The Millionaire in Your Basement

By: Pete Deisroth

One of the best pieces of advice we offer our first-time home buyers is to consider constructing a basement suite in their new home. Given all of the details and anxieties that accompany making possibly the largest purchase of one’s life, adding a construction piece to the puzzle can be a hard sell. In short, it is worth your time to take a look at the math…

You have an accepted offer for $250,000 on a 1200 square foot home with a full basement: your estimated monthly mortgage payment is $1,115.00 (assuming a 5% down payment, and a 5-year fixed rate at 2.59%, amortized over 25 years). Estimated construction costs¹ for a kitchenette, two bedrooms, and a bathroom are $30,000. The suite does not have to be extravagant to be comfortable, and you can save a lot of the construction expense if you are handy with tools, or can contribute any amount of sweat equity. With a “purchase plus improvements” mortgage, your new estimated monthly mortgage payment is $1,249 (assuming the same details as above). The difference in your monthly mortgage payment is an increase of only $134.

Now, let’s consider the net result. By applying the income directly to your mortgage, your new monthly, out-of-pocket, mortgage expense is reduced to $249. Using the same principles, we discussed in our previous blog post, “The Cost of That Morning Coffee”, let’s consider two other possible applications:

Application 1:  Contribute the income into an investment vehicle. For this example, we will deposit the funds into a conservative mutual funds portfolio, in a Tax Free Savings Account (TFSA) with an estimated return of 5% (you should expect a 4-6% return on a conservative portfolio) ² and allow it to grow. When the mortgage matures in 5 years, your investment account can grow to $68,090 which is a 13.48% return on your investment. You would have to split the income into you and your spouse’s TFSAs, to stay within your contribution limits, but the TFSA investment income earned is yours to keep, “tax-free”. If you contribute the funds into your Registered Retirement Savings Plan (RRSP), you will experience even greater savings, as your RRSP contributions will decrease your tax liability. For someone earning $50,000/year, you could realize an additional tax savings of $3,094/year. The net return over the 5 year, mortgage interest term, then increases to 39.26%. If you continue contributing the income funds to your RRSP for the duration of the amortization period (25 years), at an annual rate of 5%, your RRSPs could have an estimated value of $595,510, which would provide you with annual income of $47,785 for another 20 years. Add that to the future value of your home, illustrated in Application 2, and your minimum net worth will be $1,341,944. And, that doesn’t even consider the annual tax savings from both your RRSP contributions, and the mortgage interest and utilities write offs that will minimize the earned income from the suite (refer to table 1).

Application 2: Make your normal mortgage payments, and then apply to your mortgage as a “principal only” payment the income earned from the suite (many financial institutions offer multiple opportunities for you to pay down your mortgage more quickly without penalty). In this application, the monthly suite income is applied to the mortgage as a “double-up” payment. At the end of the 5-year term, you will have saved $3,963 in interest. Continue applying the monthly “double-up” payments to your loan, and your mortgage will be paid off in 11 years and 11 months. Over the amortization period, you will have saved $53,896 in interest and you will have decreased your amortization period by 13 years and 1 month.

Using simple math for illustration purposes, if you increased the rent to $1200/month for years 13 to 25, your total income earned from suite, if rented for the entirety of the amortization period, would be $331,200. Appreciating the value of the home at 4.0% over 25 years, your home would be worth $746,434. Add the future value of your home to the total income provided by your suite, and your minimum net worth would increase to $1,077,634.

This exercise illustrates that a minimal investment in a basement suite can provide great returns, by increasing your current monthly cash flow, increasing your net worth, or by increasing the equity stake in your home while decreasing your time of indebtedness. There are other aspects of maintaining a basement suite you will want to consider: being is a landlord is not for everyone. However, considering the benefits of converting part of your home into an income suite, for even a single mortgage term, should be an integral part of your family’s financial planning discussions. Come and see us, and let us help you construct a plan, and introduce you to the millionaire in your basement!

(Table 1) Tax Advantage of Income Suite: In the above example, 50% of the home was converted into an income suite. Consequently, 50% of the mortgage interest and utility costs can be deducted from the suite income earned to reduce the home-owner’s tax burden. Consult a licensed tax professional to facilitate identification of eligible deductions to maximize your benefits.

¹Check with your city services to confirm zoning, permit, and building code requirements.

²Past performance does not guarantee future performance; consult your investment professional to review the appropriate investment options for your situation

Pete Deisroth is a registered mortgage broker, and formerly an account manager, mutual funds sales representative, and manager of client care for RBC, Royal Bank.