Since I’m at the age now that starting a family has become a frequent topic of conversation, having a sound financial plan to make sure one’s child has the option and privilege to get an education, seems like a wise thing to consider. We are going to discuss real estate (surprise coming from me I know) as a viable alternative to RESPs for funding your children’s education. This strategy I stole from one of my best mortgage professionals Jason Henneberry, Owner of Mortgage Pal. A few months back he had this exact strategy featured in “Canadian Real Estate Wealth Magazine”.
You may or may not be aware, the Canadian Education Savings Grant was initiated to help families save for their children's post secondary education. The federal government “tops up” your contributions to a maximum of $500 ($2,500 x 20%) per child per calendar year, to a lifetime maximum of $7,200.
On the surface, this sounds like a great deal, and it’s hard to pass up an immediate 20% return on your money. But it’s up to you to make ongoing investment decisions that will affect the long term performance of the portfolio. If we assume a 6% annual rate of return and you invest $2,500 per year and take full advantage of the CESG program, your child’s education fund will be worth approximately $83,000 in 17 years.
And as with most government initiatives, there are a lot of rules that dictate under what circumstances, in what amounts and for what purpose the money can be used. What happens if your child decides not to attend post secondary education? What if they have a brilliant idea and prefer to use the money to start a small business instead?
Perhaps there is a better way to spend your $2,500 per year and give your child more options and better control over their financial future.
The best student loan that money can buy…
Now let’s take a look at what would happen if you chose to forego the government grant of $500 and invest the $2,500 per year (or $208/month) to service a small equity loan on your primary residence in the amount of $39,195 based on 6% interest. Many people have access to much cheaper money against their home currently but this gives us a nice, long range cushion.
You decide to use the equity loan as the source of your 20% down payment for the purchase of a one-bedroom condo near UBCO valued at $189,900. The condo is new construction and comes with a waiting list of students willing to sign a one year lease at $1200 per month in gross rental income. After property taxes, condo fees and management expenses, you net $125 per month which covers the payments on the $156,782 mortgage that you obtained to buy the property. Use the positive cash flow to make two additional payments per year and at the end of 17 years, assuming an average interest rate of 4.50%, the mortgage will be free and clear!
The 80 year real estate price index tells us that Canadian real estate historically appreciates at a rate of about 6% per year. But even if we half that number and assume an average growth rate of 3%, the property will have increased in value to $323,920 by the end of the 17th year. And you own it free and clear (400% more than the $83,000 RESP).
Your child now has the option to sell the property and use the cash to pay for school, or take over ownership and refinance to create a self funding student loan which their tenant will pay off for them while they complete their education and eventually enter the work force. This second option has the added benefit of “staying invested” during those years and allowing the property to continue to appreciate. Remember, the RESP would have to be liquidated to pay for school and your child loses out on potential growth of the asset over time.
The gift that keeps on giving…
It’s important to remember that the rental income from the property should more or less keep pace with inflation over the years as well. Assuming an average inflation rate of 3% per year, the rental income will have increased from $1200 to $1925 per month.
Let’s assume that your child decides to go to school and refinances the property to $210,500 to access the same $83,000 that would otherwise have been available in the RESP. At an average rate of 6% and monthly payments of $1,052, using the positive cash flow to accelerate the mortgage, it will be fully paid off in 11.2 years. That includes 4-5 years for school and a half dozen years getting their career of the ground.
Provided our assumptions hold true over the course of time, your child (now 28 years of age) will be the proud owner of a clear title property worth approximately $448,381 which generates NET cash flow of over $21,000 per year. Show me the RESP that even comes close to delivering that kind of long term performance!
And in terms of education, your child not only has a degree (hopefully!), but they might also have learned a thing or two about how to manage real estate during their formative years. And now they can leverage their asset as they move into the next phase of their lives, perhaps to pay for a wedding, or to help them with the down payment for their own home, or maybe even to do the same for their kids and pass the knowledge along to the next generation.
For a full PDF analysis showing the performance of the one bedroom units under construction right now at UBCO over time just drop me a quick line to [email protected]
Strategy and much of this content provided by Jason Henneberry of Mortgage Pal.