This is a guest post by a new blog: The Financial Blogger. This article summarizes the debt swap technique that I plan to use when I start using the Smith Manoeuvre.
You might have already heard about what some people call “good debt” and “bad debt”. According to this new definition, a good debt is linked to an asset that produces income or will create a capital gain in the future. Then, bad debts are related to our consumption such as cars, furniture or simply over spending habits. In fact, most of us have already contracted bad debts. However, there is a way to switch bad debts into good debts. The technique is fairly simple, but some requirements apply.
There is a limit of bad debt you will be able to flip to the other side. This limit is determined by the total of your non registered investments. In order to apply a debt swap, you will need non registered investments to be able to pay off your bad debts completely.
Why not take from your RRSP? Simply because the amount withdrawn from your portfolio will be added to your revenue and you will pay taxes. In addition to that, once you take RRSP’s out, you can get them back in (except in the case of purchasing your first house or if you return to school).
You need to complete two transactions in order to swap your debts. The first one is to liquidate your investments to pay off your bad debts. Then, you will contract an investment loan in the same amount to replace your investments. By linking your investment to a debt, you will probably have a lower rate and the interest will become tax deductible.
People that are not comfortable with leveraging strategies might not want to pursue this technique. This is a big mistake as you already have debts. Therefore, you are not changing your financial position. The amount of debts and assets remain the same. You are making fiscal changes.
For those who want to stick to a financial plan of debt elimination, you can still do a debt swap and then pay principal plus interest on your investment loan. You have the possibility to choose the term and amortization for your loan. Additional payments are also allowed by most institutions. Once the loan is completely paid off, make sure that your bank will remove the lien on your investments.
Debt swapping can be use through an investment loan or through the equity in your property. As long as you can prove to the Government that the new debt is related to investment and that the goal of them is to earn income, you are all set. Your debt won’t change but you will probably pay less interest and it will be tax deductible. Make sure to follow part 2 of the Debt Swap on The Financial Blogger.