|
By Peter F. Baigent CFP, CLU, CHFC,
RFP.
Negotiating Debt For Your Client
Some of the leverage programs available to the advisor are highly structured
and easy to use. However, I have found that better deals can be made with
better terms for the client. We have made it a practice to submit the loan
application ourselves on our own forms to a lending institution we have
worked with for our clients, or to submit the application to the client’s
bank, or both. I have found that lenders find the clients of a financial
advisor to be their most desirable type of client. This is partly because an
advisors client’s are high income, or high net worth, or at the very least
responsible and determined to get ahead.
An obvious advantage to the advisor is additional fee revenue for this
service, or the placement of the investments depending on the nature of the
engagement with the client. However, the more important advantage is in
protecting the client from over-zealous loan officers. Often the bank or
other lending institution will want a higher rate of interest then will be
warranted, or they try to make the loan appear that it is dependent on the
customer bringing other business to the bank, or investing the borrowed funds
with them. Tied selling is against the law but is seldom prosecuted by the
regulators who fear doing their job and offending the big banks. As it is
never good business to hold your assets at the same place that has your debt
we can protect the client from that. If anyone thinks that a financial
institution will not grab a client’s assets, registered, or not when they
want to pay down their loan, just ask around.
Many lenders will want to treat an equity take out mortgage as a higher risk
second mortgage, or they may try to have it CMHC insured at an added cost to
the client. If the clients existing first mortgage and new second mortgage
are in total less than the 75% of the appraised value of the home then fist
mortgage rates apply and CMHC insurance is not required. This is an important
negotiating point, which the client on their own is usually not up to arguing
with the bank. As the advisor you can calculate an accurate loan to value
ratio (LVR) and be the negotiator with the lender. In fact our loan proposal
form shows the rate and terms we are looking for. So the lender knows before
they even get back to us what we expect from them. After you have done a few
deals with a lender and they have found your information to be credible, they
quickly get to know what you expect if they want your referrals and the your
client’s business.
In some cases we are also negotiating loans that are not secured by the
client’s home. But the equity take out mortgage is our favourite because it
does not require a personal guarantee and usually carries a much lower
borrowing rate. Our work can be seen as financial advisor, debt consultant
and then investment advisor. In either case, our fee is deductible to the
client for this service in addition to any application fees, appraisal costs,
etc. which they may be required to pay.
There is some truth to the old saying that: “A bank will only loan you money
when you can prove that you don’t need it.” However an experienced advisor
that believes leverage is right for their client can usually arrange for the
funds. For the client that does not have a lot of assets for collateral, or
room for very much debt servicing, a monthly saving program should be
considered if debt re-financing is not workable. There are many programs on
the market that will loan one dollar for every dollar invested thus starting
a leverage program on a small scale, but almost doubling the clients’
investment potential. But read the fine print in the loan agreement. Keep in
mind that the same potential for gain has a potential for loss as well.
However, by investing for the long term that risk can be minimized.
Borrowing To Invest With No Tax Relief
Often debt can be used to meet other financial planning situations even if
there is no tax relief. The obvious is of course debt consolidation, or the
raw-land example mentioned earlier. However there are many other
opportunities worth considering. One common example is a parent(s) who want
to help their children but the children are not financially responsible
enough, or they do not have any debt servicing room. Often parents are
reluctant to give up capital for fear they may need it later in retirement.
They may be sitting on a lot of equity in their portfolio or their homes,
which they are not using. Taking a loan in their name and buying a portfolio
of investments in their name in Joint Ownership with their adult child has
some interesting uses. Firstly, junior cannot cash the investment without the
parents blessing. In this case, at least half of the loan interest could be
deductible. The estate can pay off the loan at death. The portfolio will pass
automatically, without probate to the adult child at the parents’ death. The
value of the portfolio can be deducted from the child’s share of the
inheritance as per the will. The portfolio can even have the income paid to
the adult child if the parents want to help out without giving up the capital.
If junior is in bad shape financially, or he already has numerous loans,
mortgages, or credit card balances, this can help while still protecting the
parents. This arrangement need not be a part of the matrimonial assets if
juniors’ marriage breaks up.
For the same reasons, the client can take a loan or a mortgage to help their
favourite charity. In some cases servicing the loan is more attractive than
using their own capital and may have immediate tax benefits. In cases where
the clients’ do not want to use their own assets for fear of triggering a
capital gain the loan route has some advantages. If the asset with a capital
gain is a listed security it may now be advantageous to donate the listed
security to the charity directly so as to benefit from the new 25% inclusion
rate. If they do not want to realize any capital gains then a loan could be
the answer. In a year of unusually high income, a sizable tax deduction can
solve a lot of problems and help the charity at the same time. Paying off the
loan from their eventual estate also reduces the net estate subject to
probate fees.
Even using a life insurance policy as collateral for the loan entitles the
borrower to a much lower interest rate at a bank, while freeing up capital
for other purposes. But, mainly it can avoid any taxation resulting from
borrowing directly form the insurer, or cashing out the policy and triggering
an income inclusion for the year. Even though an old life insurance policy
may have a low guaranteed loan interest rate, a large loan will usually
produce a tax slip at the year-end for the amount borrowed in excess of the
cost base. Many people are very surprised when they inquire as to the cash
value of their old life insurance policies if they have also been reinvesting
the dividends or using them to automatically buy paid up additional insurance.
The problem is that many of these old policies have a cost base near zero.
The loan cost may become deductible depending on what the funds are used for.
But by using them as collateral they can use the funds for other purposes and
leave the loan in place to be paid off from their estate with the tax-free
proceeds from the life insurance policy.
For many years we have used second mortgages to help our children and client’s
let the kids get into their first home. These are participating mortgages at
zero percent interest drawn for the percentage the loan bears to the purchase
price. So if the parents loan the kids 10% of the purchase price of the home,
they receive 10% of the proceeds when it is sold. However, for the kids it
allows them to get into a home sooner, does not affect their debt servicing
ability, protects the capital in the event of a marriage breakdown and allows
the parents to have a leveraged investment without any annual income to add
to their tax until the property is sold. For another article on this subject:
Click Here
Registered Retirement Savings Plans (RRSP) loans have been around for a long
time and are popular in Canada with those people who can’t seem to get ahead
and start on a Pre-Authorized Cheque (PAC) program. The rates are quite low
and the loan can be paid off quickly if the client has the fortitude to apply
the tax refund to the RRSP loan balance. I have always advocated one-year
RRSP loans. But in some cases a client with a large unused contribution room
can do some major debt refinancing by use of a large RRSP loan and perhaps a
longer payback period if necessary. Some interesting scenarios can be
developed to restructure non-deductible debt. A simple example is a client
with 10,000 of credit card debt and 20,000 of contribution room who takes an
RRSP loan for 20,000 in February. The tax refund at a 47% marginal rate would
be $9,400.00 to be received within a few months. That plus the regular
payments for a couple of months until the refund arrives should be sufficient
to discharge the debt. Of course the client has to make payments on the RRSP
loan for the year, but the interest cost on the debt is cut almost to a
quarter of the credit card rate and within a year they are debt free. It also
prepares the way for them to pay of future charge card balances each month.
Reverse mortgages are another example of non-deductible debt that can on
occasion be the right answer for unique situations. We have used this in the
past where a client does not want to downsize, but needs additional income
Although a client’s non-deductible debt is a financial planners worst
nightmare, there are cases where it can be used to meet some of the client’s
wishes.
Using Debt To Achieve Other Goals
Often the client is willing to undertake a leverage-investing program if it
helps them reach another goal that may be more important to them. For
instance many seniors find the Clawback of their Old Age Security (OAS) to be
very upsetting to them. If after all of the other income sheltering methods
have been used, the client will still be exposed to clawback, leverage can be
very appealing to them. Interest paid to purchase investments is of course
deductible the year it is paid. This reduces their net income and can put
them back on the receiving end of the OAS. By lowering their income with the
use of leverage they increase their eligibility for other government
programs, which are income related, such as health care and home-care costs.
Income Splitting is probably the greatest benefit that can be achieved with
debt. Where the client’s goal in the long term is income splitting, a
leverage loan by the higher income earner with a low interest rate to the
lower income spouse can help achieve the goal. It is important that interest
at the prescribed rate, or a commercial loan rate at the time the loan is
made, be paid with thirty days of the end of each year in order to avoid the
attribution rules. A promissory note should be in writing to evidence the
legal obligation to pay the interest. With the current low interest rate
environment it is an ideal time to consider a loan to a lower income spouse,
so as to lock in a low interest rate for a long period. In this case the loan
paid by the spouse is a deductible expense to the lower income spouse. Even
though the investments may be held in Joint Ownership for estate planning
purposes it need not affect the interest deductibility if the loan and
investment transactions are well documented.
An understanding of interspousal transfers and attribution rules may at first
be intimidating. However, a little time spent understanding the rules reveals
many planning opportunities. The CCRA Interpretation bulletin # IT-511R is 35
pages long and a perfect cure for insomnia. If you can get through it, you
will find other ideas on how to help your client while staying within the
spirit of the rules.
There are many variations for income splitting, both deductible and non-
deductible, including reverse attribution. For children remember that capital
gains do not attribute back to the parent. There is no attribution to parents
on income reported by an adult child.
For new clients that come to you with prior unrealized losses the gain can be
realized and the proceeds from the investment applied to any non-deductible
debt. After thirty days the client can repurchase the investment if desired
form funds acquired from new borrowing and thus have the cost of carrying the
investment tax deductible. The realized loss can also be carried back up to
three years to be applied against prior capital gains. Recent rulings by the
Supreme Court of Canada have reinforced the rules about the deductibility of
loan interest.
Summary
We have found that even the wealthy like to use leverage to invest even if
they do not need to accumulate more assets. It is for some, just part of the
game of wealth accumulation. For others it gets them to where they want to go
faster. For the advisor it is a powerful tool to get the client to where they
want to go. Everyone knows that any portfolio that can go up 20% or more in a
year can also go down 20% or more in a year. The trouble of course is that
the loan still needs to be repaid regardless of the value of the portfolio.
Although leverage can be a high risk if not handled properly, arranging the
debt properly can minimize the risk to the client. By starting small if
necessary, the client can get comfortable with the process and still have
funds elsewhere for use when needed. The larger the loan the more important
it is to protect the client against margin calls, or calls on a demand loan.
Choosing the correct investment mix for the portfolio is very important.
Coordinating the proper terms of any borrowings is just as important a part
of your fiduciary responsibility to the client. Used properly, leverage can
be a great tool for you to help your client reach their goals.
Copyright – www.money-software.com
Peter F. Baigent CFP, CLU, CHFC, RFP. is a Past President of the Canadian
Association of Financial Planners for British Columbia, a former Director of
the Canadian Association of Financial Planners. He has spoken across Canada
on financial planning matters and has taught courses for the Chartered
Financial Consultants & Certified Financial Planners degrees. He is the
founder of Money Minders Software which produces financial planning software.
|
