if the borrower cannot make the interest-only payments? Are the repercussions the same as with a regular mortgage?

Yes. A default is a default. Don’t pay and they take your house away. (Of course, there are government rules that apply to all forced sale processes, and they vary by province.)

What’s it good for?

An I/O mortgage increases a borrower’s cash flow. The idea is to use that cash, when appropriate, for purposes other than paying off a mortgage. Examples include paying down a large credit-card balance that you can’t consolidate into the mortgage, exploiting unused room in a registered retirement savings plan or investing in an income-generating business.

But I/Os are like razor blades. They’re effective, but when misused you can hurt yourself. If you’re going to just blow the monthly I/O cash flow savings on things such as cars, trips or needless renovations, stay away from I/O mortgages.

And don’t think you’ll get a bigger mortgage by paying interest-only. Competitively priced I/O mortgages are subject to the government’s stress test. This limits buying power by making borrowers prove they can afford much higher interest rates – 5.69 per cent or higher, as of this week.

An unconventional savings tool

By diverting mortgage payments to higher-earning investments, an I/O mortgage can pad your retirement savings. A case in point is the following strategy for disciplined long-term investors with no high-interest debt, at least 20-per-cent equity and RRSP contribution room.

Step 1: Get a low-cost, interest-only mortgage to slash your monthly payments.

Step 2: Invest that payment savings in your RRSP.

Step 3: Use the tax refunds resulting from these RRSP contributions to make a prepayment on your mortgage each year.

The numbers

For illustration, imagine you have:

  • A $500,000 home appreciating at 2 per cent a year;
  • A $400,000 mortgage;
  • An RRSP to which you currently contribute $500 a month;
  • A 37-per-cent tax bracket;
  • An annual return in your RRSP of 4 per cent.

Now, suppose you have two choices for a new mortgage: A regular 3.49-per-cent five-year fixed, or an interest-only 3.88-per-cent five-year fixed.

By paying just interest, your mortgage payments would drop by $505 a month, letting you invest that much more in your RRSP.

To see how redeploying that $505 a month could help, we asked Jason Heath of Objective Financial Partners Inc., to crunch some numbers. Mr. Heath holds the certified financial-planner designation.

After five years, our sample borrower’s pretax net worth, assuming she invested her mortgage payment savings into an RRSP, has grown from that $100,000 down payment to $238,923 with the regular mortgage; and to $243,741 with the interest-only mortgage. That’s almost $5,000 of pretax net-worth gain in just 60 months. But the real magic happens over years of compounding market gains. After 25 years, our sample borrower’s RRSP is well over double what it otherwise would have been. And remember, all the while, she’s also been making annual prepayments toward her mortgage principal.

Once retirement hits, the homeowner can:

  • Downsize and pay off the remaining mortgage;
  • Keep making the modest mortgage payments from her greater retirement cash flow;
  • Refinance into a reverse mortgage (worst-case) to eliminate all payments.

An RRSP accelerator with caveats

Keep in mind, “an RRSP introduces deferred tax liabilities,” Mr. Heath says. In other words, when you take money out of an RRSP, Canada Revenue Agency wants its cut.

“If they were to wind down the strategy after five years and withdraw [the roughly $35,000 extra they amassed in their RRSP], they’d have to pay tax on it,” he says. “If they withdrew it all in a lump-sum, it could make them worse off to choose the interest-only/RRSP strategy, not better off.”

On the other hand, if they didn’t need the money until retirement and “could take withdrawals at a low tax rate over multiple years, it could make them better off.”

Rate of return matters, too. Investment dealer Edward Jones expects long-term annual equity gains in the 6-per-cent to 7.5-per-cent range. Such returns would dramatically enhance one’s success with this strategy, versus our purposely conservative 4-per-cent assumption.

For risk-tolerant mortgagors looking to augment their retirement nest egg, this is a tactic worth considering. But tax and investment nuances can make or break the gains, so get advice from a licensed financial adviser and explore the alternatives before attempting it.

Robert McLister is a founder of and intelliMortgage. You can follow him on Twitter at @RateSpy

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