June 12, 2007, 2:29 am

Debt Swap Part2

by: The Financial Blogger    Category: Leveraging Strategies
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I recently wrote a post on milliondollarjourney.com as Frugal Trader kindly accepted my post as guess writer. I though it would be a great idea and honour to be featured on his website. I wrote the first part of two articles about debt swap. A debt swap is the action of turning your bad debts into good debts. In other words, it is to be able to switch a non tax deductible debt into a tax deductible debt. The process was previously explained in the first post and I’m now making a small example to make it clearer.

 

Let’s say you have a car loan at 8% in the amount of $20,000. You also have $20,000 in your investment portfolio. Then, you should cash in your investments and pay off your debt. At that time, you would be left debt free but without any investments, this is not where we want you to be.

 

The next step is to apply for a $20,000 investment loan to buy back your investments. You should pay around 6,5% to 7% for such loan. By doing this, you are technically going back to the same situation; $20,000 in debts and $20,000 sitting in your investment portfolio.

 

However, you are now paying less interest and this charge is now tax deductible. Interests paid on loans that are made to invest and get income are tax deductible in Canada. If your marginal tax rate is 40%, you would be paying a net interest rate of 3,9% to 4,2% as you will receive 40% of the interest paid over the year in tax return.

 

Congratulation! You just find a way to switch 20K in bad debts into good debts. Please note that by cashing your investment, you might trigger capital gain and the tax impact must be considered before doing such things. In most cases, you should make money out of this strategy.

 

If you want to try the full leverage strategy, you should pay interest only on your loan. Compound interests will make its magic and you will double or even triple your investment over time. If you prefer to pay off your debt completely at one point, you always have the option to pay principal plus interest or to make lump sum payments.

 

If you don’t have non-registered investments but you do have a property, the Smith Manoeuvre could be a really good start. This strategy will gradually transfer your mortgage into a tax deductible debt.

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