When it comes to investments for registered plans such as Registered Retirement Savings Plans (RRSPs) or Registered Retirement Income Funds (RRIFs), most people tend to focus on familiar options like stocks, bonds, Guaranteed Investment Certificates (GICs), and mutual funds. However, the Income Tax Act allows for a broader range of investments, including arm’s length mortgages.
This lesser-known investment option offers a unique opportunity for investors looking to diversify their portfolios by holding mortgages inside their registered plans. In this post, we will explore what arm’s length mortgages are, how they work, the role of intermediaries like brokers and trustees, and key considerations for anyone thinking about this type of investment.
What is an Arm’s Length Mortgage?
An arm’s length mortgage is a private mortgage agreement between two parties who are not related by blood or marriage. The key distinction is that the lender and borrower must act independently, with no personal relationship that could influence the terms of the transaction. The term “arm’s length” emphasizes the fact that the two parties are dealing with each other at a professional distance to ensure fair market practices.
This type of mortgage must also comply with fairness and transparency requirements, meaning neither the borrower nor the lender can receive an undue advantage. Unlike traditional bank mortgages, arm’s length mortgages are often privately negotiated, providing both the borrower and lender with more flexibility to customize the terms.
How Does an Arm’s Length Mortgage Work?
Setting up an arm’s length mortgage involves several steps, typically with the help of mortgage brokers, lawyers, and trustees. Here’s a breakdown of the key stages:
1. Role of the Mortgage Broker
Although it is possible to arrange an arm’s length mortgage without a broker, many investors choose to work with a mortgage broker. Brokers bring expertise in underwriting and help negotiate terms that suit both the lender (investor) and the borrower.
The broker ensures that the borrower has sufficient equity in the property, reducing the lender’s risk. Additionally, the broker helps underwrite the mortgage by assessing the borrower’s creditworthiness and confirming that the deal meets the legal and financial standards required for funding through a registered plan.
In certain provinces or cases, the trustee (who manages the registered plan) may require that a licensed broker or mortgage administrator underwrite the mortgage before they allow it to be held within a registered plan.
2. Involvement of a Lawyer / Notary
Once the terms are agreed upon between the lender and borrower, a lawyer becomes involved to ensure the documentation is legally sound.
- The lawyer’s duties include:
- Preparing the mortgage documents based on the signed agreement.
- Conducting a title search to confirm property ownership and identify any existing liens or encumbrances.
- Obtaining a property valuation and insurance documents.
- Collecting prior encumbrance statements and tax certificates to ensure all outstanding obligations are clear.
The lawyer ensures all necessary paperwork is completed properly so that the transaction proceeds smoothly, protecting both the lender and borrower.
3. Role of the Registered Plan Trustee
When a registered plan (such as an RRSP or RRIF) is used to fund the mortgage, a registered plan trustee plays a crucial role in facilitating the process. Trustees are financial institutions or specialized companies that administer registered accounts according to Canada Revenue Agency (CRA) regulations.
Trustee Responsibilities:
- Review and approval: Once all documents are finalized, the lawyer submits the paperwork to the trustee for approval. The trustee ensures the mortgage complies with CRA rules, including:
- The property must be located in Canada.
- The loan-to-value ratio (LTV) must not exceed 100%.
- Registration of ownership: If approved, the trustee registers the mortgage under the account as the legal owner. The lender, however, is designated as the beneficial owner of the investment. In practice, this means that while the trustee manages the paperwork, the lender retains full ownership and control over the mortgage investment.
- Ongoing administration: Throughout the life of the mortgage, the trustee stays in communication with the lender, reporting any payment or administrative issues.
How Payments and Communication Work
One of the key differences between an arm’s length mortgage and a traditional bank mortgage is that the borrower does not deal directly with the trustee. Instead, the trustee communicates only with the lender (investor) since the mortgage is held as an investment in the lender’s registered plan.
Common issues that may arise include:
- Missed or returned payments
- Insurance lapses or cancellations
- Property tax arrears
- Foreclosure notifications
When any of these situations occur, the trustee notifies the lender. However, the trustee will not act unless the lender provides written instructions. It is ultimately the lender’s responsibility to monitor the performance of the mortgage and take action if necessary.
Hands-Off Investing: Using a Broker or Mortgage Administrator
For investors who prefer a hands-off approach, the option to appoint a mortgage broker or administrator exists. The trustee must approve this arrangement, and once approved, the designated third party will handle all communication and maintenance related to the mortgage on the lender’s behalf.
This option is especially useful for investors who may not have the time or expertise to manage the day-to-day administration of the mortgage. The lender can focus on broader investment strategies while leaving the management of the mortgage to a trusted professional.
Advantages of Arm’s Length Mortgages
Investing in arm’s length mortgages offers several potential benefits, particularly when held inside registered plans:
- Diversification: Mortgage investments provide an alternative to traditional equities, helping reduce risk through portfolio diversification.
- Predictable Income: With regular mortgage payments, investors can generate a stable income stream, which can be especially attractive for those in retirement.
- Control Over Investment Terms: Lenders have more control over the interest rate, payment schedule, and other terms compared to conventional mortgage investments.
- Tax-Deferred Growth: When held in an RRSP or RRIF, income from the mortgage grows on a tax-deferred basis, maximizing returns over time.
Potential Risks and Considerations
While arm’s length mortgages can be lucrative, they also come with certain risks and challenges:
- Default Risk: There is always a chance the borrower may default on payments, leaving the lender to pursue legal remedies such as foreclosure.
- Liquidity Constraints: Unlike stocks or bonds, mortgages are not easily liquidated. If the lender needs quick access to cash, selling or exiting the mortgage investment can be difficult.
- Active Involvement Required: Investors must monitor the mortgage’s performance and handle any issues that arise, such as missed payments or property insurance cancellations.
- Regulatory Compliance: The mortgage must meet CRA requirements, which can involve additional paperwork and oversight by trustees.
Is an Arm’s Length Mortgage Right for You?
Before investing in an arm’s length mortgage, it is essential to evaluate whether this type of investment aligns with your financial goals and risk tolerance. Consult with a financial planner or tax advisor to understand the potential benefits and drawbacks, especially in the context of your overall investment strategy.
If you decide to pursue an arm’s length mortgage investment, it is also important to work with a trustee that offers this option within their registered plans. Not all trustees support mortgage investments, so research is necessary to find the right partner for your needs.
Conclusion
Arm’s length mortgages offer a compelling opportunity for investors looking to diversify their portfolios and generate predictable income. When structured properly, these investments provide flexibility and control that traditional mortgage products may not offer. However, arm’s length mortgages also require active involvement and careful management to ensure they meet legal requirements and perform as expected.
By partnering with experienced brokers, lawyers, and trustees, investors can navigate the complexities of arm’s length mortgages while enjoying the benefits of tax-deferred growth within registered plans. Whether you are an experienced investor or new to private lending, this investment option can be a valuable addition to your portfolio if aligned with your financial goals.