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.
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.
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:
- The ability to service a higher debt over time until your mortgage is paid
- A solid investment plan for ensuring growth
Readers: Are you doing the Smith Manoeuvre as outlined by Fraser Smith? Are you contemplating it? What do you think of the risk level?