How To Assess If The Smith Manoeuvre Is Good For You

January 22nd, 2012 | Category: How To | 11 comments

I have been wanting to write about the Smith Manoeuvre for a long time now since I believe many think they are doing it but aren’t really. In fact, they are simply borrowing to invest. I am not sure why the Smith Manoeuvre term are so often referenced loosely because it has a really high level of risks as you will read. Lets find out if you are in fact doing the Smith Manoeuvre and if you want the level of risks it has to offer.

What is the Smith Manoeuvre?

In the true sense as explained by Fraser Smith, the Smith Manoeuvre has the following principle: “After every payment you make, you borrow the principle amount and re-invest it”. In essence, it means that you use the equity in your home to invest (in the qualified investments) and the interest can now be tax deductible. What this means is that for every payment, you would borrow hundreds of dollars and buy investments. Unfortunately, using stocks for this purpose is too expensive and that’s why Fraser Smith recommends mutual funds (MER anyone?). The result is that 20+ years later your $300K mortgage is now a $300K investment loan and you need to hope the investments have appreciated with it as well. Make sure to read the article snippet from Jonathan Chevreau (after you finish reading of course :) ).

Here is a graph showing how the Smith Manoeuvre looks like in terms of debt. Can you see that between your mortgage and the HELOC setup to invest with your borrowed equity stays constant at $300K? That’s the principle outlined by Fraser Smith. I find that quite risky because your debt level never decreases. The interest does become tax deductible since you are not investing with money borrowed from your HELOC but you need to be highly confident in your ability to pay the monthly interest in your HELOC.

Smith Manoeuvre Mortgage

Below is a graph showing the potential cost of servicing your Smith Manoeuvre. Your mortgage payments are fixed for 25 years generally speaking and when you start borrowing from your HELOC to invest, the interests are on top of your mortgage. In the case below, the monthly mortgage payments are of $1,400 for a $300K mortgage at 3.5%. As your HELOC increases, so does your monthly payments. I used 4% for the interest of the HELOC below which is relatively conservative. If you can negotiate, you should be able to have your HELOC at prime.

Smith Manoeuvre Monthly Cost

The major benefit, as outlined by Fraser Smith is that over time your investments should have grown and depending on your investment skills, your assets should grow larger than your loan. At some point, the monthly income from your investment should be able to cover your interests. Based on your ability to service your extra debt, you could re-invest your dividends (or other income) which would definitely accelerate your growth. I won’t outline potential scenarios for an investment growth as there are way too many variables. The easy part is understanding the cost of the process – the benefits really depends on your investment plans.

Note that the setup isn’t all that simple and not all banks or financial planners can set you up properly. Be sure to research your Smith Manoeuvre provider to make sure the setup will allow you to deduct the interest on the loan. Be careful on the mutual funds provided if that’s what you choose – today’s 5 star mutual fund is often tomorrow’s bottom performer.

What is NOT the Smith Manoeuvre?

In simple terms, borrowing money from a HELOC isn’t considered a Smith Manoeuvre. It’s simply using leverage to invest which is perfectly acceptable and will still allow any investors to deduct the interest from the loan from their taxes. Whether the loan comes from a bank or from yourself through any of your line of credit, the government still allows you to receive a tax deduction from the interest on the loan as long as the investments qualifies.

You can also repay it if it pleases you to reduce your debt or you can keep it at the same level if you continue to generate more income than it costs you. Borrowing to invest, I find, is much more manageable and you can pick your investment options based on the overall amount you borrow. For example, if you decide to borrow $20K, than you could put $4,000 in 5 dividend paying companies (REITs will complicate your taxes but they are also an option).

Can You Stomach The Smith Manoeuvre?

I have read about it many years ago after purchasing my first place but I could never pull the trigger because the debt level isn’t supposed to be reduced. As Fraser Smith explains, you always borrow the equity paid from your mortgage. That means your debt servicing level never goes down and it requires any investors to be extremely diligent about their finances to manage the debt servicing. More so if you use a line of credit with a variable rate since the payments will fluctuates over time.

There are 2 things you need to do a Smith Manoeuvre:

  1. The ability to service a higher debt over time until your mortgage is paid
  2. A solid investment plan for ensuring growth
It’s also worth noting that the bank (or lending financial institution) will get all the money it expected through the mortgage payments. There are no substitutions there and the only way to reduce the interests the bank earns from you is to accelerate your payments, manage your mortgage rate or make lump sum payments. In short, the Smith Manoeuvre is just a fancy name for accessing all the available equity in your home and investing it as you make your payments.

Readers: Are you doing the Smith Manoeuvre as outlined by Fraser Smith? Are you contemplating it? What do you think of the risk level?

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Dividend Income - January 2012

January 17th, 2012 | Category: Dividend Income | 30 comments

My first dividend income report for the year!

With dividends, slow and steady wins the race. Remember that it’s a marathon. For those of you new to my blog, I have been tracking my  dividend income since I ‘officially’ initiated my strategy a couple of years back. If you have not done so recently, I recommend you review your portfolio to ensure you are satisfied with your current strategy.

Last year, my goal was to reach $5,000.00 in dividends and I fell a little short with $4,742.25. I am still quite satisfied as I was also trying to strike a balance between higher yield and dividend growth investments that follow the 10/10 rule with dividend aristocrats. As I DRIP most of my dividends (where I can), I let the power of compound growth do its work with my dividends. It’s quite boring to watch I tell you :) In 15 years, looking back at the earning growth should be quite revealing though.

I am going to be aggressive in my Dividend Income target for the year and go for $7,000!!! My yearly estimate currently land at $5,700 so I will need some savings to generate and an extra $1,300 for the year. If I assume 5% yield, I would need to add around $20K. That’s quite a bit of savings, let’s hope I have some dividend increase along the way to help me out :)

Dividend Income

I made some investments in the past few months with a couple in November that are starting to show in my dividend income now. I bought National Bank (NA) and Manulife (MFC) in November and they are doing well so far. My estimated earnings for January 2012 is $515.16. I don’t make large purchases often. I do my TFSA contribution once a year but I do send $200 – $500 cheques to my DRIP shares with Computershare and CIBC Mellon every now and again. When you don’t stare at it, you realize after a while that it’s growing steadily.

Dividend Paying Holdings

Here is a list of my current holdings as of writing by accounts.

Broker Accounts (RRSP, TFSA, …)

Computershare & CIBC Mellon Accounts

Readers: Do you have a sector you are favoring this year?
Disclamer: Please note that this blog post represents my opinion and not an advice/recommendation. I am not a financial adviser, I am not qualified to give financial advice. Before you buy any stocks/funds consult with a qualified financial planner. Make your decision at your own risk – see my full disclaimer for more details.

Image: Simon Howden / FreeDigitalPhotos.net

Crooked Banks? Mortgage and Real Estate Propaganda?

January 15th, 2012 | Category: Banks, Mortgages | 7 comments

The title is a mouth full – eh? I read an article over the weekend about the current low mortgage rates offered by many banks and the comments were most entertaining (more about that in a bit). The title was intriguing: “Why are mortgage rates hitting record lows?“. Who wouldn’t be interested if they have a mortgage. The article simply goes over the new mortgage rate promotions by the banks for a short period of time and how it could be beneficial to refinance your mortgage. I have written a number of posts on refinancing and accelerating your mortgage but the article is not what caught me; the comments caught me!

Banking Propaganda

When you read the comments, it would seem like there is a propaganda but the reality is that the Banks are in it for the money – what business isn’t? Obviously, they will compete with each other and try to get more loans coming their way. As a customer, you are responsible for ensuring YOU get the product that works for you. When it comes to a mortgage, it’s your choice to pick the number YOU want to borrow, not the bank. I don’t remember ever reading in the contract that the bank will decide the amount I should borrow. They tell you what they are comfortable lending you (I’ll agree that the limits are sometimes high) but YOU choose to pick what you can afford. They don’t know what new car you’ll get or what new services you’ll suscribe to :) Ok. I am being sarcastic here but it seems that everyone is ready to blame the banks and the financial system for their inability to manage their finance …

Canada’s Laws aren’t the same as U.S. Laws

I am not too familiar with the U.S. laws around mortgages and home ownership but in Canada, you just can’t walk into a bank and give the keys back. First of all, if you have problems with making the payments, the bank will work with you to see how they can help. First thing they will probably do is extend your amortization to see if it helps since it will reduce the payments. Next, they’ll work with you and look at all your assets. Everything is fair game since you signed the papers – your RRSPs, TFSAs and so forth. Remember that banks aren’t in the real estate business so it’s in their best interest to have you make the payments. Even if a bubble was to burst, don’t expect to see many walk into a bank and return the keys as we saw happened in the U.S. during the financial crisis. These individuals would have to declare bankruptcy and that means you are really broke as opposed to having a house valued under your mortgage.

Real Estate Bubble ?

The low interest rates obviously got many buyers looking and buying but is it the banks that are guilty? Remember, they are in the business of making money and mortgage rates are tied to bond rates. As long as bond rates will be low, so will the rates. I won’t go into the sub-prime fiasco here as I don’t think one can use that as an excuse for taking a mortgage larger than they should. At which point in life do you stop being accountable for your decisions?

As far as I can remember, the bubble started 7 years ago in the Vancouver area – that’s when I started hearing it anyways. It’s got to be massive by now :) Every time someone can’t afford to buy anymore, it would appear we are in a bubble. It’s worth noting that newspapers sensationalize the value of housing in Vancouver. An average house in Vancouver is greater than $800K, but all you got to do is drive 30 minutes away and you have one for $500K. Those are houses; apartments and condos can be lower. The Greater Vancouver Area is quite large and you can find an affordable place if you really look, but you won’t be living in the swanky area. As a homebuyer, you need to plan a down payment though. Seriously, consumers have to really question their buying habits if they want to buy everything with no down – homes, cars, furnitures, … Enjoy today and pay tomorrow isn’t a sustainable model. It’s the model business offer you though.

I am not saying there isn’t a bubble, more so in some areas, but I am not sure if an interest rate increase will burst the supposed bubbles we are in. Most people have 5 year terms, and if you assume an average 3 year term, it would take 3 years for the pain to really surface. I think job losses are more concerning than the interest rates when it comes to housing prices but that’s just me. I expect the housing prices to flatten and correct themselves within a 10% range over the next couple of years.

Got it off my chest!

I took the opportunity to rant a little here after reading the comments. At the end of the day, YOU are responsible for your actions. YOU choose how much YOU save and how much YOU spend. Try to live within your means and understand the life style your finances can really offer. If you do that, it won’t matter what the interest rates are.

Readers: Are the interest rates a concern to you? What actions do you take to avoid being in trouble?

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