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Smith Manoeuvre – When Should You Consider It

home valueThe Smith Manoeuvre is a strategy that allows Canadian home owners to convert their mortgage into a tax deductible investment. It’s often referred to as the Canadian Tax Deductible Mortgage. South of the border, our American friends benefit from having the interest on their mortgage as tax deductible where as in Canada, none of those benefits exist.

The interest paid on our mortgage is paid with after tax income. Not so long ago, The Smith Manoeuvre found a way to convert the biggest debt individual would take over a lifetime into a tax deductible investment. The first time I read that, I was ready to jump with both feet but once I understood the process, I was a little reluctant due to the cash flow requirements.

I realized that while it’s a good thing to get tax credit wherever possible, the cash flow needs to be really thought through. As a result, I started thinking about when it would make sense to start it.

  • Is it for everyone? I don’t think so. You need a strong debt servicing ability which means a dependable income
  • Should you start right away when you buy your home? I don’t believe you should. Manage your initial mortgage term and plan how to proceed as you debt will increase while your investment also increase but you will have debt.

Related: How to assess if the Smith Manoeuvre is for you 

Mortgage vs The Smith Manoeuvre

The common point between a mortgage and the Smith Manoeuvre is the debt factor. They both allow you to manage your debt. They differ in the debt servicing model and the end result benefit.

Debt Servicing

With a mortgage, you make your payments and over time, the ratio between the principal and interest changes. You pay a lot of the interest up front unfortunately. The only way to reduce the interest is by either getting a better rate or increasing your payments.

With the Smith Manoeuvre, you make your payments and borrow from the principal paid to create an tax deductible loan for investments. The interest on the investment loan is serviced by the line of credit (also referred to as an Home Equity Line of Credit or HELOC). Your HELOC ends up growing on its own while the payments on the mortgage are fixed since you still have to pay for it. Your debt level doesn’t really decreases; in fact, it grows when you consider the interest on your HELOC.

Tax Deductible Interest

The interest on a mortgage is not tax deductible but once you convert the equity from your principal payments into an investment loan, the interest becomes tax deductible as long as the investments meet the requirements (income producing investments). Make sure you run the math, the higher your taxes, the more you save in this case. It requires diligence to see the benefits through.

The Smith Manoeuvre Is All About Debt Comfort

Your ability to handle the Smith Manoeuvre is going to be about your ability to handle debt since it’s all about leverage. What the Smith Manoeuvre ends up doing is leveraging your home equity to invest.

Personally, I wasn’t ready to start the Smith Manoeuvre when I took the mortgage on the house. I was not comfortable with the debt level I would have needed to carry. My plan was to reduce my mortgage in order to assess the ability to execute the Smith Manoeuvre at a later time. While learning about GDS (Gross Debt Service) ratio and TDS (Total Debt Service) ratio, I decided to come up with a value I would be comfortable to execute the Smith Maneouvre. Just like the banks look at your GDS and TDS to lend you money, you can look at this to decide on when you can start executing the Smith Manoeuvre if you are interested in the concept.

I have a Google Template (Debt Servicing Calculator) ready for you to try your numbers. The example below assumes a Family Gross Income of $100,000.

  • GDS: Mortgage only ratio against your income. The guideline expects a borrower to be under 30%.
Gross Debt Service Ratio

Gross Debt Service Ratio

  • TDS: Overall debt ratio against your income. The guideline expects a borrower to be under 40%.
Total Debt Service Ratio

Total Debt Service Ratio

  • MSR: Mortgage Safety Ratio – I came up with this one and I am still refining it, go easy on me :). The goal is for you to assess your comfort of debt in order to move on and decide on focusing on other investments. A MSR under 3.5 is showing a confortable debt ratio, anything above starts to show some risks and there is little room for safety unless you have a large emergency fund.
Mortgage Safety Ratio

Mortgage Safety Ratio

 

Smith Manoeuvre – Mortgage Safety Ratio

The MSR is based on the GDS and TDS since it’s all about evaluating when you can really focus on investments or the Smith Manoeuvre for example. It’s not meant to be a hard line but a guideline to show you where you stand in terms of debt. The formula is simple, I look at your remaining mortgage amount compared with your family income and add the ratio with the GDS and TDS ratios against a safe value. The closer your GDS and TDS is to the safe value, the better your ratio is.

I have provided my template for my readers to look at the GDS, TDS and my new MSR. That way you can get an idea of your relative debt compared with financial institution expectations and also evaluate what you are comfortable with.

Success with the Smith Manoeuvre

I am interested in executing the method but I am still looking for a success story when using the Smith Manoeuvre and I am curious how long it actually takes to see the success. I understand the theory and the math behind but since it takes years to see the results from investments, I would love to hear from home owners that have done it and share their feedback. Would you do it again?

The Smith Manoeuvre doesn’t reduce debt initially and ads risk in my view. Be sure to be in the best financial position to execute the strategy. Just like an emergency fund, paying your mortgage first provides a type of safety in the event that your income will change. An emergency fund will help during unemployement but you might still have to adjust. Rather than be faced with downsizing, if you had made extra payments, you can extend the amortization because you were ahead.

Not all HELOC can work either if you try to do it on your own as you need a re-advancable HELOC to avoid paying the interest from your income. A re-advancable HELOC allows you to accumulate the interest within the HELOC.

Another important consideration is the money flow. You need to be able to show and prove the money flow so be diligent about the accounts you are going to use. You don’t want to mix the accounts with your normal accounts. I would go so far as to recommend a new discount broker such as Questrade for your invesments.

My strategy so far has been to accelerate my mortgage and also invest in my TFSA, RRSP and RESP.

Readers: Share your opinion on the Smith Manoeuvre or your experience if you have done it.

Image courtesy of renjith krishnan – FreeDigitalPhotos.net

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25 Responses to "Smith Manoeuvre – When Should You Consider It"

  1. aB says:

    Disclaimer: I don’t have a mortgage yet, looking to buy soon, and have been reading as much as I can on the Smith maneuver. I am waiting on my copy of the book.

    My understanding of it is this, please correct me if I am wrong. [I have found that every explanation I have come across is confusing to me.]
    I have a mortgage, with a (re-advancable) HELOC.

    For the mortgage side, I just pay it as a normal person would, with my normal cash flow.

    On the HELOC side, whenever I pay the mortgage, I take the amount of principal paid to the mortgage out of the HELOC and invest it. The HELOC payment is paid by the HELOC.
    [Or to complicate things by investing the principal divided by the interest rate.]

    At tax time, I can report the HELOC interest, as tax deductible, and apply the return to the mortgage. [Investments hopefully taxed favourably.]

    If the investments produce a dividend, then apply that to the mortgage.

    Once the mortgage is paid off, the investments are (hopefully) larger than the HELOC. [Which may or may not be paid off depending on approach.]

  2. Jared says:

    Hello,

    I have been doing the SM for a few years. Currently the income provided from the investments is making an extra mortgage payment each month.

    I invest in Canadian Dividend paying stocks in my SM account and use all of dividends generated to pay down the mortgage each month. At this time, it equates to having a 3rd payment to the mortgage each month with basically no change to my cash flow. As you can imagine this greatly reduces the time it will take to pay off the non-deductible mortgage. Once the mortgage is paid off, I will then use the dividend income to service the investment loan and likely pay some of the investment loan overtime.

    • The Passive Income Earner says:

      @Jared

      Thanks for sharing. I really appreciate it. Do you mind me asking if your SM account is above the SM HELOC? Even? Under? How fast do you feel it accelerates your mortgage payments?

      • Jared says:

        The investment account is well above the HELOC at this point, but for me that doesn’t really matter all that much. Obviously below wouldn’t be a good thing, but as long as the income generated hasn’t reduced that is mostly what I am interest in.

        For this year, the principle reduced by the extra payments will be about equal to what would be paid off with just our regular payments. So we are doubling the reduction in principle this year.

        To clarify, the dividend income doesn’t cover both the payment and the interest on the HELOC, as I currently just pay off the HELOC interest from the HELOC. The dividends are significantly more than the current interest.

    • Ferd says:

      If I understand correctly, the dividends you receive through your investments cover the interest of the HELOC as well as an extra mortgage payment?? THAT IS IMPRESSIVE!

      As well, do you also borrow the principal paid back with that extra mortgage payment, thus doubling up on monthly borrowings?

      • Jared says:

        The dividends do cover the interest on the HELOC, but I don’t use them for that at all. I put all dividends directly to the mortgage and pay the HELOC interest with the HELOC.

        As I am buying individual stocks, I borrow from the HELOC whenever there is enough money avaiable to make a reasonably sized purchase with the money. This is usually every 2 or 3 months depending.

        • The Passive Income Earner says:

          @Jared

          Thanks so much for sharing. From what I can see, you are focused on paying off the mortgage and once that’s done, you will pay off the HELOC. Will you keep the same mortgage payment amount to pay off the HELOC? That’s like converting the mortgage payments into savings even though it covers the HELOC since it increases your net worth.

          • The Passive Income Earner says:

            @Jared

            Might I ask which institutions you are setup under? Any challenges in getting setup?

          • Jared says:

            We haven’t decided for sure to pay down the HELOC as soon as the mortgage is paid off, but I suspect we would start to pay it down some right away. We had discussed bringing it down to 50% of the house value and the leaving it there. If the value of the investments is significantly above the value of the HELOC, then we would be much more likely to keep the HELOC in place.

            It will likely really depend on interest rates and tax considerations at the time we get there. The tax deduction of the loan is a nice offset for the dividend income and since at that point we would already be maxing out all registered plans, having more deductions against investment income would be nice.

            We use BMO readiline for the Mortgage and HELOC. Setup was no different than any mortgage. The investment account is at questrade.com but there is no special reason for that. We also have a bank account at BMO that is used exclusively for moving money related to the HELOC and investment account.

  3. Ferd says:

    I don’t have a mortgage (yet) but have done some extensive reading on it, mostly from MDJ (which I think has a success story, if you want to read it). Anyways, especially for a dividend investor like you, it becomes even more interesting. When borrowing the amount of capital paid back, you don’t have to keep a portion for the interest payment coming up (or not as big a portion) since the dividends will take care of it.

    As long as you keep your returns higher than the interest rate, you are greatly benefiting (basically, you earn growth on money you don’t have). And the “interest rate” you have to beat isn’t the nominal interest rate, since you incur tax savings. It’s actually lower!

    When I do contract a mortgage, it will be my assessment of my strength in investing that will determine if I go forward with the SM, not really my debt-to-anything ratio (Because at first, your HELOC isn’t that high anyways, 15K maybe, and it then grows in proportion to your payments)

    I’m by far no specialist, so correct me if I’m wrong!

    • The Passive Income Earner says:

      @Ferd

      You get the fundamentals. I am not sure if I consider MDJ’s SM a success because his portfolio vs HELOC liabilities are mostly breaking even. That’s why I am curious about others as I am really only familiar with his and I would have expected growth in the SM Portfolio but it seems the HELOC is keeping up with the growth. MDJ is doing amazing overall though – a great success. I have not read how he is paying down the HELOC though …

      I will say that the job status makes a big difference in taking on risks. Government employees have golden pensions and benefits from a job security and retirement perspective that can allow them to be more risky possibly (I willing to take on the comments here …). Others who can be target of layoffs have other risks even if the math of income vs interest works. If you ever have to slow down your mortgage payments, it will drastically affect the HELOC interest payments if it’s really tight.

      For me, I started with a $300K mortgage and that is big to do the SM and retain a high level of debt. I am almost below $200 now and that’s why I look at when it makes sense to start. I like the principal but it is still debt, it’s leveraged debt.

      Another way to look at it is to value it from a Net Worth perspective. With the HELOC and Mortgage and Investments, you won’t see a net worth growth for a while.

      Great comments. I like the discussions as I want to put the SM in place but I am trying to assess when and if the debt is something I am comfortable with.

      Cheers!

      • The Passive Income Earner says:

        I just had a look and his SM Portfolio for March 2013 is now 20% above his HELOC. It wasn’t always the case and since he was done with the mortgage, he may have accelerated the pay back of the HELOC.

        I want to look at how it was during the mortgage years to evaluate the comparison. The reason for that, it’s to assess the risk of having to sell the investments to close the HELOC. It might be needed – think of a divorce or anything like that for anyone. I believe it’s an important risk to assess and define if you are comfortable with it.

        • Jared says:

          We are in the middle of paying off our mortgage (about 55% paid off) and have been doing the SM for 4 years or so. How comfortable you are with leverage is always the biggest factor in the SM.

          If you wouldn’t borrow the money to invest if you were offered the investment loan straight, then probably the SM isn’t right for you.

  4. Good for you Jared! Income generating and reducing debt is the key to financial freedom!

  5. BlueChip says:

    What type of investments are you guys using for the SM. My understanding is that Dividend stocks or ETF are the main types someone would use when implementing the SM.

    • Jared says:

      @BlueChip

      I exclusively use Dividend stocks in my SM account, but I think it really depends on your goal with the account. I use Dividends as I want to generate income to pay down the mortgage faster. Ed Remple would say use All-Star Mutual Funds, indexers would say use an Index ETF. You need to be a bit careful with the Mutual Funds and ETFs if they have a payout as a lot of times that includes Return of Capital which can cause some tax and calculation headaches.

  6. BlueChip says:

    Thanks Jared.

    My concern is that I have read that using Mutual funds you lose a lot of your return to the MER vs if you use an ETF the MER’s are a lot smaller. Any thoughts on that?

    I have spoken with the TDMP people out of Toronto and they are only using mainly ETF’s.

    Does your dividend paying stocks mainly pay the dividend Quarterly or Monthly?

    Thanks for your help.

  7. Jared says:

    @BlueChip

    First, if you are talking TDMP make sure you have read http://www.milliondollarjourney.com/tax-deductible-mortgage-plan-tdmp-worth-it.htm . Especially the comments from Ed Rempel about it. It should give you some questions to make sure you ask about.

    The biggest thing to look out for is Return of Capital if you are getting distributions, the link above will explain all the issues it can cause. If no ROC occurs, then ETFs would be fine.

    What ETFs do the TDMP people you are talking to recommend using?

    My dividend stocks are mostly quarterly. The portfolio I have is mostly made up of the Canadian Dividend achievers. The timing of distributions was not something I was concerned with when doing my selections.

  8. BlueChip says:

    I am probably going to use the Scotia step mortgage and invest on my own vs use TDMP. I should be deciding very shortly.

  9. Lisa says:

    Hello,

    wondering if the SM is worth doing with a second mortgage, as the 65% rule from October has changed things for me.

    Just curious, would appreciate any feedback.

    440K house appraisal (approx.) with 270 owing on mortgage:

    Option #1
    Equity Line Visa or 2nd mortgage
    440k
    75% = 60k available
    80% = 82k available

    Option #2
    Refi – HELOC
    65% = 286k
    subtract mortgage balance $270k
    Available equity =16k

    Thanks
    lisa

    • Erich says:

      Lisa,
      Though a second mortgage frees up a lot more money to invest, this would just add to your non-deductible interest costs. A HELOC is considered by the CRA as a “loan for investment purposes”, and therefore the interest paid is tax deductible, and is one of the primary reasons to consider the Smith Manoeuvre. This tax refund is applied to the mortgage principal to help accelerate paying off the mortgage, and free up more space in the HELOC at the same time (and increase your tax deduction the following year).

      At the end, you are left with NO mortgage (much sooner than without this plan) and a HELOC worth the total cost for your buying prices for your portfolio. Depending on your tax situation and the HELOC interest rate, it may be worth it to keep the HELOC and only pay its interest for some time afterwards, and invest the dividends leftover after paying the interest.

  10. Erich says:

    PIE,
    I wanted to share this resource I found extremely helpful in considering the Smith Manoeuvre. This calculator allows you to play with the assumptions of returns, dividend yield, your mortgage amount and how fast your mortgage gets paid off:
    http://www.milliondollarjourney.com/smith-manoeuvre-potential-returns-spreadsheet.htm
    (I found the thread comments helped me sort out what all the fields are for)

    I have 16 years left in my amortization, and its pretty surprising how large the portfolio could be after that much time, and how much sooner my mortgage will disappear. Now that I feel educated enough to execute it, I’m waiting for a reasonable sized market correction to be comfortable with valuations enough to buy a whole starter portfolio at once.

  11. Arun says:

    I will get my home this December and I will consider SM method, but I will need pay down some mortgage first. Actually, I am very much interested in implementing the method.

    I also like to hear some success stories.

  12. I tried the SM for a while in 2011. Honestly, I didn’t have the fortitude to keep going with it when we looked to move from that home.

    I still don’t think we have the confidence to do the SM right now. Paying off the mortgage debt is a higher priority.

    That being said I would look to revisit the strategy in 10-15 years – likely not a full implementation of the SM but a dividend heavy approach (which of course depends on interest rates).

    Nice article PIE – book marked!

    SPF

    • @Sustainable PF

      Finally someone who tried and decided against it. It has been difficult to find people on the flip side of the Smith Manoeuvre. What was it that you weren’t comfortable with? Was it the amount of debt overall?

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