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By: Adrian Mastracci
North Shore News
Business Section, “Loose Change”
Sunday, September 14, 2003
The borrowing landscape has changed considerably
since late 2000.
Virtually all categories of loan interest rates
have experienced significant reductions since
the end of 2000. Credit card rates being the notable
exception.
The low rates have enticed many borrowers. For
example, the prime rate dropped from 7.5% in December
2000 to 4.75% today. Five-year mortgage rates
hover around 5%.
However, during this panacea many have incurred
debts beyond their comfort zone. The never-ending
stream of payments place considerable pressure
on paycheques. More personal bankruptcies and
mortgage arrears will surface when interest rates
begin to climb.
Borrowers should try to incur interest costs
deductible for tax purposes, and to pay off non-deductible
loans as quickly as possible.
The impact of loan interest deductibility is
illustrated in the following table. It calculates
the real costs of a typical 6% loan, for both
deductible and non-deductible interest, for three
B.C. income tax rates:
Understanding the implications of deductibility
is key. Take the 37.7% tax rate. If the interest
is non-deductible, the borrower has to first earn
9.6% and pay income taxes to have the 6% for the
interest.
If it is deductible, the real cost is 3.7% after
the tax savings. The 5.9% cost difference between
deductible and non-deductible interest is significant.
But is the borrower ready for this? A non-deductible
18% credit card rate really costs 28.9% in the
37.7% tax rate. Ouch, that smarts!
Without a doubt, incurring non-deductible loans
is very costly. It presents a large hurdle to
building the nestegg. Even in a low income tax
rate.
These ideas help the borrowing and repayment
strategies:
- Review the effects of rising rates on loans
coming due in the next three years. Refinancing
existing loans may reduce the interest costs.
- If there is only one loan, and the interest
is non-deductible, establish a repayment plan
to minimize interest costs.
- 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.
- Any borrowing incurred for the RRSP is not
deductible.
- The mortgage prepayment clause may allow an
additional 10% to 20% per year reduction of
principal, and/or doubling up the monthly payment,
without incurring a penalty.
- If the finances permit, reduce the mortgage
amortization from the typical 25 years to the
10 to 15 year ballparks.
- 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 rates are negotiable.
Formulate a sustainable borrowing strategy. In
short, borrow when necessary, repay loans quickly
and examine the interest deductibility.
This avoids the common pitfalls of borrowing.
Better yet, chipping away of the precious nestegg
will be minimized and the investment plan can
start sooner.
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