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How Wasting Freezes Can Warm Your Children’s Hearts: Advanced Strategies for Lowering Your Final Tax Bill

Previously, I have waxed (hopefully) poetic on the potential tax benefits on the sale of the family business or upon the death of key shareholder in that business or the family holding company by implementing an “estate freeze” many years in advance.  In simple English, an “estate freeze” typically involves reorganizing the share structure of the company so that the older generation swaps their shares that have previously increased in value for fixed value for preferred shares worth the same amount and with the same unrealized tax liability.  As a result of these machinations, unless tax rates change in the future, mom and dad have now capped their final tax bill on their company shares. Accordingly, in some cases, keeping future growth out of mom and dad’s hands may be the difference between the kids having to sell the company or mortgage it up to its eyeballs in order to pay their parents’ final taxes versus the company successfully transitioning to the next generation.

At the same time as mom and dad swap their common growth shares for fixed value preferred shares, a new class of common shares are created and either issued to younger members of the family, or, as is more common, issued to a family trust mom and dad control that lets them decide later who will get these new shares. Thus, the future growth of the company, which will show up as an increase in value to the new common shares, will no longer be taxed in mom and dad’s hands. In addition to potentially saving the company for future generations at the parents’ death, this can also potentially save the family scads of tax dollars if the business is instead sold during mom and dad’s lifetime. By having the future growth taxed in the kids’ hands, the family can now tap into the kids’ separate lifetime capital gains exemption for small business (about $900,000 at this point for most businesses, but $1,000,000 for farmers and fishers) against this growth. For example, a family of 4 could now minimize tax on approximately $3.6 million of growth rather than just mom and dad’s combined $1.8 million. In most provinces, this represents tax savings of easily more than $400,000 for the example just shown.

Unfortunately, by the time some families get around to implementing a freeze, the value of mom and dad’s shares may have already reached stratospheric heights. Thus, although the freeze may still save the family buckets of future tax dollars, unless the family also engages in other planning, that final tax bill on mom and dad’s death or the sale of the company during their lifetime may still be enough to make stoic men swoon and brave women cry.

Today’s article talks about taking an estate freeze to the next level so that it not only caps mom and dad’s future tax bill but actually reduces it. This is what us lawyer types call a “wasting freeze”, a name tax and financial planning professionals like to use to make our jobs sound slightly sexier.  

While a plain old vanilla estate freeze is typically a one-time event, a wasting freeze usually involves yearly steps after the original freeze has been completed in order slowly chip away at mom and dad’s unrealized tax bill. Just like it typically takes years for a company to grow, it usually also takes many years to systematically reduce the value of mom and dad’s shares without paying too much tax along the way.

This gradual process of reducing mom and dad’s future tax liability is accomplished each year at tax time and can often occur without triggering any or minimal extra tax along the way. For example, even though mom and dad are transferring future growth in the company to their kids, they may still want to continue receiving their typical annual income from the company in order to support their hopefully lavish lifestyles. Post-freeze, mom and dad will likely get paid exclusively through company dividends.  If they were getting paid the same way and the same amounts previously, their yearly tax bill won’t change. If they were receiving a mix of salary and dividends previously and want to have the same amount of after-tax money in their pockets, the increased combined corporate and personal tax hit will still be minimal at worst.

Using dividends in a slightly different way than usual makes the magic happen.  Most of us who own shares in public or private companies simply receive our dividend payments from time to time while continuing to own the same number of shares after getting paid. A wasting freeze instead involves the company retracting or the shareholder redeeming some of the newly issued preferred shares in exchange for dividend payments.  It’s a lot like selling the shares back to the company but for tax purposes, the transaction is treated differently than a typical sale. In this scenario, the shareholder unloading these shares is taxed on the money received as dividends rather than capital gains. Even better, the capital gains otherwise payable is ignored. In the end, if mom and dad were receiving exclusively dividend income previously and continue getting the same amount post-freeze, their current tax bill won’t change but their future capital gains tax hit is slowly but surely going down.

This is best explained by way of an example. Assume that mom does an estate freeze and now owns $2 million worth of preferred shares, all of which will be taxed as a capital gain upon her death. She has always received $100,000 in dividends from the company and will continue to do so going forward. Rather than merely receiving annual payments for this sum without surrendering any of her company shares, she now “redeems” $100,000 of her shares each year.  She is taxed on the dividends in the same way as she’s always been taxed and the unrealized gains on the $100,000 of shares no longer in her hands is ignored. As a result, 5 years later, she has redeemed $500,000 worth of preferred shares, now only owns $1.5 million worth of shares and will have lowered her final tax bill by as much as about $130,000 if she lived in British Columbia. And all of this happened without her having to pay any more tax over these 5 years than she would have otherwise.

But, the taxy excitement doesn’t stop there. If you’ve laboured through some of my articles on how companies are taxed and the different type of dividends (available at www.colinsritchie.com) or are a tax geek, you’ll know that all dividends are not created equal. For private companies in Canada, you have your choice of three different types of dividends, all of which are taxed differently. If used strategically, correctly allocating dividends can both accelerate the timeline for reducing mom’s future tax bill and even reduce her tax bill along the way. They are as follows:

  • Small Business / Ineligible Dividends. These are generated either by business income that was taxed at the small business rate of 11% in B.C. or from investment income such as either interest, rent or the taxable 50% of capital gains realized by a company taxed as investment income at really, really high rates, 50.67% in B.C.  (although much of this is refundable to the company if they pay out enough dividends to shareholders.) Because this money was taxed in the company at either a really low tax rate or generates a large tax refund to the company paying those dividends, people receiving these payments get only a small tax credit to apply personally.  If receiving no other income, someone getting $100,000 in non-eligible dividends in B.C. would pay less than $15,500 in tax (i..e, about 15.5%.), factoring in only the personal tax credit and ignoring things like the OAS clawback.
  • Eligible Dividends. These arise from either the portion of active business income that wasn’t taxed at the small business rate (i.e., 27% in B.C. rather than 11%) or from eligible dividends the company received from other companies, including any investment dividends it receives if it owned shares in Canadian publicly traded companies. Because either your company or the company paying investment dividends to your company paid a lot more tax corporately on the money left to pay you dividend, shareholders receiving eligible dividends enjoy a much more generous tax credit personally when receiving these dividends.  If receiving no other income, someone getting $100,000 in eligible dividends in B.C. would pay less than $7,600 in tax (i. e, about 7.6%), factoring in only the personal tax credit and still ignoring the OAS clawback.
  • Capital Dividends.  Capital dividends are tax-free to the receiving shareholder and are the holy grail of the dividend world. They were created as a way to pay tax-free money to incorporated business owners from the non-taxable 50% of any capital gain realized corporately so that they get to put that money into their personal bank accounts just like non-incorporated business owners could. Likewise, because someone personally receiving a life insurance payout on death gets that money tax-free, most of a corporately owned life insurance policy can be paid out of the company as tax-free capital dividends. Thus, someone receiving $100,000 worth of capital dividends still has $100,000 to spend any way they fit rather than having to share some of this with Ottawa.

Strategically allocating the right type of dividends each year to mom turbo charges the benefits of a wasting freeze. Although mom in our example received a fixed $100,000 per year in order to keep her tax bill to a manageable level and perhaps because she didn’t need any additional money, the family had “only” reduced her final tax bill by approximately $130,000 after 5 years or by 25%. If mom was in her 90’s rather than 60’s, the family might consider speeding up the process. On the other hand, because tax rates increase as income increases, at a certain point, it becomes counterproductive to pay mom out any more taxable dividends, as the tax rate on the last dollar paid will eventually exceed the amount of tax mom would have paid on that dollar at death if taxed as a capital gain. Moreover, paying that tax ahead of schedule only makes sense most of the time if paying at a significantly lower rate, as every dollar paid in tax is one less dollar left to grow along the way.

That’s where capital dividends might come in. Assume that the company sells a building or bank shares inside its investment portfolio at a profit, triggering a capital gain. In such years, the company might use some of this tax-free money generated from the sale to retract more of mom’s shares than it normally does, since it won’t impact her current tax situation but can profoundly reduce her bill at death.  Likewise, if there was a life insurance policy inside the company on dad that paid out, the company could then redeem a bunch of mom’s remaining shares in one fell swoop if desired, or even some of the shares she inherits from dad.  Although I could easily write an entire article on using life insurance both as part of a wasting freeze and to also reduce mom’s own tax bill at death if there was also a policy on her life, I’ll leave that for another day. For now, I’ll just say that corporately owned life insurance has some surprising tax advantages if used correctly and  it’s usually worth a second look, no matter your views on the life insurance industry.

Wasting Freezes and Selling the Family Business

As noted earlier, a family can save an enormous pile of money if it is able to tap into several family members’ separate lifetime capital gains exemptions at sale, if the unrealized gain at sale is significantly higher than can be otherwise sheltered under the original shareholder(s)’ exemption. If the freeze is implemented after the value of the original shareholder(s)’ shares are already well above that mark, mom would still be stuck with a large and potentially unnecessary tax bill. Secondly, it may take several years for the new common shares to grow in value, so that the new family members can tap into a significant amount of their capital gains exemption.

A wasting freeze can help with both problems. Imagine a business worth $3 million at the time of the freeze and unrealized gains of the same amount, with mom and dad each owing $1.5 worth of shares.  They hold the new common shares in a trust that names them and their 3 adult children as discretionary beneficiaries. They plan to sell the business in about 5 years and each of the parents typically takes out $100,000 per year in dividend income. Assume that the business is worth $4.5 million at the time of sale. If they took no further steps, only the $1.5 million in future growth in the company can be sheltered using the kids’ capital gains exemptions, with mom and dad facing a combined tax bill on $1 million of gains (approximately $267,500 if at the highest BC tax rate, assuming that the lifetime exemption has increased to $1 million per person by the time of sale ($3 million in total gains minus $2,000,000 of gains sheltered under the lifetime capital gains exemption.)

If mom and dad get wasted (i.e., use a wasting freeze strategy) instead, they will be able to avoid the potential $267,500 tax bill completely. They will have redeemed $1 million of their preferred shares along the way. Each dollar of preferred shares redeemed simultaneously boosts the value of the kids’ common shares. Accordingly, at the time of sale, mom and dad’s shares have decreased by $1 million to $2 million, which they can shelter under their own exemptions, and the value of the kids’ shares has increased by the same $1 million.  Accordingly, the kids would collectively declare $2.5 worth of gains, all of which can be sheltered under their own capital gains exemptions. When the dust settles, the family now keeps an extra $267,500 without having to pay any extra tax along the way to make this happen.

Wasting Freeze and Holdcos

In some cases, it might actually be worth creating a holding company to hold a non-registered portfolio with significant unrealized capital gain both to cap the future gains and in order to use a wasting freeze to whittle away at the future unrealized tax bill produced by of decades of buy and hold investing in blue chip stocks. The existing portfolio can be rolled into the new holdco without triggering any taxes due to another wrinkle in the Income Tax Act, although the shares will still be taxed on their existing gains when eventually sold inside the company. There are a lot of pros and cons to this strategy, plus other options to consider, but if the plan is to keep the portfolio intact for the next generation without having to sell too many RBC shares at your death, this is one potential way of making that happen.

Conclusion

Although an estate freeze can be a wonderful tool for minimizing a family’s taxes and increasing what is left behind for future generations, sometimes it needs a helping hand. By annually redeeming freeze shares after the freeze has come and gone, diligent shareholders can systematically lower their eventual tax bill on their corporate assets at death or sale. Insurable shareholders can even take it one step further by purchasing insurance on themselves that can be used to redeem freeze shares on death by paying out capital dividends (although more so on the first death) to reduce the tax pain eventually faced by their estates. Although these options need to be considered carefully with the help of seasoned number-crunchers, the savings and benefits can be enormous.

Warming Hearts Through Estate Freezes

Imagine ordering a large drink late in a steamy August afternoon after just completing a day’s toil in the sun. After several thirsty minutes waiting, watch in rapturous delight as the waitress finally brings over a tall, frosted glass, beaded with moisture . . . only to discover that it’s mostly ice. For lawyers and financial planners like me, that’s what I see when calculating actual size of the estate many of my clients will leave to their heirs after paying taxes. Although there are many ways to cut down on the ice quotient, the one I want to talk about today is called the “estate freeze.”

In simple terms, a freeze operates to cap or “freeze” the amount of unrealized capital gains on company assets that is taxed on when the grim reaper comes calling for that freezing shareholder. The freezer swaps the common shares that have grown in value for one or more classes of fixed value preferred shares that maintain control over the company but won’t participate in future growth. Instead, the company issues new common shares that are currently without value to the next generation or to a trust that the freezer controls and, when a holding company’s portfolio skyrockets higher or an active business’ widget sales go through the roof, those new common shares soak up all the new growth. Although the freezer will still need to pay tax on any unrealized gains on the preferred shares (s)he owns after their last gasp, (s)he will have at least minimized the tax (although not emotional) pain for those left behind.

Obviously, timing when to do the freeze makes a profound difference to the tax savings the freezer’s estate will eventually enjoy. If the company doesn’t continue to grow in the future or if the freezer dies within a year or two of implementing the freeze and the new common shares haven’t yet had a chance to significantly increase in value, then the whole exercise was likely a waste of time. On the other hand, for a company that doubles in value over 5 years, the savings to the deceased’s estate can be over $250,000 on every million dollars of gains that would have otherwise been taxed in their hands at this point. If amount of capital gains that are included in income and are taxed increases in the future, as many worry, the savings could be even more. For example, if the inclusion rate for capital gains increases from 50% to 75%, a properly done freeze could save the estate $375,000 per million dollars of capital gains avoided.

When to Consider Getting Chilly

Whether a freeze is worth considering depends on a host of factors. Perhaps the biggest are how much have your company shares already increased in value and how much will they continue to grow before your death if you leave well enough alone, as noted earlier. As a friend of mine once said, ask yourself if the juice (i.e., the benefit) is worth the squeeze (the cost and effort involved in extracting the relevant breakfast beverage.) The best candidates for a freeze own active businesses that they are looking to either pass down to the next generation or sell to an outsider. In the first case, minimizing the tax bill at death may make the difference between a business staying in the family poised for continued success or either a forced sale to pay the taxes owing at death or hamstringing heirs with large bank loans in order to pay that bill.

If the goal is instead to minimize taxes on an eventual sale, capping the original shareholders’ share value and transferring future gains to other shareholders allows more family members to claim the lifetime capital gains exemption on their shares upon sale. Every shareholder can avoid most of the tax on almost $900,000 in increases to the value of their shares at this point (the exempted amount increases yearly due to inflation) if they and the business satisfy certain criteria. By doing a freeze to transfer future growth to spouses and children, etc. after your own shares have unrealized gains of about $900,000 can mean hundreds of thousands of dollars in savings in some cases. For example, someone doing a freeze when her shares have grown by $900,000 in value in favour of her husband and 3 children in the expectation that the company would be worth $4,500,000 upon sale may be able to avoid capital gains tax entirely at that time. In that example, the new common shares owned in a family trust would be worth and could be apportioned equally amongst her hubby and children so each could shelter $900,000 of growth, with mom using up her exemption on the $900,000 in shares she retained after the freeze.

By contrast, if she does nothing, remains the sole shareholder and owns $4,500,000 worth of shares at sale, the tax bill could easily exceed $900,000 at today’s levels and far more if the inclusion rate for capital gains climbs in the future. As an added bonus, in some cases, a freeze might help a family save tax along the way by allowing them to sprinkle dividends to qualifying adult family members who actively work in the business but whose salaries aren’t enough to optimize the family’s annual tax savings.

On a related note, a freeze requires an accountant or business valuator to put a value on the company at the time of the freeze. Businesses hit hard by Covid may be able to turn this to their benefit if they are confident that the blip in value is short-lived by doing the freeze based on the current Covid-influenced levels so the new common shares can reap the rewards when the economy and business value both improve.

On the other hand, freezes are not just for active businesses. Doing a freeze for your holding company can still save your family a host of potential taxes on your eventual passing, particularly if combined with some of the other options I talk about in my next article on “wasting freezes” and share redemptions on death using life insurance. As I will also discuss, investors with large non-registered portfolios or perhaps rental properties might even consider setting up a new holding company, then rolling those assets into the company on a tax deferred basis (but do watch out for property transfer tax) to cap the future tax bill owing at death. This strategy works best if the plan is for the children to keep the assets, such as a real estate portfolio, for the long term after your death but can even mean huge savings if that isn’t the plan in some cases. If nothing else, it may provide your heirs with the flexibility to wait a few years after your death for the real estate or stock market to improve rather than forcing them to sell as soon as you’re in the ground in order to cover your final tax bill.

Reasons for Giving Freezes the Cold Shoulder

Admittedly, freezes are not for everyone. Besides taking into account the cost of doing the freeze and any additional annual expenses that might result, particularly if creating a family trust to hold the new common shares or setting up a new holding company, I suggest taking the following into account:

• A freeze may only delay the day of reckoning. Although shifting part of the potential tax bill from one generation of taxpayers to another is often great tax planning, it might not be so beneficial if the kids will need to wind up the company in short order anyway. It still may be worth proceeding if the freeze provides the heirs with some discretion regarding when to sell assets like real estate or if there are still tax savings to be had despite the desire to wind thing up shortly after your death.

• A freeze only works if the company continues to grow or you use the aftermath of the freeze to decrease the value of the freeze shares. If you plan to draw down the value of any company during retirement and suspect that it will eventually be worth less than it is now, then a freeze is not for you. The only exceptions may be if you also do a “wasting freeze” during retirement, as I discuss in my next article, to more actively transfer some of the capital gain tax bill to the next generation.

• Are you too young? If doing a freeze using a family trust, realize that the trust has an effective lifespan of 21 years in this situation, as all unrealized gains inside the trust are taxed on its 21st anniversary. Although the shares can be transferred out of the trust on a tax-free rollover basis at any time prior to then, some parents may not be keen to gift the shares directly to the children at that point, particularly children with rocky marriages, financial issues or similar problems. On the other hand, 21 years is a long time for children to get their act together and the parents can always just allocate the common shares to back themselves if that has not happened. This would undo the benefits of the freeze but it is always good to have this option if life does not turn out as expected.

• How much does control matter? How solid are your children’s lives? Practically speaking, doing a freeze doesn’t mean having to give up control of the company if the freezers retain all of the voting shares and control the family trust that also owns the new common shares. This allows them to continue with business as usual inside the company and to continue to pay themselves as many dividends and as much salary as their hearts desire and the Income Tax Act allows. If shares are gifted to the children directly, there is less control, which increases the chances of problems if a child is divorced or has creditor issues. Even if the shares are held in a trust, there are at least theoretically potential problems if one of your children divorces. One way of minimizing that risk is making it a precondition of the freeze than any married children get prenuptial or marriage agreements excluding the value of any shares from any divorce settlement.

• Are there other tax fighting weapons in the armoury? A freeze can be a silver bullet in the right circumstances but a empty shell in others compared to some of the other tax minimizing options available. Corporate life insurance can help minimize, reduce or pay the final tax bill, particularly if there is a big tax-free payout on the first death. Loaning money to a family trust (assuming most of your capital gain assets are outside of a company) at 1% so you can actually sprinkle income to your descendants now can be a really effective strategy in many situations. Even if you have to pay more tax now to get a critical mass of assets into the trust, it might be a blessing in disguise if the taxable amount of capital gains increases in the future anyway. Unfortunately, the trust idea may not be a particularly useful one if most of your assets are held corporately.

Conclusion

The tax bill faced by many estates on their corporate assets or non-registered holdings often takes a very big gulp out of what taxpayers want to pass along to their heirs, but proper estate planning can often reduce that large gulp into a small sip. Implementing an estate freeze many years prior your final passing may be one way of making that happen. In my next article, I’ll discuss some ways to supercharge the benefits of a freeze to hopefully make that final sip of taxes into a mere moistening of the lips.

Should I Stay or Should I Go Now – Whether or Not to Refinance Your Mortgage and How To Ease The Pain

Covid 19 is the sort of financial tsunami that bowls over and swamps all but the most conservative of financial projections. As we slowly begin to pick ourselves up, dry out our wet clothes and figure what comes next, I am suggesting to many of my homeowner clients with fixed rate mortgages to look at their existing mortgages to see if there are any opportunities to turn at least some of the lemon that is Covid into perhaps a shot glass full of lemonade.

When diving down into the rabbit hole of mortgage refinancing calculations, many surprises may await. Accordingly, I strongly suggest that you arm yourself with the expertise of an experienced mortgage broker like my friend and fellow Moneysaver contributor Russ Morrison that has been around the block at least twice to help you maximize savings and minimize unnecessary bank penalties.  And, after crunching the numbers, if you believe that it does make sense to pay whatever penalties come with paying up your current mortgage, it’s just as important to ensure that your shiny new replacement mortgage provides you with as much flexibility and as many features as possible in order to hopefully help you continue to save for many years to come. Don’t worry – I’ll save that next topic for another article.

How it Works

Trying to understand the ins and outs of whether or not it makes sense to pay down your existing mortgage ahead of schedule is a lot like trying to read a book in a foreign language upside while not wearing your glasses – extremely frustrating, confusing and open to misinterpretation. I’ll talk about the details of how this is calculated in a second, but at the end of the day, these calculations determine whether the savings you’d reap under the new mortgage would be enough if you continued your current payments going forward to pay down the mortgage penalty that you’d be adding to your new mortgage by the time your old mortgage expired. Put another way, if your mortgage balance would be $500,000 after taking advantage of all the prepayment options I’ll discuss later to lower your penalty, with 3 years until renewal, and your monthly payments are $3,500, would a new mortgage for $515,000 (current balance plus an arbitrary $15,000 penalty) and $3,500 in monthly payments leave you with a smaller mortgage balance 3 years from now than would be the case if you just kept paying down your current mortgage? If so, and the hassle factor and any associated costs from making the change aren’t too significant, then you’d want to look at making that change. I highly suggest getting your broker to spell out any additional costs or other downsides in advance so that you’re not surprised later. For example, will there be any legal or appraisal costs and, if so, how much?

Furthermore, if you want access to a new secured home equity line of credit (“HELOC”) from your new lender, how do those rates compare to what you currently have? HELOCs are usually variable and are also based around the bank’s prime lending rate. It is quite possible that in these days of Covid that your new HELOC rate might not be as attractive as your old one. You’ll need to take the extra interest you might be paying on the HELOC in the future into account before making your final decision if you’re planning on using your HELOC extensively going forward.

If your new mortgage is fixed term, then the calculations to determine whether you’re better off refinancing your mortgage are relatively straight forward. If you opt to go variable, however, then these calculations will need to take into account how your variable rate might change over the remaining balance of your current mortgage.  Although in these days of Covid, it is hard to imagine when rates might start to climb again, I still suggest taking this into consideration and crunching the numbers to include at least a rate increase or two at different points of time during the period in question. Taking on a variable mortgage does mean taking on more risk.  Factoring in what things look like if rates do climb, however how unlikely that may currently seem, forces you to see what could happen if life throws us yet another curveball. If you’re still ahead of the game despite these more pessimistic estimates, then you can proceed with more confidence and certainty. If the numbers no longer work, you can either stay with the status quo or, if the savings if rates don’t change are too much to pass up on, then at least you’ll have made an educated decision with a better idea of the downside if things don’t go entirely your way.

Calculating Your Prepayment Penalty

If you pay down a typical fixed rate mortgage ahead of schedule, it’s going to cost you. The penalty is generally whatever is higher – the interest you would have paid on the remaining balance of the mortgage over the next three months, or what they call the “interest rate differential” or (“IRD”), which is allegedly based on the difference between what you would have paid in interest over the remaining term of your existing mortgage vs. what you would have paid in interest over this same period on a fixed term mortgage at current rates for the remaining mortgage term. For example,  if you had 36 months left on your existing mortgage, the IRD would look at the interest you would have paid over those three years under the status quo minus the interest the bank can get now lending out your current mortgage balance to someone else based on their current posted 3-year mortgage rate. In theory, you are compensating the bank for not being able to get as much interest on the money you’re returning to them ahead of schedule when they have to lend it out to someone else now at lower rates.

There is one very important exception to the IRD calculations just discussed. Banks are only allowed to charge an IRD penalty during the first 5 years of your mortgage. After that point, they can only charge three months’ interest. Although longer term mortgages (i.e. like 10 years) are not particularly common (they are generally priced higher than 5-year mortgages for several reasons, one of which is to compensate them for lost IRD payments if the borrowers do cancel beyond the 5 year mark), if you’re the exception to the rule and already beyond the 5 year mark, you should have your mortgage broker on speed dial. You’ll be able to avoid the sticker shock that I’ll be taking about in the ensuing paragraphs if you do refinance.

Calculating a typical IRD penalty sounds pretty straight forward, but all lenders are not created equal and the devil is in the details.  For the naive, if your current 5-year mortgage rate was 3.39% and the posted rate for a three-year fixed rate mortgage today was 2.39% on a remaining mortgage balance of $300,000, you’d expect that the interest rate used to calculate your penalty would be 1%. Not so fast. Your original 3.39% rate was very likely not the “posted rate” advertised to the masses but a discounted rate that is referred to as the “bank rate” or the “discounted rate.” That is also true for the 2.39% rate currently posted – it’s likely that because the bank truly loves you and values your business that they would be willing to go a little lower than the posted rate, but only just for you, of course. As a result, the rate some banks use to calculate the IRD is the difference not between the actual 3.39% 5-year mortgage rate that you are currently paying and that 3-year posted rate of 2.39%, but the posted rate when you took out your mortgage two years ago and that 3 year posted rate. The difference between the posted rate and the bank rate on your original 5-year mortgage may actually be 2% or more higher in some cases! Thus, instead of using 1% (3.39% – 2.39%) to calculate your IRD, some banks might use 3% or more using this example (5.39% – 2.39%). Alternatively, they might get to the same 3% result by subtracting the 2% discount you received 2 years ago from the current 2.39% posted three-rate. Never mind that shorter term mortgages don’t get discounted nearly as much as 5-year fixed mortgages, nor that banks aren’t discounting their rates nearly as much these days in these times of Covid. Put another way, how many lenders out there do you think would be willing to discount their posted 3-year rate of 2.39% by 2% to 0.39%? In the end, there are currently a lot of horror stories regarding some potential prepayment penalties, particularly for those poor souls who aren’t refinancing in order save money under new rates but who might be losing their homes due to the financial crisis or are forced to refinance purely for cash flow reasons.

It’s important to note that banks aren’t the only way to get a mortgage in Canada. In addition to banks, or private mortgages, your choices include monoline lenders (lenders who only do mortgages rather than the whole array of products banks offer) and credit unions.  Generally, banks charge the highest penalties on fixed mortgages, although it really varies from lender. Bottom line: it’s vital to do your research prior to entering into your next mortgage to determine how lenders calculate their IRD penalties, as well as other key considerations like portability (the ability to transfer your old mortgage to your new home) and penalty- free prepayment privileges that can reduce any penalty if you do need to get out of your mortgage at a later date.

In the end, as Russ Morrison, licensed mortgage god, advises, picking the right mortgage is a lot more than just comparing interest rates. That’s why I suggest working with a mortgage broker rather than going it on your own. It’s free, you get to shop the entire mortgage market and you also get lenders’ best rates up front rather than only after you’ve found a lower rate elsewhere.  Perhaps most importantly, however, a good broker will walk you through the other considerations I’ve just discussed so the mortgage you pick fits you like a glove and you know how to optimize its features.

If it still makes sense to prepay your mortgage, there are a few things that might minimize the pain:

  • Be strategic when picking the time to pay down your mortgage. Get your broker to calculate both the savings and penalty happen to be if you pay down at different points in time. One of the big things to keep in mind, however, is that you won’t know for sure what the posted rate for the period closest to your remaining mortgage term will be in advance, nor the rate that you’d be able to get on the new mortgage that you will actually take on. If you try to get too cute, you may not be able to get the same mortgage rate offered today, which could more than offset any reduction to your mortgage penalty you might get by waiting. As well, using our previous example, if you wait until there are only 2 years left in your current mortgage, the IRD would look at the 2-year posted rate rather than the 3-year one. It could well be that the 2-year rate is lower than the 3-year posted rate, which means that, although the calculations would only look at 2 rather than 3 years of lost interest for the bank, the rate used to calculate that penalty may actually be higher: for reducing the IRD, you usually want the posted rate offered for the remaining term of your current mortgage to be high, not low so that the difference between the two rates (and thus, the rate used to calculate your penalty), is as low as possible.
  • Prepay the pain away.  When calculating the best time to pay down, it’s vital to remember that the penalty is only applied against the outstanding balance at the time of paydown.  Thus, the less you then owe, the smaller the penalty you’ll incur when repaying the bank’s dough. This will occur naturally over the lifespan of any mortgage, although if you’re still 25 to 30 years before it’s scheduled to be paid down completely, each payment at this stage is likely mostly interest anyway. There are steps you can take, however, to hammer down your mortgage balance before you pay it out and, as a result, significantly reduce any mortgage penalty. Most mortgages allow you to pay a set percentage of the original balance loan (a range of 10 to 20% is pretty common) each year in one or more lump sum payments. You may also be allowed to increase your regular payments by that same percentage, too, often without this affecting how much you’re able to prepay in lump sum payments. I’ll dive into the ins and outs of prepayment rules in a separate article but here are the basic things to keep in mind when looking at these options:
  • The early bird gets the worm. The earlier you start prepaying, the smaller your mortgage balance when it’s time to calculate the penalty.  Each prepayment means that every regular payment you make thereafter will be directing more money towards the mortgage balance rather than in interest payments. Just like when looking at investment returns over the long term, the magic of compounding also casts its financial spell when trying to reduce your mortgage balance by making extra payments as soon as possible.
  • Read the fine print and use it against them. Different lenders offer different prepayment percentages and features. Some allow you to make as many lump sum payments each year over a small minimum payment amount as your heart desires, while others aren’t as generous. Others may even restrict when you make your annual prepayments to a set date, such as each year’s mortgage anniversary! Since you’re stuck with these rules and limitations, it’s essential know the hand you’ve been dealt so you can employ these rules to your best advantage. For example, are the prepayment periods based on your mortgage anniversary or the calendar year? If you’re planning to pay down your mortgage, you could save you a lot of penalty dollars if you diarize the earliest date you can make your next lump sum prepayment and time your mortgage paydown for after you’ve done just that. If you have a 20% yearly prepayment privilege, getting to make an extra 20% prepayment reduces your mortgage penalty by that same 20%!
  • Let your HELOC lend a hand. Although taking advantage of the prepayment privileges propounded in the preview paragraph may sound promising on paper, it might be another thing entirely coming up with the money to make this happen in the real world. That’s where your existing HELOC comes in.  If you use your existing HELOC or even arrange a new one in anticipation of paying out your mortgage early to fund lump sum prepayments or also free up the cash to also increase your regular payments as well, this can take a huge bite out of that future mortgage prepayment penalty. And, when it’s time to take out that cheaper, lower rate mortgage, you can borrow enough to pay down the balance of the HELOC. Even better, since the prime lending rate has fallen so fast so soon, the interest you’re paying on it in the meantime may actually be significantly lower than the rate that you’re paying on your current fixed rate mortgage anyway.  Not only will you be reducing the penalty you’ll pay the bank down the road – you’re doubling down your savings by reducing the rate of interest you’ll be paying along the way as well!
  •  Consider using your TFSAs to turn the tide. If you’ve got a lot of money already tucked away in your TFSAs and you’re still struggling to come up with your prepayment, consider dipping into your TFSAs to come up with a bit more cash.  You can always borrow back the money to fill up your TFSAs as part of your new mortgage, although you will have to wait until the next January before you can replace the money you’ve withdrawn. This option works best for investors who don’t expect a lot of growth or income from their TFSAs between now and then, as the opportunity cost for reducing the prepayment penalty using your TFSA loot is the tax-free income and growth you would have received had you stayed invested. If you’re one of those people who have calendar prepayment privileges and want to make that final penalty-free prepayment in January before refinancing your mortgage, consider pulling your TFSA money out in late December if you want to minimize potential lost investment growth. Your new mortgage can include enough money to restock your TFSAs and you can start earning tax-free TFSA dollars once again with minimal opportunity cost. Just don’t try to claim a tax deduction on the money used for TFSA purposes, as that’s not allowed.
  • Cash in your cash accounts. Another potentially useful way to prepay that mortgage is to sell existing non-registered investments to raise the cash. There will be a tax bill to pay on any capital gains, so you’ll need to take this into account before making this decision. If you were going to be selling some of the investments anyway within the next couple years and are worried about having to pay more tax on capital gains in the future like I am, this might be something you could consider doing anyway. Want to stay invested? Perhaps you can use your HELOC to buy back those investments. Not only will this reduce your eventual prepayment penalty and perhaps even lower your combined interest rate if your HELOC interest is lower than your fixed rate mortgage, you can now write off the interest on the money you’ve used to repurchase those investments! If selling investments at a loss, however, be sure not to repurchase the exact same ones or wait for at least 30 days after selling to do so or you won’t be able to claim that loss for tax purposes. When eventually getting your new mortgage, you’ll likely need to pay down the existing HELOC, which might mean having to sell your investments again, but you can take out a new HELOC at that point with whoever is issuing your new mortgage or even look at carving out a separate mortgage just for investment purposes if that gives you access to a lower interest rate.Either way, try to keep the investment loan portion of your mortgage or any HELOC as a separate mortgage or portion of any HELOC for tax purposes. Not only will this make your accountant far happier, it will also likely save you a bunch of tax dollars going forward. If the debts are kept separate, you can arrange your finances so that you pay as little as possible towards your deductible debts and direct more towards your non-deductible ones. As a result, more of your debt and more of your interest will be tax-deductible, which can result in significant tax savings.

Final Considerations

When refinancing your mortgage, there may also be some opportunities to reduce your current expenses if times are tight. Although the break-even calculations assume that you’d continue your normal payments under the new mortgage and keep your amortization period (i.e. the number of years before your home is completely mortgage-free) the same, you don’t have to do either of these things.  Under your new lower rate mortgage, your minimum regular payments will probably be lower despite adding the interest penalty to the balance. If your focus at this point is on keeping your monthly costs lower, you could likely reduce those payments slightly and still have the penalty paid down by the time your current mortgage would have expired. Or, if cashflow is particularly tight, you might decide to decrease your payments and increase your amortization period which could significantly reduce your regular payment costs to make ends meet until your finances improve. At that time, when funds permit, you could look at increasing your regular payments under the prepayment privileges provided under your new mortgage in order to get things back on track. For some of us, the decision to pay down our current mortgage may even be based purely on reducing our regular costs even if the size of the penalty doesn’t otherwise justify making the change. If you’re in that boat, you’ll just have to make sure that you still qualify for a mortgage or to see if you have any relatives willing to act as guarantors.

Conclusion

Although 2020 has caused many financial problems for far too many Canadians, there may at least be a few ways of easing the sting and helping us get our houses back in order. For some of us, paying down our mortgage early might be one such opportunity.

Free Online Presentation November 6, 12:15 pm

Once more the World Money Show and Canadian Money Saver Magazine have generously invited meme to be part of their 3 day Extravaganza of investing and financial planning running from November 4 to 6.

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To register and find out more, please click on the following link:Registration Link: https://online.moneyshow.com/2020/november/canada-virtual-expo/speakers/ffvcms0311172/colin-ritchie/?scode=051449