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| Adrian Mastracci, president
of KCM Wealth Management, says “Without
a doubt, incurring non-deductible loans is
very costly. It’s a sizeable impediment
to building a nestegg. Even in a low tax rate.” |
For Immediate Release
Vancouver, BC (July 28, 2003):
The borrowing landscape has changed considerably
since late 2000.
Adrian Mastracci, investment
counsel & financial advisor with Vancouver
based KCM Wealth Management
comments, “Virtually all categories
of loan interest rates have posted significant
reductions since the end of 2000; credit card
rates being the notable exception. Some historical
lows are still being made.”
"North America has a large appetite for
new borrowings and refinancing of existing debts,”
mentions Mastracci, "This poses a wonderful
problem for borrowers; however, it is a double-edge
sword."
“There is enormous pressure on paycheques.
The low rates have enticed many borrowers,”
Mastracci continues, “For example, the prime
rate dropped from 7.5% in December 2000 to 4.75%
today. Five year mortgage rates hover near 5%.”
“During this panacea many have incurred
debts beyond their comfort zone. Along with a
never-ending stream of payments,” points
out Mastracci, “Perhaps, even flirting with
financial ruin. No wonder the nesteggs get chipped
away.”
“While low rates are a temporary blessing,”
says Mastracci, “More personal bankruptcies
and mortgage arrears will surface when interest
rates begin to climb.”
“Whenever possible, borrowers are better
off to incur interest costs which are deductible
for tax purposes,” notes Mastracci, “And
to pay off non-deductible loans as quickly as
possible.”
Mastracci illustrates the impact of loan interest
deductibility with the following table. It demonstrates
the effective costs of a typical 6% loan rate,
for both deductible and non-deductible interest,
calculated for three general income tax rates:
“Let's understand the implications of deductibility,
say in the 35% tax rate,” mentions Mastracci,
“If the loan interest is non-deductible,
the borrower first has to earn 9.2% and pay income
taxes to have the 6% for the interest. If it's
deductible, the real cost is 3.9% after the tax
savings.”
“There is no risk free 9.2% return in today’s
investment climate,” explains Mastracci,
“The 5.3% cost difference between deductible
and non-deductible interest is too significant
to pass up.”
“But is the borrower sitting down?”
muses Mastracci, “A non-deductible 18% credit
card rate really costs 27.7% in the 35% tax rate.
Ouch, that smarts!”
“Without a doubt, incurring non-deductible
loans is very costly. It’s a sizeable impediment
to building a nestegg,” says Mastracci,
“Even in a low tax rate.”
Mastracci offers these suggestions to manage
borrowing and repayment strategies:
- Don't overindulge in debt of any type. Especially
credit card debt.
- Review the devastating effect of a rising
rate scenario on loans coming due in the next
three years. Examine if consolidation or refinancing
of existing loans reduces the interest costs.
- If there is only one loan, and the interest
is non-deductible, establish an appropriate
repayment plan so that interest costs are minimized.
- If there is more than one of loan, segregate
each loan so that there is no confusion if any
of the interest is considered deductible.
- If both non-deductible and deductible loans
exist, make “interest-only” payments
on the deductible loans. All saving capacity
repays the non-deductible loans, starting with
the highest rate one.
- Business owners should segregate business
loans from personal loans. Repay the personal
non-deductible ones first and leave the others
at interest-only.
- Be extra careful with an investment loan
where the asset purchased has been sold. The
interest cost on the remaining loan may no longer
be deductible.
- The borrowing incurred for the RRSP is not
deductible.
- Perhaps a personal stock or mutual fund (outside
the RRSP/RRIF) is showing a significant loss.
It may be time to take the medicine, sell it
and use the proceeds to reduce a loan.
- Read the mortgage prepayment clause. It may
allow an additional 10% to 20% per year reduction
of principal, or the doubling up of the monthly
payment, without incurring an interest penalty.
- Obtain an amortization schedule for the mortgage
along with some “what if” scenarios,
such as how to pay it off in half the time.
- If the finances permit, reduce the home mortgage
amortization from the typical 25 years to the
10 to 15 year ballparks. The bundle of interest
saved helps immensely.
- Transfer credit card balances to a line of
credit and allocate the interest savings to
the repayment of non-deductible debt.
- Don't take no for an answer. Shop around
if the lender is not receptive. Many of the
posted loan rates are flexible.
“Use good judgement, formulate borrowing
strategy and stay out of financial trouble,”
summarizes Mastracci, “Chipping away at
the nestegg is like encountering a series of speed
bumps.”
“Avoiding the common pitfalls of borrowing
builds the nestegg sooner,” concludes Mastracci,
“In short, borrow when necessary, repay
it as quickly as possible and examine the interest
deductibility.”
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