Setting up The Smith Manoeuvre - The Blueprint

1. 1. The Financial Blogger

   The advantage about going with indexes is that you have a passive approach and you can benefit from the full potential of the market.

   However, in your situation, it seems that you can beat the market so I would consider stock picking :-)

   Good luck with your strategy! (mine finally shows positive results!)

   Mar 6th, 2008 @ 8:26 am

2. 2. Daniel

   Would it be easy to change (reduce) the income tax deduction from a paycheck and apply the saving directly to the mortgage part?

   Mar 6th, 2008 @ 10:51 am

3. 3. FourPillars

   I think Canadian dividend stocks are a perfectly valid way to do leveraged investing. It won’t be as diversified as worldwide ETFs but you have your rrsp and other non-reg accounts for that.

   Your timing might be pretty good - the financials are getting killed this year.

   I’m wondering if the market is pricing in the possibility of a dividend cut for CM and BMO? CM is yielding 4.82 percent and BMO is yielding 6.34 percent.

   The BMO yield is just too high…

   Mar 6th, 2008 @ 11:37 am

4. 4. str8jkt

   So without using an additional investment loan to cover the remaining 40k to completely cover the Rempel Max amount, are you planning on investing the entire amount available in your HELOC then ($60,000)?

   If so are you planning on paying for the interest on the HELOC out of your own pocket, since I don’t know if the increases from principal payments will be enough to cover off capitalizing the interest in the HELOC?

   Mar 6th, 2008 @ 11:41 am

5. 5. Derek

   I like and agree with what your saying. I may take out some home equity to get my portfolio more even with RRSP to Non registered content. I would look at the dividend achievers from Claymore and the div fund from ishares as core holdings. I would then add more of funds like PWF and and MFC than should be more stable and have lower payout ratios.

   I agree with above. BMO may take a hit like C in the US, but that would be an opportune time to buy i would think. I get more excited as the market falls. Who else wants to see the market sell off 25-40%?? What an opportunity that would be! We could all have the chance to be Wanna be Derek Fosters! lol.

   I don’t like using lots of leverage, but the low cost of borrowing combined with markets selling off make it almost too good to pass up. If you could buy say PWF and have no Dividend cut it should be able to cover all interest costs (since after taxe writeoffs it should only cost about 3.5% to borrow).

   Mar 6th, 2008 @ 12:01 pm

6. 6. FrugalTrader

   str, yes i plan on investing the full $60k as my principle payments will support $100k. It’s a conservative version of the Rempel Maximum.

   Mar 6th, 2008 @ 1:50 pm

7. 7. telefantastik

   Daniel: that’s an interesting question: the T1213 (http://www.cra-arc.gc.ca/E/pbg/tf/t1213/t1213-04e.pdf) form does have a section on “interest expenses on investment loans”, so it appears that you can indeed reduce related tax at source. It would be interested to hear what others think/know about that possibility: it would allow you to apply tax savings against mortgage to increase HELOC room right away, instead of only at year-ends - meaning more time for compound growth.

   FT: sorry to pry, but by investing the full 60k right away without the additional loan - do you mean this is the initial LOC amount you will have on your home-equity when you start? The reason I ask is: with your ongoing payments down the road, as you pay off interest on that 60k, and unlock more room in your HELOC over and above the original 60k - how would you invest the little additional room left over each payment period? It would not be economical to invest these small amounts into stock because of brokerage commissions. Or do you intend to leave the 60k portfolio alone for a few years, until the additional room in HELOC grows to another chunk that can be invested at once to add to the devidend-stock portfolio?

   I’m planning to implement SM within a year’s timeframe as well, but haven’t yet figured out best approach to investing the initial sum vs. the small increases with each mtg payment. Seems like one option is to build the initial portfolio, and then “plug” the growing holes with small mutual fund purchases in similar holdings; when the mutual fund side grows enough, switch it to equivalent stock/ETF holdings, to cut on MERs. This approach triggers capital gains tax though, so it’s not perfect either.

   Mar 6th, 2008 @ 9:34 pm

8. 8. FrugalTrader

   telefantastik, the initial $60k is the amount in the HELOC. I plan on deploying the money as I find stocks that I like. I plan on paying down the mortgage in lump sums, so as long as I have enough to buy a lot of shares, then i’ll purchase. To answer your question, no, I don’t plan on buying a little bit at a time with every principle pay down.

   Mar 6th, 2008 @ 10:39 pm

9. 9. Bay Street Rookie

   Hi all,

   I’ve been reading this blog for quite some time but to make this comment I’ve had to change my name to preserve my identity. Working at an investment bank on Bay Street, I’ve got to advise caution on these bank stocks.

   Being on the inside of the bank, and we’re talking about the securities side, we get a very different perspective on the inside functionings of the banks. I would just like to remind you all that Citigroup had to cut its dividend. FourPillars has it down pat. The market is a little skeptical about BMO and CIBC’s dividends.

   Judging by the capital restrictions on traders at my own bank (and its apparent the same is happening across Bay Street), alot of banks are trying to shore their balance sheets up for more turmoil.

   For instance, alot of you don’t realise but Scotia just did a $300MM preferred share deal today. RBC did $1 bln in subordinated debt and CIBC did $1 billion in deposit notes. A week ago, TD did nearly $2 billion in funding through Deposit notes and Preferred shares. These are all means to shore up capital and provide funding.

   Be wary that BMO suffered at one point, its largest one day drop in 25 years until it rallied a bit. The rally meant it only has the dubious distinction of having its worst day in 5 years.

   I’ve followed alot of your blogs and I have a high regard for many of you… Some of you clearly are very talented and to an extent, it’s inspired me to consider blogging as well.

   So keep off CIBC, should this stock go below 55, it could well cut. As for BMO…40 bucks is probably NOT the floor!

   Just thought I’d throw in my 2 cents.

   Best regards,

   Bay Street Rookie

   Mar 6th, 2008 @ 11:09 pm

10. 10. Cannon_fodder

    FT,

    My mortgage with BMO is a 5 year term that ends in September. I’m able to move it to a Readiline mortgage within 90 days of my original mortgage’s end date without penalty.

    I’m not clear as to what the interest rates would be for this product - how did yours relate to prime and was it broken into two main sections (e.g. the mortgage and the LOC)?

    Mar 8th, 2008 @ 4:45 pm

11. 11. FrugalTrader

    Hi Canon, the actual readiline HELOC is at prime. However, I have a mortgage portion and a HELOC portion. They should be able to set something up for you in the same manner.

    Mar 8th, 2008 @ 6:16 pm

12. 12. Cannon_fodder

    FT,

    So is the mortgage portion at prime - 0.45%? I was trying to remember about some statements regarding the interest rates vs. being able to only pay the interest.

    Are you able to only pay the interest costs on the HELOC or do you have to guerilla capitalize the interest?

    Mar 8th, 2008 @ 7:13 pm

13. 13. bj

    How are you screening for the stocks in your short list? Looks like many are part of Mergent’s Canadian dividend achievers list. Have you used value line to narrow down the results? Other tools?

    Mar 8th, 2008 @ 7:23 pm

14. 14. FrugalTrader

    Canon, i locked in my rate a while back so I got prime - 0.85%. In my situation, I could potentially pay the interest servicing costs of the HELOC out of pocket, but I think I will be capitalizing the interest. More on this Monday.

    bj, if you’re looking for a good stock screener, I sometimes use the microsoft online screener that includes email updates when stocks reach a certain price. I basically wait for the stocks on my list to get “cheap”.

    Mar 8th, 2008 @ 7:52 pm

15. 16. cnidog

    FT,

    In this post, and your previous posts on the SM, it seems like you advocate using your dividend payments from your investment to pay down your mortgage. This expands your HELOC, which can be used to purchase more investments.

    This seems sensible, however, I noted that in Comment #113 of the Anti-Smith Manoeuver post, Ed Rempel says, “This is the #1 most common error in the SM. If you take a distribution, you must pay 100% of it onto the tax deductible credit line or investment loan. If you pay any onto your mortgage, you have messed up your tax deductions.”

    Am I misunderstanding something here or are you setting yourself up to mess up your tax deductions.

    Thanks in advance for any clarification.

    Mar 9th, 2008 @ 8:56 pm

16. 17. FrugalTrader

    cnidog,

    Great question, dividends/interest can be withdrawn from a leveraged investment account but not Return Of Capital distributions. Please read the post below for more information:
    http://www.milliondollarjourney.com/key-tax-considerations-on-an-investment-loan.htm

    Mar 9th, 2008 @ 9:03 pm

17. 18. cnidog

    FT,

    Ah, right. Looking back at comment #112 in the Anti-SM post, I see Acorn was referring to a return on capital.

    Thanks for the clarification.

    Mar 9th, 2008 @ 10:34 pm

18. 19. Acorn

    About FirstLine mortgage… When I was refinancing my old mortgage, the First line offered me the best deal. They easily waived the Proof of income requirements and I’ve got the largest possible mortgage+ HELOC amount based on my property value in oppose to my monthly income. However, the give me 70% of my property value vs. 80% that usually is being offered by banks. Remaining banks I’ve contacted had no idea about SM and possibility to capitalize the interest from investments to support a large HELOC. An amount of HELOC they offered was 3 times smaller than the First Line’s one.
    Somebody told me that First Line doesn’t report HELOC to the credit agencies. Is it a true statement?

    Mar 10th, 2008 @ 4:51 pm

19. 20. Cannon_fodder

    I borrowed Tim Cestnick’s book “101 Tax Secrets for Canadians” (2007 Edition) and found a few interesting tidbits, one of which relates to SM. (Although not a new book, I think it would be a great subject for review and giveaway since everyone could get something out of it.)

    So as not to plagiarize, he provided an example of the effective returns from leveraging.

    Let’s compare 3 scenarios: what is common to all is that the borrowing rate is 5%, the MTR is 40% and the amount invested is $100,000. In one of the scenarios (#1), the $100k assumes no leverage and the investments grow at 8%. In the other two scenarios, you put up $50k and borrow the additional $50k but in one case (#2) the investments gain 8% while in the other case (#3) they lose 8%.

    Let’s assume that this runs only 1 year, that you cash out (thus triggering capital gains/losses), your interest costs are deductible and that you have capital gains previously that you can use to offset the incurred losses in scenario #3.

    Since I can’t easily embed a table the summary is that the effective returns are: #1 - 6.4%; #2 - 9.8%; #3 - (15.8%).

    As others have stated, leveraging can amplify returns but it can GREATLY amplify losses.

    With that in mind, Tim Cestnick goes on to include 8 Rules of Leveraging. I happen to be leaning toward FT’s way of thinking with respect to NOT using tax efficient mutual funds but rather blue chip Canadian dividend paying stocks.
    Like FT, I will be tapping in to the large amount of equity built up in my home to provide a “Big Bang” SM.

    I’ve run various scenarios through my calculator and there is a certain appeal to having a portfolio that is net cash flow positive from the beginning (factoring in tax deductions from borrowing and income tax from dividends). I believe a self-funding HELOC/Investment Portfolio would allow one to sleep a little easier and it satisfies four (almost 5) of the 8 rules:

    Rule 3: You need stable cash flow. If for some reason you need to scale back your mortgage payments due to loss of income, that would also scale back the principle paydown and amount to reborrow to service the HELOC. The self-funding setup where your dividends (after tax) cover your HELOC interest costs (after refund) remain unaffected.

    Rule 4: Have a long time horizon (> 10 years). There should be no need to sell during tough times because even if the market value < book value, the dividends will usually (although not always as we have seen very recently) keep up with interest costs. This should allow one to keep the same structure for a long time.

    Rule 6: Structure your leverage so that interest costs are deductible.

    Rule 7: Ensure you take on the right kind of loan, and a HELOC is the preferred one (vs. margin loans at a brokerage that could suffer from margin calls at the worst time).

    Ultimately, this may not be the ideal investment portfolio for net worth improvement, but perhaps it is an appropriate choice when borrowing heavily upfront. Certainly, investing in individual stocks is really only an option when working with large lump sums. A typical SM scenario involves investing only hundreds of dollars at a time and that is where mutual funds would be at an advantage.

    Mar 27th, 2008 @ 4:23 pm

20. 21. FrugalTrader

    CF, I should have pointed out in my SM blog post that my strategy for the SM is a MODIFIED version as you stated. I like mine better. :) Great comment btw, i’ve read most of Tim Cestnick’s books and find them all very useful. The great thing is, they can be picked up at the library.

    Mar 27th, 2008 @ 4:32 pm

21. 22. LookingForAdvice

    Hi all. I’ve been reading your blog about the The Smith Manoeuvre and I found it very interesting and informative. However I can’t fully understand, perhaps I’m a little slow lol. I’m also fairly young (27 years old) and new when it comes to financial planning. I will eventually seek out a financial planner, but I’m a self learner and enjoy trying to learn by example. If someone wants to give me their input on my situation I would love to hear it. I guess the question is: With the situation below, what would be the best way for me my 1 million dollar goal?

    Current Home Value: 425K
    Purchase Price: 400K
    Current Mortgage: 230K 4 Year Fixed Rate @ 4.8% with 2 years left.
    Remaining Amortization: 14 Year(s) 11 Month(s)
    Bi-Weekly Mortgage Payments: $826.00
    Current Non-Registered Portfolio: 100K
    Current Non-Registered: 26K
    Liabilities: 20K

    Thanks in advance for all the input. I’d also love any other kind of recommendations like literature, websites and etc…

    Tom

    Apr 6th, 2008 @ 3:36 am

22. 23. FrugalTrader

    Tom, congrats on your success thus far. Since you are fairly new to financial planning, you should probably think twice about leveraging your home to invest in the markets. To start, you should read the book “The Smith Manoeuvre”. Along with that, you should go through my smith manoeuvre posts. Check out my Smith Manoeuvre resource post for more details.

    Apr 6th, 2008 @ 9:04 am

23. 24. Cannon_fodder

    FT,

    How are you planning on avoiding certain clawbacks when you retire considering that dividend income accelerates (due to 145% gross up) this possibility?

    I’m playing devil’s advocate of investing in dividend producing equities vs. tax advantaged mutual funds which only would result in capital gains. The dividend producing equities would, in my opinion, lessen the risk that the CRA would deny interest deductibility. On the other hand, their income would not be as favourably treated as capital gains.

    Apr 17th, 2008 @ 2:30 pm

24. 25. FrugalTrader

    Hey CF,

    The only clawback that I would be concerned with is OAS which would occur @ 65 and older. I’m not particularly concerned with this clawback as it is 35+ years away. Who knows if it will still exist at that time.

    Apr 17th, 2008 @ 3:07 pm

25. 26. Ed Rempel

    Hi Tom,

    Here are some ideas of how you might implement the SM. You can borrow up to 80% of your home value or $340,000. With a mortgage of $230,000, you could borrow up to $110,000 to invest.

    Your mortgage payment of $826 bi-weekly would pay $406 bi-weekly of principal. You will need $200 bi-weekly to cover the $110,000 investment (at 4.75% prime), which would still leave you $206 bi-weekly to invest. In total, this could give you $110,000 plus $206 bi-weekly to invest - all without using your cash flow.

    You will probably be best to break your mortgage and replace it with a readvanceable mortgage at a lower rate. Calculating all the variables to see if this is better than any other option (such as just getting a top-up credit line until your mortgage comes due) can be complicated. We have an in-depth spreadsheet to calculate this. It is probably worth it for you, though, since you can now get a mortgage at 4% or less.

    Looking at all parts of your finances can also yield a lot of other opportunities. For example, you could do the “Singleton Shuffle” by selling all of your non-registered investments and paying them down on your mortgage. Then you can immediately reborrow to buy back the investments, which would immediately make $126K of your mortgage tax deductible.

    Also, we have a strategy called the “Debt Miracle” to combine other debts into your mortgage, including the payments you are making. It can accelerate the SM to roll all of your $20K liabilities into your mortgage.

    The risks of the SM relate almost entirely to the investments. The key is to invest effectively and tax-efficiently - and to always look at is as a long term strategy. Looking at the SM as a part of your retirement goal can help to make sure you always keep it as a long term strategy.

    Ed

    Apr 23rd, 2008 @ 3:05 am

26. 27. Curious

    Ed(and others),

    I have been reading this blog and I am impressed with the information you provide about the SM and also about 1 year or variable rate mortgages ending up better in the long run.

    I am going to refinance my house and start the SM in the next couple of months. The house value is $400,000 with a mortgage of $180,000. This leaves me with $140,000 of equity to invest.

    My plan was to refinance so I have an outstanding mortgage of $320,000 at P-.75% using the Scotia Step mortgage so I will have a starting LOC of $0.

    I will be paying a lower rate of interest on the initial $140,000 of equity I am using to invest. Besides a bit of hassle claiming the interest from my year end mortgage statement can you see any other issues arising ?

    Thanks for your input.

    Apr 28th, 2008 @ 1:48 am

27. 28. Ed Rempel

    Hi Curious,

    You are mixing the tax deductible and non-deductible amounts in one mortgage, which means that you can only claim the proportional amount of interest as a tax deduction. Any mortgage prepayment will also pay down the tax deductible debt the same amount.

    If you want the lower interest rate, you can have 2 separate mortgages within the STEP, so that they are separate. You can then pay over 40 years on the deductible mortgage, but much faster on the non-deductible.

    I understand why you are looking for the lower interest rate, but that means you are also paying down your deductible debt, which means your tax deduction is dwindling. It will take more cash to cover a principal and interest payment, as well. We looked at some scenarios like that and found that keeping the tax deductible amount as an interest only credit line almost always ends up with a higher long term benefit. The reasons are the higher tax refunds and that you can allocate more cash to paying down your mortgage.

    You seem to still believe in the Sacred Cow and want to be debt-free, including your tax deductible debt. That is nice, but will have only a fraction of the long term benefit of the SM.

    It sounds like you are not looking at any form of readvance, so the disadvantages of the STEP over all the other banks may not be an issue for you.

    Ed

    Apr 28th, 2008 @ 2:13 pm

28. 29. Curious

    Thanks Ed,

    Your message did clear some things up. I will set up two mortgage portions to properly track the interest. I was also intending on getting the LOC with the STEP to readvance further funds to invest, so I wouldn’t lose out on the power of the SM.

    What are the disadvantages of STEP?

    Apr 28th, 2008 @ 2:33 pm

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