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Debt Swap – Part 1

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 Simply because the amount withdrawn from your portfolio will be added to your revenue and you will pay taxes.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.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 7 comments… add one }
  • FourPillars June 12, 2007, 9:13 am

    Hi FB, this swap is a pretty interesting idea for someone who has debts and non-registered investments. I guess another consideration which should be looked at is capital gains taxes on the liquidation since this will take away from the ‘profit’ of doing such an exercise.

    Great post!
    Mike

  • The Financial Blogger June 12, 2007, 3:02 pm

    Hi Mike,
    I actually mentioned the capital gains taxes on the second part of this post on my blog :
    http://www.thefinancialblogger.com/debt-swap-part2/

    You are right, it is very important to consider how much you will pay in taxes by doing this strategy. However, as you will pay taxes on capital gains at one point, you can consider that you are just doing crytalization of your portfolio at a given time.
    Cheers,
    FB.

  • florch June 12, 2007, 3:25 pm

    If it isn’t too costly the embedded capital gains after performing the switch are attractive. Financial Jungle had an excellent post about this…
    http://financialjungle.com/2007/06/06/investing/deferred-capital-gains-tax-is-the-best-debt-in-the-world/

  • Qubikal June 12, 2007, 7:21 pm

    FT,

    Great tips once again. I’ve been following your thoughts and questions since you’ve been putting together your research for the Smith Maneuver back in November/December; right about the same time I discovered the SM.

    You mentioned that you had not started to implement the SM and am curious to know what is your reasoning behind the delay, as you seemed very gung ho about the SM idea from the start?

    I apologize if this offends you in any way…

    Thanks

  • FrugalTrader June 12, 2007, 7:46 pm

    Qubikal, no offense taken! I’m currently under a 5 year fixed mortgage and i’m not a big fan of paying fees to switch mortgage early. We are however going to move to another home in the near future. When we do, I will get a re-advancable mortgage to start the Smith Manoeuvre. My non-reg account is geared up and ready to be sold! :)

  • Richard Johnson January 8, 2008, 12:44 pm

    I’d be wary of certain debt swaps until the Supreme Court hears the Lipson appeal in April of 2008.

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