Why a 6% Tax-Deductible Loan Costs Less Than a 4% Mortgage
A borrower who refinances at a low rate and pays non-deductible interest can achieve a lower after-tax cost by borrowing at a higher rate when the funds are used for income-producing investments. When the interest becomes deductible, the tax refund can make a 6% loan cheaper than a 4% mortgage. Same house, higher rate, lower real cost. The difference is five words in the Income Tax Act: "for the purpose of earning income."
The Purpose Test Decides Everything
The Canada Revenue Agency does not care what collateral you used. It cares what you did with the money after you received it. A mortgage secured by your primary residence is considered personal expense debt even if the rate is 2.5%. Interest on a loan used to buy dividend stocks, bonds, or rental property is deductible even if the rate is 7%, provided there is a reasonable expectation that the investment will produce taxable income. The law turns on use, not asset type.
This creates a structural arbitrage most borrowers miss. At a 50% marginal tax rate (combined federal and provincial, which top earners in several provinces reach), a 6% deductible loan costs 3% after tax. A 4% non-deductible mortgage costs 4% after tax, always. The deductible loan is cheaper by 100 basis points despite carrying a rate 200 basis points higher. The gap widens as rates or tax brackets rise.
Two Paths, Same Equity
Take Sarah, age 41, $680,000 home with $290,000 owing at 3.74%, $390,000 in equity. She wants to invest $150,000. Path A: she keeps the mortgage as is, takes a separate HELOC at 6.5%, invests the $150,000, deducts the HELOC interest. Her mortgage costs her $10,850 a year in non-deductible interest. The HELOC costs $9,750 a year, but $4,875 comes back as a tax refund (50% bracket). Net cash out: $15,725.
Path B: she pays down the mortgage to $140,000 using existing savings, then immediately re-borrows $150,000 at 6.5% and invests it. Now the mortgage costs $5,240 a year. The investment loan costs $9,750, minus $4,875 refund. Net: $10,115. She saves $5,610 annually by transforming $150,000 of non-deductible debt into deductible debt, using the exact same equity and paying the exact same nominal rate on the new loan.
The CRA permits this under Singleton v. Canada (2001), which held that a taxpayer may arrange their affairs to maximize deductibility as long as each transaction has a bona fide purpose. This is tax planning: arranging your borrowing so the interest becomes a government subsidy rather than an irreversible cost.
Where the Math Breaks
Three conditions flip the recommendation. First, if the investment produces only capital gains and no dividends or interest, the CRA will disallow the deduction. You cannot borrow to buy growth stocks that pay no dividend and expect a write-off. The income must be taxable income, not merely hopeful future gains.
Second, if marginal rates are below 33%, the deductibility advantage thins. At a 33% bracket, that 6% loan costs 4% after tax, exactly matching the non-deductible 4% mortgage. Below 33%, the mortgage wins.
Third, if you cannot sustain the carrying cost during a market drawdown, leverage becomes a liquidity trap regardless of tax treatment. The deduction cushions the cost, but it does not eliminate the monthly payment. A $150,000 loan at 6.5% requires $812 a month in interest alone. If the portfolio drops 18% and dividends get cut, you are still writing that cheque.
The rule is not "deductible debt is always better." The rule is: when you are going to borrow either way, borrow in the structure that turns the interest into a government subsidy. Most mortgage debt sits in the wrong structure because borrowers shopped for rate and ignored the tax line.
A borrower who refinances at a low rate and pays non-deductible interest can achieve a lower after-tax cost by borrowing at a higher rate when the funds are used for income-producing investments. When the interest becomes deductible, the tax refund can make a 6% loan cheaper than a 4% mortgage. Same house, higher rate, lower real cost. The difference is five words in the Income Tax Act: "for the purpose of earning income."
The Purpose Test Decides Everything
The Canada Revenue Agency does not care what collateral you used. It cares what you did with the money after you received it. A mortgage secured by your primary residence is considered personal expense debt even if the rate is 2.5%. Interest on a loan used to buy dividend stocks, bonds, or rental property is deductible even if the rate is 7%, provided there is a reasonable expectation that the investment will produce taxable income. The law turns on use, not asset type.
This creates a structural arbitrage most borrowers miss. At a 50% marginal tax rate (combined federal and provincial, which top earners in several provinces reach), a 6% deductible loan costs 3% after tax. A 4% non-deductible mortgage costs 4% after tax, always. The deductible loan is cheaper by 100 basis points despite carrying a rate 200 basis points higher. The gap widens as rates or tax brackets rise.
Two Paths, Same Equity
Take Sarah, age 41, $680,000 home with $290,000 owing at 3.74%, $390,000 in equity. She wants to invest $150,000. Path A: she keeps the mortgage as is, takes a separate HELOC at 6.5%, invests the $150,000, deducts the HELOC interest. Her mortgage costs her $10,850 a year in non-deductible interest. The HELOC costs $9,750 a year, but $4,875 comes back as a tax refund (50% bracket). Net cash out: $15,725.
Path B: she pays down the mortgage to $140,000 using existing savings, then immediately re-borrows $150,000 at 6.5% and invests it. Now the mortgage costs $5,240 a year. The investment loan costs $9,750, minus $4,875 refund. Net: $10,115. She saves $5,610 annually by transforming $150,000 of non-deductible debt into deductible debt, using the exact same equity and paying the exact same nominal rate on the new loan.
The CRA permits this under Singleton v. Canada (2001), which held that a taxpayer may arrange their affairs to maximize deductibility as long as each transaction has a bona fide purpose. This is tax planning: arranging your borrowing so the interest becomes a government subsidy rather than an irreversible cost.
Where the Math Breaks
Three conditions flip the recommendation. First, if the investment produces only capital gains and no dividends or interest, the CRA will disallow the deduction. You cannot borrow to buy growth stocks that pay no dividend and expect a write-off. The income must be taxable income, not merely hopeful future gains.
Second, if marginal rates are below 33%, the deductibility advantage thins. At a 33% bracket, that 6% loan costs 4% after tax, exactly matching the non-deductible 4% mortgage. Below 33%, the mortgage wins.
Third, if you cannot sustain the carrying cost during a market drawdown, leverage becomes a liquidity trap regardless of tax treatment. The deduction cushions the cost, but it does not eliminate the monthly payment. A $150,000 loan at 6.5% requires $812 a month in interest alone. If the portfolio drops 18% and dividends get cut, you are still writing that cheque.
The rule is not "deductible debt is always better." The rule is: when you are going to borrow either way, borrow in the structure that turns the interest into a government subsidy. Most mortgage debt sits in the wrong structure because borrowers shopped for rate and ignored the tax line.
Sources
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