We have a few clients with SM at Scotia. It works, but requires more manual transactions each month than the readvanceable mortgages at several other banks.

There are several types of their STEP mortgage that have different options, so you need to be clear on the options that you will have.

The biggest problem was that you needed to go into the branch every month to get your credit line increased, but most of the setups today have an automatic credit line increase.

The other issue is that you cannot invest directly from the credit line. Therefore, it may take manual transactions to invest monthly and the money to invest may have to be transferred to a separate chequing account.

They don’t automatically capitalize interest, like the other banks, but you can get around this with “guerrilla capitalization” – which is essentially the strategy you mentioned. Pay the interest from your chequing, but then immediately take the money back by taking the exact same amount from your credit line to the chequing account.

You need to be able to show that they money borrowed was the money that was used to pay the interest on the investment credit line. If so, then the credit line normally remains 100% tax deductible.

Ed

Interesting strategy. Does it make sense?

Here is how I see it from several different perspectives.

1. Tax – It appears that tax deductibility of the interest should be no problem. The MicroFIT project is essentially a business. You are buying equipment that probably would be worth nothing (or less because of the cost of removing it) at the end of 20 years, but the income is all business income, not return of capital (as far as I know). You are just receiving income for selling power.
2. MicroFIT project – I’m not an expert on the MicroFIT projects, but anything with a 16% return must be high risk. You need to understand the risks before you proceed. We have met a few people that looked into them, so my knowledge is just indirect, but I have heard that some people could not go on the grid and received nothing, some received lower rates, the power created varied based on weather and the exact directness of the angle towards the sun, there were questions about the costs of insurance and maintenance, are you really going to stay in this home for 20 years, what control do you have with only one possible customer, and what is the cost of removing the obsolete equipment at the end of 20 years? My understanding is that the $880/month is not guaranteed and that there are various costs and risks that you should be aware of.
3. Use as SM strategy? – You could enhance the strategy by doing it as an SM strategy. If you would get a readvanceable mortgage instead, then you could capitalize the interest payment, so that you do not have to pay the credit line interest from your cash flow. You could use that money to pay down your mortgage more quickly and reborrow to invest.
4. Add Cash Dam – If you had a readvanceable, you could also pay the MicroFIT income onto your mortgage each month and also reborrow that to invest. This would convert most or all of your mortgage to tax deductible.
5. Interest rates – The best rates we are getting today on readvanceable mortgages is prime -.65% on the mortgage (slightly higher than your rate) and prime +.5% on the credit line portion (lower than your rate). While the net interest cost in month 1 would be slightly higher, the benefit of converting your mortgage to tax deductible from both the SM and Cash Dam would easily make this worth it.
6. Investment – How does the MicroFIT compare to other investments? Once you understand the full cost and risk, I expect you will find that your expected rate of return is quite a bit lower than 16%. It is also fully taxed as business income, so even if the return is 16%, if you are in a 40% tax bracket, you would pay 6.4% tax, making your net 9.6%. A long term average return on the stock market is 10-11% and capital gains tax would be only 2% (which can mainly be deferred many years into the future). In other words, even if the return is really 16% and risk reasonable, the after tax expected return is only slightly more than the stock market.

Does that answer your questions, David?

Ed

I see you’re quite active helping reader of this blog and I have a question.

I am getting a $80k non-automatically readvacement HELOC from HSBC at P+.75, also with a $352k variable-close mortgage at P-.79 mutures in 2016 (very recent renewal) biweekly payment of $700 which around $400 gets into the principle.

Here is my plan,
I moved into a new house in a new community, corner lot, with raised basement. So, we got lots of sunshine. So, I am thinking of putting the HELOC into a microFIT project, which going to cost me about $65k. Since local hydro company (Hydro Ottawa in my area) guarantee to buy my generated electricity at $.802 per kW for the next 20 years.

So, with the investment of $65k, I will get about $880 per month (or 1.35%/month or 16%p.a.), as business income. So, the cost of the project surely tax-deductible with no problem with the CRA. Since the 16% is not compounding, and so I have an additional thought.

I will put the $880/month income towards any investment for additonal growth or income for the next 20 years or so.

So I have the following questions:
1) Does the general plan make sense?
2) I understand I have to declare money from Hydro Ottawa as interest each year, rather than deferred. Does it make sense to use as SM strategy?
3) With the additional investment of $880/month, does it matter now return of capital is part of the distribution since the “borrowed fund” is for microFIT project.

Thank you so much.

If you borrow against your condo to buy a home that will be your principal residence, the interest is NOT deductible.

This is one of the most common errors made by people with rental properties. Just to be clear, interest is deductible because of the purpose for which the money was borrowed, not what was used as security or the type of loan.

The extra amount you borrow to buy your home will not be deductible, since the purpose of borrowing is to buy a principal residence. Whether this amount is a mortgage or a credit line. does not affect whether or not it is deductible. A mortgage will be at a lower rate.

The first question is whether or not keeping the condo as a rental is a good idea. It will likely make you some money over the years, but generally condos don’t make very good rental properties. Older, multiple unit buildings are usually much better investments.

This also depends on what you would do otherwise. Having a rental vs. not having one is probably better. If you are looking at the Smith Manoeuvre, there are multiple ways to do it. If you have a rental, you can do the SM on both. Or if you don’t have a rental, you could use the extra equity and possibly an investment loan to invest a similar amount, except in the stock market instead of keeping the rental. The stock market has far higher long term growth (6 times higher return in the last 30 years), so this strategy could give you far higher returns without the hassle of being a landlord.

The second question is, if you keep the condo, how should you structure it? I would suggest:

1. Since your mortgage is coming due, refinance it with a readvanceable mortgage that allows multiple mortgages and credit lines.
2. Keep your existing balance as a mortgage portion. This amount needs to be kept separate, since it will be the only tax deductible amount.
3. Borrow enough for the 20% down on your home against the condo, and then make that amount a separate mortgage portion.

As for rates, the prime -.85% is probably the best mortgage rate now, but you can get the credit line portion at prime +.5%. The prime -.85% is only in 5-year closed mortgages. You should only lock in for 5 years if you are quite sure that you will not need to refinance or want to sell for at least 5 years. The 1-year fixed is also a good option. We are getting 2.64% today.

Ed

Pretty interesting article and comments, my congrats!

I have some questions regarding a topic that seems to me somewhat similar to a SM strategy. My condo mortgage term is almost due; I wanted to sell it and buy a house. When I went to my FI to discuss my options, they recommended that I : (i) keep the condo as rental investment and renew the condo mortgage (ii) get a HELOC on the condo and use it to finance the downpayment of the house (iii) get a mortage for the house (purchase price – downpayment). The house will be my primary residence with a basement that I plan to rent as well. According to them, on the condo mortgage / HELOC combination, I can get tax deduction on both: the interests payment of the condo morgtage + the interest payment on the HELOC used to finance the downpayment of the house.

1. Does this arrangement make sense for you? What advantages / disadvantages / risks do you see on it? Can I really deduct interest payments on the HELOC following this strategy?

2. They also offered two options for the condo mortgage / HELOC combination:
a) Renew the condo mortgage and get a HELOC = 80% Condo Value – Condo Mortgage and then use it to finance the house downpayment. (mortgage rate ~prime – 0.85% and HELOC rate ~ prime + 1%)
b) Get a HELOC for 80% Condo Value and use it to pay the condo mortage and then to finance the house downpayment. (HELOC rate ~ prime + 0.5%)

What option would you pick and why? Why would I pick option b) over a) and pay 1.35% more on the mortage component? Am I missing something, perhaps some tax aspects?

Off topic: For tax purposes on the investment property, I can deduct condo mortgage interest payments, mgtm fees and insurance from the rental income and have to pay taxes on the outstanding balance. However, as I am paying the condo mortgage, the interest payment gets reduced and so the tax deduction, which leaves me paying more taxes every year. Any suggestions on how to optimize this? Perhaps by taking option b) on the condo mortgage / HELOC combination (see question 2)

Thanks a lot in advance,

LuBoy

What are your thoughts moving forward?
Best,
Duncan

FrugalTrader, are you planning any updates for this post?

Let’s just check at the end of this year to see how it went. That is only one year, which is a short period of time, but we are still confident in a continued recovery over the next year or 2 – just like it has from all previous declines.

All the stats you mentioned are irrelevant, unless you can estimate to what extent they are already priced into today’s market prices. Since those are all well-known, I doubt any of them will affect the markets.

The US still dominates in most sectors – retail, distribution, marketing, technology, telecom, health care & finance, and locally in utilities and real estate.

A sector does not have to perform well to outperform – just better than expectations. For the US, expectations are so low, it is hard to imaging not beating them. For example, among the best-performing stocks last year were Ford (456%), Bank of America (124%), & Citibank (77%). These companies did not have awesome performance. They just survived and didn’t lose money – which was infinitely higher than was expected of them.

Ed

All I’m seeing so far is a statistical recovery. GDP numbers came in at 5.7 % recently. Sounds impressive right? I think we need to look a little deeper into those numbers though. First, over 60% of this growth came from inventory rebuilding. Digging deeper, you can see that inventories had dropped below sales, so a replenishment was required. Increasing inventories add to GDP, while sales from inventories decrease GDP. I’m not suggesting that businesses building inventories is a bad thing, however that growth will only continue if sales grow. To this point, if you examine the consumer spending data, you’ll see that it actually declined in the 4th quarter both annually and from the previous quarter. US domestic demand also declined from 2.3% in the third quarter to just 1.7% in the fourth quarter. That does not bode well for signs of economic strength.

Imports also fell over the 4th quarter which is strange considering that in a heavy inventory rebuilding cycle, a portion of the goods that businesses need to build their products come from overseas. These falling imports have the effect thought of an increase in the statistical GDP number based on how GDP is calculated.

Finally, the impact of stimulus spending in the US accounted for 90% of the growth in the third quarter. In addition, there was a major decline in labour input in the fourth quarter(contracted by .50%). Such a decline has never coincided with a GDP this good.

Unemployment rose (hundreds of thousands of jobs were lost) in the fourth quarter. Sales taxes and income tax receipts are still falling. It’s hard to be serious in believing in a real recovery with unemployment still rising!

The US has tried to borrow it’s way out of debt to “stimulate” economic growth. As a nation that’s transformed over the years from manufacturing to a service based economy, they no longer create tangible products on a large scale to the degree of other nations do. As a result, all the stimulus money has done is buy them a little time creating even higher debt levels that will be even more difficult to reign in.

Let’s look at the US Debt figures a little deeper. In the 1940’s when debt was at all time highs as percentage of GDP, the US ended a world war and all of the “baby” boomers, went back to work. The US at that time was the world’s major manufacturer and surpassed the UK in economic might. Because they had a huge domestic manufacturing base and the population to work in those (at the time) very well paying jobs, their economy took off and they were quickly able to pay down the debts. Flash forward to the last decade, and the US economy has turned from production to hyper consumption. In the eighties, they were still a creditor nation. Now, they are the world’s largest debtor nation. The debt numbers also do not include all of their unfunded liabilities like social security and medical care for the elderly. If you add in these numbers, the real debt number is close to $50 TRILLION!!!! Certainly much higher than anytime in the past, and it’s growing far more quickly than any real economic growth.

I’ll tell a story to explain why the trade deficit is a far greater problem than many realize and why the US dollar will eventually experience a total collapse.
Imagine 4 people stranded on an island, three chinese workers and one millionaire American. They come to an agreement that they’ll each assign tasks to one another to sustain themselves. They agree that three of them will hunt, harvest and prepare the food while the fourth, the American millionaire will eat all of the food, leaving them just enough scraps left over to sustain themselves after he dines. In addition, the American agreed to issue each of them IOU’s for every meal that will entitle them to a portion of his wealth at some future date when they eventually get off the island. This goes on for some time and the American spends his days lounging and eating on the beach while the other three toil and labour to prepare food for him. One day though, the American has a heart attack and dies. At first, the other three panic, realizing that their IOU’s could now be worthless as the payee is no longer able to make good on his promise! But in the mean while, they’re still stuck on the island and life must go on. They agree to alternate between each other to share the work load so that all of them get a little recreation time and the opportunity to relax on the beach. They also now have more food, that they equally distribute among one another and enjoy better nutrition and a better quality of life. Years pass, and they eventually forget all about the American. His paper IOU’s were used to start campfires and have long been burned. They no longer need him, and realized that their life on the island was actually far more rewarding without him anyway!

Do you think my story’s a little far fetched? Maybe a little, but isn’t this exactly what China and the rest of the world have been doing for some time now? Trading their real goods that they’ve worked hard to produce for IOU’s in the form of treasuries (keeping their own currency and thus global purchasing power artificially low)? to say that the world can’t function without the US consumer is like saying farming can’t continue without locust infestations! Consumption of scarce resources in return for paper IOU’s does not bode well for long term productivity.

I end with a question. Can you please explain what sectors of the US economy will fuel a future sustained recovery? And what durable advantage to they have over other nations moving forward? Innovation and education are certainly two huge strengths I can think of, but the amount of regulation and red tape that exists in the US will likely force the best and brightest to export their knowledge to other nations where such barriers don’t exist. The way I see it is that US assets (real estate etc). will eventually go up in price after the dollar collapses, but it will be foreigners buying it up not Americans.

Duncan

Definitely let’s talk later this year. Our view is that the markets a year ago were in “Irrational Pessimism” (see article on this site), so why would we go back to that?

Every loss of 30% or more in the history of the S&P500 had a gain of more than 30% within 1-2 years, except the 2009 was only +27% after 2008’s -37%. The stock market has always been resilient.

If you noticed my recent articles on “Stock Market Risks” on this site, the general view of investors is that the stock market is far more risky than it actually is. In actual fact, other than in the 1930s, the S&P500 has fully recovered from every calendar year decline within 4 years and 88% of declines were fully recovered in 1-2 years.

So far, we have seen a large recovery that we expected that was a realization that we are not going off a cliff, but the real recovery has not really started yet. The economic news is mostly good, with GDP back to positive and most companies showing good earnings and beating expectations.

Do you remember the market 10 years ago? The US was a world-beater with large surpluses, at the centre of a technology boom, and DOW was going to 35,000 (book). Those exaggerated expectations were to high and built into the market at the time, which lead to the only decade (other than the 1930s) ever with not growth in the US market.

Now the expectations are the opposite. The US is widely expected to collapse, the dollar will crash, the twin deficits will result in hyper-inflation, China will pass it soon and the US will lose its place as the main world currency. Now the expectations are so low that if the US merely survives, it will shock everyone.

Oil prices were about $10/barrel and gold was about $250/oz. with no prospects of rising.

Ten years ago, the bar of success was 20 feet high for the US and inches high for commodities. Today it is 6 inches off the ground and almost impossible not to outperform for the US, while the expectations are 20-feet high for commodities.

You saw the US debt figures on Wikipedia. The US debt is about the same as 15 years ago and about half of what it was in the 1940s. Both times they paid it down with a few years of surpluses. You can’t add debt of government-controlled organizations like Freddie Mac & Fanny Mae without including their assets. Actual debt is manageable so far.

The only issue with the trade deficit is the currency. Since everyone already knows about it and the US dollar has already fallen, is this not already built into today’s price for th US dollar?

I can’t see how inflation can happen. If we have pressures, the Fed will raise rates to keep inflation low. So our view is that inflation will definitely remain low. The only question is whether the will have to raise rates to keep it low. If they do raise rates, that will tend to push the US dollar up – not down.

The fear of inflation seems to discount the facts that the US continues to import tons of goods at very cheap prices, has continually new and cheaper technology and demographics supporting lower and lower inflation.

The supply of commodities will eventually catch up. No matter how much demand increases, commodity prices should fall back to normal, unless there is a real permanent shortage. Higher demand leads to higher supply which means the longer term price of commodities should remain low. This is in sharp contrast to the current expectations that commodity prices will continue to rise into the stratosphere.

Chasing the out-performers of the recent past is not good investing. We made a killing in the last year by going much more aggressive at the bottom of the market, when the huge recovery was obvious to anyone with faith in the economy and humans.

Today, the global and US markets are only a bit over half recovered. The low-quality stocks have recovered a lot, but the high quality stocks have hardly moved. The main recovery is still to come.

Remember, what actually happens does not affect the market. What affects the market is what actually happens COMPARED TO EXPECTATIONS. The US will almost definitely beat expectations, while it is hard to see how commodities can possibly match the expectations of continued double-digit growth.

Ed

No, I’m not really a contrarian.We research and invest with the world’s top investors.

If you take the top investors that beat their indexes over long periods of time, most are value investors. Value investors rarely buy what is currently popular, since there is usually little value there.

We get to hear the opinions of these All-Star Fund Managers regularly. They are very different from the average fund manager working for a big institution and usually very different from currently popular opinions or those in the media.

What I hear makes me a big optimist. I have faith in free enterprise, free trade, human ingenuity and the stock market. I don’t foresee anything dire for the U.S.

The issue with commodities is that, by definition, a commodity is an item without unique characteristics. Oil or gold or wheat from one supplier is the same as from the next, so the only way to compete is on price. Unless there is a permanent shortage of supply. commodities will have low prices long term.

Your comments about corporations are true, but don’t really apply to the stock market. I would suggest you read the recent article on MDJ about the Risks of the Stock Market.

Ed

I fully agree that the States biggest asset is their ability to innovate. Unfortunately though, due to increased regulations and an increasingly litigious society it’s becoming harder for those innovations to be brought into fruition. But who knows, policy can quickly change and they could still come out on top. My point is that whether the US economy picks up or not, it doesn’t matter if you’re in commodities. They will rise with or without the US! One thing is for certain though, that the long term trend for the dollar is down. Commodities will never be worthless, can you say the same for shares of a corporation?

Ed, I hope you are right but I doubt it and I think the ‘recovery’ we are seeing is just the bailout money working its way through the system. If the money supply “printing press” gets turned off things will quickly grind to a halt. If they keep spinning then look out for hyper inflation in the US.

My point is that anything that is widely known will not move markets.

For example, you and millions of other investors believe that commodities will rise because of demand from China. Are you waiting to buy commodities until then or do you already own commodities exposure? So, if growth happens as most people expect, that supports TODAY’S price, not a future rise.

Commodities may not be at their highs, but most are still up a lot this decade. Commodities are not like equities that usually rise in the long term. Rising demand alone does not increase commodity prices, only if supply cannot keep up. Demand is expected to rise, but so is supply. There were some large gains initially because supply was behind, but huge increase in demand may or may not lead to higher commodity prices.

The question is: will the future turn out to be even better for commodities than your rosy forecast or will it be somewhat lower? Today’s price reflects all widely-known information. If the future is great, but slightly less than expectations, then commodities may well fall.

Another example is farm land, which you mentioned. Again, I have heard this from quite a few people. I recently talked with a guy that bought farm land 3 years ago for $1,000/acre and just sold it for $1,500. That’s a 50% rise in 3 years. It would normally take 15 years for that much of a rise. The farm land boom has already happened as well.

The biggest gains will be in a sector where the future turns out to be quite a bit better than today’s expectations. If you focus on that and try to find information that is not widely known, you can find bigger opportunities.

The US economy still has many areas to grow. Most of the cost of a product is marketing. When I used to work in the mattress business 20 years ago, a high-end mattress set cost $250. We sold it to stores for $500 and the stores sold it for $1,000 (sometimes more). So 75% or more of the money is in marketing, packaging, distribution, retail, etc. From my experience, less than 25% of the money for manufactured products goes to manufacturers. The US dominates in most of the other areas.

They still dominate the world in financials, health care, retail (staples & discretionary), technology & telecom and real estate and utilities are usually local in each area. So, they can still dominate the world in 8 of 14 sectors.

The advantage the US has is their innovation. Whatever the next big thing is, they will probably be there.

The US may or may not be successful the next decade, but the expectations are low. We are investing there because the belief in the fall of the US is rampant and we believe vastly overdone.

I use the same US debt figures from Wikipedia. Look at the 2nd graph showing debt as a % of GDP. The red line is public debt. You will see it is still lower than 15 years ago and about half of where it was in the 1940s. Both those times, they came out of it with little problem.

I think the massive number of articles predicting a debt crisis in the US and the collapse of the US dollar are extrapolations of recent trends, but the stimulus programs will stop. I think the articles are also political pressure to try to encourage Obama to cut spending.

Anyway, the panic about the US that is rampant seems to us to be hugely over-exaggerated.

Ed

This is totally incorrect (where do you get your statistics please?)
The real numbers can be found here:

http://en.wikipedia.org/wiki/United_States_public_debt

http://youtube.com/watch?v=2I0QN-FYkpw