March 12, 2018

Think Twice Before Committing to The Home Buyers’ Plan

Today, we’re going to talk about one of our biggest financial mistakes over the years. It relates to the appealing Home Buyers’ Plan (HBP). Our young selves happily lunged into it acquiring our present house more than 15 years ago. At the time, it seemed like a very wise decision and the strategy provided us with a substantial chunk of change that greatly helped us in the short term. With retrospect, it now looks more and more like a very poor financial choice that considerably cost us in the long haul.

Everybody would love to, one day, have a nice home. For many, owning a big house is synonymous with financial success.

For most young folks, becoming a homeowner seems like a steep financial achievement and many may think it will remain only a distant dream. Then, they hear about the Home Buyers’ Plan (HBP) and their dream suddenly becomes more accessible. They see no-hassle free money that potentially can boost their house down payment (maybe a mistake). For some, the HBP may even provide the only cash to finance their once unattainable dream (definitively a mistake).

Fiscal Debt That Can Have Significant Long-Term Repercussions

The HBP allows you to avoid paying taxes on some RRSP withdrawals if you use those funds to buy your first house. After a two-year grace period, you have 15 years to repay your RRSP. The problem is that for most participants, the resulting tax bill will end up costing them much more in the future. The long-term implications and financial impact of that heftier tax bill cannot be ignored.

It makes no sense to withdraw from your RRSP avoiding only a 25-30% tax bill and later, to repay your RRSP with an ensuing 45-50% tax cost.

A typical example would be Luke’s, a 25-year old Montrealer that cashed out 15K$ from his RRSP under the HBP. With all expenses related to buying his first house, Luke was very glad about the extra money this harmless maneuver provided. With a low annual salary of only 30K$, he initially avoided a tax bill of about 28%.

Two years later, disillusion kind of suddenly stunned him after he realized he would have to repay 1K$ each and every year for 15 long years. Adding a thousand bucks on top of mortgage payments was a real stress on his already tight budget. At that point, still not earning that much, the related fiscal cost was not yet a problem and stayed the same around 28%.  

A few years down the road, Luke was making 50K$, the tax cost grew with his frustration as it jumped to approximately 37%. Continuing to earn more 12 years after his initial enrollment into the HBP, the fiscal cost passed over 45% and would be sustained for the last 5 years of the program.  

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Enrolling into the HBP in a 15-year commitment (more like 17-18 years in reality) and the associated long-term financial obligation can be complex to analyze. It can be hard to project yourself that far into the future and figure how much we will be earning. In fact, most young individuals can’t imagine making that much money, but salaries trying to keep up with inflation and fast evolving working conditions as they climb the employment ladder will get many there. Tax rule changes are also next to impossible to anticipate, particularly over a period that extended.  

As we said before, future tax implications of the HBP should not be neglected. Most people will get into the HBP at the start of their career earning relatively low wages. They will be happy to get a big refund or to avoid taxes but unfortunately, odds are they will end up paying much more consequent tax 10-15 years afterwards.

That’s what happened to us. The actual fiscal cost of putting money back into our RRSPs is far greater today that the initial benefits we got many years ago. This is especially true for my ambitious wife. She earns a lot more today and her marginal tax rate is now over 50%. Ouch!  

My naïve young self was under the false impression that HBP repayments would be tax deductible like regular RRSP contributions. The reality is that RRSP funds withdrawn under the HBP already provided a tax deduction when they were initially subscribed. Logically, they simply cannot provide a second or double deduction.

We know you have to account for inflation and a thousand bucks back then is comparatively worth a lot more than the same thousand today.  Even though real implications can be tough to grasp depending on each individual situation, you can bet relative future tax costs will often be higher.

At first, what seems like borrowing from yourself (your RRSP) can be very appealing until you realize you eventually will have to make payments (aka repayments) and deal with a comparative lofty tax bill instead of getting charged interest.

In the end, the HBP was a bad financial decision for us, especially from a fiscal standpoint. As we said before, we consider enrolling in the HBP one of our worse financial decisions.

On top of it all, like good publicity, the home buyers’ plan can give you the false sense you can afford a bigger house. That fast and easy seemingly free down payment can become very costly in the long run. Over time, this may even prevent you to Get to Financial Independence Quicker with a Smaller House.

It’s true the HBP can help you reduce your CMHC premium (what you pay for the Canada Mortgage and Housing Corporation to insure your loan) or even qualify for a mortgage in the first place by possibly increasing your down payment. But we believe, even more with experince, you should not only rely on the HBP to buy a house you probably can’t afford after all.

Compounding the Adverse Effect of the HBP with Popular Zero-Tax Strategy

It’s not the end of it, the financial industry also aggressively promotes a now very popular yet questionable strategy: borrowing to invest to reduce your tax bill virtually to nothing.

In summary, the strategy consists of getting a short-term loan to invest in your RRSP for 90 days (to respect the pending HBP condition) before withdrawing it all under the HBP to reimburse the loan. The loan amount is adjusted to maximize your tax refund. Your tax bill can even be reduced to zero as some financial institutions advertise it. That way, you get your hands on a juicy tax return withdrawing money you didn’t have. 

The catch, or the first catch should we say, is you will have to contribute back (or repay) those borrowed amounts to your RRSP. And you will not get tax refunds for those RRSP contributions under HBP conditions. Even though those repayments can be gradual, most people forget or don’t understand and can have a very hard time when they realized they have to make those repayments. The option to add repayments to their taxable income is not that interesting either as it will create an unwelcomed and often unplanned tax tab.

The other aspect of it (the second catch) can have even more damaging effects. Tax savings generated by the zero-tax strategy are often under 20-25%. In fact, marginal tax savings will get lower and lower as you get closer to zero tax. The potential for financial disaster increase very much with those initial relatively lower tax savings. Impact of future tax cost of only saving under 20% can become huge as taxes inflate to 40-50% when repayment time comes.

The HBP without borrowing is not as bad because the initial considered tax rate is on top of your actual salary (comparable tax rate around 30%). The compounding more dangerous consequence of the zero-tax borrowing strategy is that it drags down your marginal tax rate to the lowest levels (comparable tax rate under 20-25%).   

Greedy financial advisors like these HBP borrowing and zero-tax strategies a lot. They get paid commissions on loans and initial RRSP contributions. The also trap you into becoming a loyal returning customer that must repay his RRSP every year for 15 years after that.

Regular forced HBP repayments may still be considered a good thing for some who have a hard time putting money aside. It should at least build up they RRSP savings. But will they get the best returns and advices from salespeople with already questionable motives. Odds are these advisors will also make them invest into high-fees products.

Before we go any further, we must admit we are guilty as charged, we amplified our mistake by innocently buying into the attractive HBP borrowing-to-invest strategy many years ago. Luckily for us, the program was limited to 20K$ per spouse back then. We still both borrowed and engaged substantial amounts into the HBP. We were very happy about our initial tax savings of about 10K$. It seemed huge at the time but with retrospect, we now know it was small relativity speaking (a tad over 25%).

The ill effect of the HBP have not been as bad in my case because my modest salary didn’t increase as much and was reduced by voluntary time away from work like this year’s leave. For instance, in 2017, I will probably skip my HBP repayment. We will still have to fork out some precious money for the resulting tax tab (around 30%). Because of regular contributions and better that expected returns, my RRSPs have grown too big. We are afraid of having a tax problem when withdrawal time comes. Too much RRSP money is still a great problem to have and a whole other subject in itself.

My wife’s salary more than tripled since our initial enrollment in the HBP. She made her last repayment last year and relative tax costs under her HBP hurt us a lot more. Especially, the last 5 years around 50%. Only considering fiscal implications, her initial 5K$ tax saving ended up costing just under 9K$ over the following years. We know it’s easy to question our decision after the fact but those last few repayments were still particularly painful.  

The Home Buyers’ Plan Only Profitable Under One Crucial Condition

As we stipulated earlier, the long-term tax implications of the HBP are difficult to grasp and analyze. Luckily, the entire problem basically can be reduced to one much simpler yet crucial condition. The trick is to compare your initial enrollment tax bracket to your anticipated repayment period tax brackets. Your future tax brackets have to be equivalent or lower than your present one. 

For the HBP to remain profitable in the long run, your taxable earnings during the HBP repayment period have to fall into an equivalent or lower tax bracket, compared to your initial enrollment tax bracket.

A lower tax bracket during repayment is better. An equivalent tax bracket would still be acceptable. But a higher tax bracket during repayment is a big no-no.

In fact, the higher your tax bracket today the better. The same way, the lower your future tax brackets the better.

That’s why the HBP is not suitable for most workers in a typical situation where most earn a low salary (tax bracket) when they enroll and make a much bigger salary (tax brackets) before repayment time comes.

The only thing that fortuitously can save a number of people is having an equivalent or slow-growing salary. For them, the fiscal cost of the HBP would be nothing because they will fall into the same tax bracket. Despite this advantage (or non-disadvantage), making repayments or settling the associated fiscal bill will still be a problem for many.

If you still think borrowing to invest under the HBP can be suitable for your situation, we would suggest another way to make sure your initial tax bracket is not too low: just don’t reduce your income under the basic lower tax bracket. That federal tax level is 45916$ for 2017. You can easily find your corresponding provincial tax level in the same vicinity (for instance, 42201$ for Ontario and 42705$ for Quebec in 2017).   

Another good suggestion would be to careful budget and prepare yourself ahead of HBP repayments. You could avoid liquidities problem a couple years down the road that way.

We hope today’s subject was not too technical and that it won’t scare you away from the HBP altogether. Talking and learning about it can only expose you to additional options that are available for you out there, in the rugged financial world.

In spite of exposed potential costly flaws, the HBP can be a good program for Canadians planning to earn less and/or already enjoying substantial earnings. In the end, the painful fiscal pill to swallow for my lovely spouse was still kind of bearable for me. Also, remember that everybody makes mistakes and the important thing is to learn from them. After all, we are doing fine despite numerous financial missteps.

That will be all from us today. Come back soon for more financial and investing talk! We look forward to reading your comments and questions! 

Photo by Lady C

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