As of Jan 20, 2011, The Canadian government has changed the rules. People will no longer be able to borrow money that is backed by the federal government to buy securities. The article that talks about home equity lines of credit or HELOC can be read at http://www.cbc.ca/canada/new-brunswick/story/2011/01/17/flaherty-mortgage-changes.html
Although, people can still borrow money at a higher interest rate to purchase securities. Since the loan is not backed by the federal government AKA insured, the bank is taking a risk that the loan will not be paid back. Therefore, the interest paid is still tax deductible, but the interest rate maybe higher than the interest rate given if the federal government backed the loan.
Is it worth the effort?
Almost every Canadian citizen pays income taxes. How much he/she pays varies depending on which income tax bracket his/her income falls under. Furthermore, the interest charged on the loan fluctuates from time to time on a variable interest rate loan.
The savings can vary, but on average, a person making 50,000/year will get back 30% of the interest paid on the loan. Therefore, a person who paid $1000 in bank interest in a year will get back about $300.
Unfortunately, when the tax payer’s income is not taxed under the highest tax bracket, and/or the interest charged on the loan is based on historically high interest rates, the income tax savings may not be worth it.
In the end, the answer to the question is simple. It depends on the factors stated above. A person making $45,000 a year may not benefit at all if he/she is paying 20% interest on a $500,000 loan. I am pretty sure someone making $500,000 may not benefit either with such a high interest rate being charged. Unless, of course, the dividends paid out by the securities purchased and/or the rising of the stock price makes the tax deductible loan worthwhile.
Investopedia’s article that discusses Tax Deductible Mortgages in detail at http://www.investopedia.com/articles/mortgages-real-estate/08/tax-deductible-mortgage-canada.asp#axzz1ku4qY3b2
As for historic low interest rates, paying the interest is a small price to pay to secure one’s financial future.
Unfortunately, this may well become the next housing market bust. If people get a loan using their house as collateral and the prime rate rises too fast, a couple of missed payments may result in foreclosures similar to the US housing bubble bursting. The US housing bubble bursting can be read at http://en.wikipedia.org/wiki/United_States_housing_bubble.
Currently, the prime interest rate in Canada went up from 2.25% to 2.5%. Most Canadians are fine with the prime interest rate being under 5%. If the prime interest rate goes above that, Canadians may no longer be able to afford paying off their loans and/or mortgages. Thereby creating the first Canadian housing market crash.
How taxes work on investments can be seen at http://www.taxtips.ca/personaltax/investing/interestexpense.htm
How it works
There are two types of loans that I do know about. Unsecured and a secured loan. Unsecured loans usually have a higher interest rate than a secured loan. The reason is the secured loan has collateral that the lender can take if the borrower defaults. The unsecured loan leaves the lender with nothing to take if the borrower defaults. Therefore, other methods will need to be used in the case of collecting on unsecured loans.
Unsecured loans are very simple. You get a loan with no collateral attached. Therefore, you get a $5000 unsecured loan from the bank. You invest the whole $5000 in dividend paying stocks. All the interest that you have to pay on that $5000 loan is tax deductible.
Secured loans gets complicated, but one should be able to follow. Now, lets assume that you get a secured loan from the bank to buy a new car using the car as collateral. Furthermore, for the sake of simplicity, the car is worth $20 000, and it does not depreciate in value. Also, the interest charged is $50 every month. The $50 paid on this secured loan is not tax deductible.
First Secured loan balance = $20 000 (not tax deductible)
In the first month, you pay $200 towards the secured loan. $50 goes to pay the interest while $150 goes to pay the loan. Since $150 of the car belongs to you, you can get another secured loan for the $150 that is paid off. With that $150, you purchase stocks that pay dividends. Since you are using a secured loan to buy stocks, the interest paid on that loan is tax deductible.
First Secured loan balance = $20 000 – $150 = $19 850 (not tax deductible)
Second Secured loan balance = $150 (tax deductible)
In the end, what will this look like.
First Secured loan balance = $0 (not tax deductible)
Second Secured loan balance = $20 000 (tax deductible)
Assuming that the whole $20 000 was used to buy dividend paying stocks, the interest paid on the second secured loan is tax deductible. Obviously, the car will depreciate in value over time, but if this was a house, houses normally appreciate over time.