Q: My husband and I are both 60 years old and working full time. We’ve just made an offer to purchase a cottage for $75,000. The cottage needs extensive renovations. We are thinking it’ll be a two-year project, costing us about $50,000. Once it’s done, we plan to rent it out for 15-20 weeks per year. The going rate in the area is $1,000 per week.
We have $30,000 cash and could cash in TFSAs to make up the $75,000. We are thinking about working slowly on the renovations using our homeowner’s line of credit and when it gets to a certain point we could transfer that to a mortgage.
Or should we use our $30,000 cash as a down payment, get a mortgage right away for $45,000 and use a combination of TFSAs and line of credit for renovations?
We already max out our RRSPs each year. And we plan to continue our TFSA contributions.
A: Debt repayment versus investing is an age-old financial planning conundrum, Debra. Given the price of real estate, investors generally incur debt in order to invest in a rental property. How much to put down as a down payment and how quickly to pay off the debt can then become strategic considerations.
The minimum down payment required for a rental property is 20%, meaning in your case, you would need to put down $15,000 on the $75,000 purchase if you wanted a mortgage on the cottage itself. Rural properties like the cottage you are considering may even require a higher down payment in some circumstances.
If you went to the extreme, you could even consider using your homeowner’s line of credit on your home for the down payment, Debra. Or you could use your homeowner’s line of credit to finance the entire purchase, if you had enough equity in your house. Both would effectively finance the purchase 100%.
Interest on a rental property is generally deductible on your income tax return. This would include interest on a homeowner’s line of credit secured by your home that is used to purchase the rental property. The ultimate use of the borrowed money is what matters for tax deductibility purposes, not that the debt is secured by the rental property itself.
Since you will be purchasing the property and then doing renovations initially over a period of 2 years, the interest would generally not be deductible until the property is available for rent, Debra.
As far as how much to borrow and how much to use from your cash and TFSA savings, this becomes in part a matter of preference. If you are comfortable with the debt and have good cash flow and risk tolerance, you could fully finance the property. If so, you are indirectly making the decision to borrow to invest – or to continue investing in your TFSA and borrow instead for the required funds. To make it “worth it”, you then need to generate a higher rate of return on your TFSA than you are paying on your homeowner’s line of credit or mortgage.
Since the interest is tax deductible, it makes the “cost” of the debt a bit cheaper. For example, if you are borrowing at 3.5% and you are in a 50% tax bracket, your cost of borrowing is only 1.75%. If you can invest in your TFSA at a higher rate of return than 1.75%, you will be better off in the long run. No doubt interest rates will rise and stock markets will fluctuate up and down, but that might be a low threshold to beat over time if you are comfortable with a bit of leverage, Debra.
If you were to cash out your TFSAs now, you may be cashing out at a low point in the stock market cycle, depending how you’re invested, given weak stock markets. If your time horizon is long enough, you may be able to pay down the rental property debt before you retire. Or you may be able to fund the debt payments in retirement with the rental income. Or you may be able to eventually use withdrawals from your TFSA strategically at a higher point in the stock market cycle to pay down or pay off your rental debt.
As a matter of interest, your estimated $1,000 per week for 15-20 weeks per year is a lot of rental income on that property. Income of $15,000 per year on a $75,000 property with $50,000 of renovations is a capitalization rate or cap rate of 12%. In other words, that’s a dividend of 12% on a $125,000 investment. No doubt there will be carrying costs like property taxes, insurance, utilities, advertising and so on, but at first blush, the rental potential sounds very appealing, even ignoring any potential capital appreciation.
How you finance it then becomes more art than science, Debra.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ontario. He does not sell any financial products whatsoever.