Should I Start the Smith Manoeuvre?
As this blog has quite a bit of content regarding the Smith Manoeuvre, I often get reader questions regarding how to start the Smith Manoeuvre, and when is a good time to start. I have answered the “how” in the past, but what about the “when”?
What is the Smith Manoeuvre
Before we get started, lets take a couple steps back and explain what the Smith Manoeuvre is to newer readers. It is advertised as the “tax deductible mortgage” and markets the tax benefits where in reality, it’s an investment strategy. It’s where a homeowner obtains a readvanceable mortgage, and uses the increasing line of credit to invest in the markets. In other words, the home owner is borrowing against the equity in their home to invest. The borrowed amount is now tax deductible and your investments are now leveraged.
For more details, you can read this post on the ins and outs of how the smith manoeuvre works.
The Question
Ok, now that we have the preamble out of the way, lets get back to the reader question. The question is about the timing of the Smith Manoeuvre. Should I start the Smith Manoeuvre? If not, when is a good time?
Lets talk more about the strategy. As I mentioned above, although it’s advertised as a tax deductible mortgage, it’s actually a leveraged investment strategy. What does that mean? Leverage amplifies both gains and losses. When the going is good, the gains are great, and you are a investing genius. However, when markets go into bear mode, things can get ugly fast. Not only is your portfolio now underwater, you have a loan balance that’s greater than the value of your portfolio.
Evaluating Risk Tolerance
The point I’m trying to make is that the Smith Manoeuvre is all about risk tolerance. Sure, it can work in the long term providing that the investor sticks to their plan. However, most investors are swayed by their emotions of fear and greed, and tend to veer from the long term plan during extreme market conditions. For prime example, when the market significantly corrected in 2008, what did you do? Did you sell with everyone? Buy during the decline? or simply do nothing?
If you found that you were constantly worrying about your portfolio balance during the correction, then chances are is that your risk tolerance isn’t suited for leveraged investing. If, on the other hand, you kept confidence in the market and bought equities while the media was declaring the end of the world, then your personality may be well suited for leveraged investing.
The Numbers
If you have the risk tolerance to follow through with leveraged investing, the next speed bump in the process is the mechanics or the numbers. To start, the homeowner should have at least 20% equity in their home. That way, they eliminate the CMHC fee of getting the home equity line of credit.
Personally, I’m not comfortable leveraging 100% of the HELOC space. Thus far, I have $50k borrowed from a credit limit of almost $200k. However, this could change should the markets provide another buying opportunity for dividend stocks.
Conclusions
In an ideal world, all mortgages are tax deductible. Unfortunately, that luxury is only for houses in the U.S. In order to have anything similar in Canada, a home equity line of credit is needed and used to invest with. Sounds simple, but there are risks to leveraged investing that needs to be accounted for before starting the Smith Manoeuvre.
38 Comments, Comment or Ping
1. Traciatim
Are you sure that’s a smith manoeuvre? I always thought the smith was liquidating assets you currently own to pay off your mortgage to borrow funds to buy more (or the same) investments thus having the same amount of exposure to both your investment risk and your borrowed funds while also reducing your cost.
For instance, you realize you have a 100K mortgage, and 50K in dividend paying stock. So you decide to sell the 50K in stock, pay 50K off on your mortgage, take out a 50K line of credit, buy 50K of dividend paying stocks. Now you have a 50K non-deductible mortgage, a 50K deductible line of credit, and 50K of income producing investment. Same amount of risks, just lower cost of borrowing. Of course that assumes your cost of borrowing is less than the previous cost over the term of the loan and also your income from your investments is higher than your cost of borrowing.
It seems to me like a pretty delicate balancing act that depends on so many factors that it would be hard to tell if it would be better just to stay where you are, just pay off a huge chunk of your mortgage and save the interest, or if it would be better borrowing to invest again.
Jun 7th, 2010 @ 9:22 am
2. Andy
@Traciatim – From my understanding you are adding complexity to the maneuver. Other than the suggested 20% equity in your home you don’t HAVE to have existing assets that you need to sell to start the SM. You could simply start investing as you pay down your mortgage. The dividends you get can go towards paying off the mortgage, along with your normal payments. The line of credit space that is then opened is used to invest again, thus converting your non-deductible mortgage into a deductible line of credit. Once the mortgage portion is gone, you could now either sell the investments to pay off the LOC, or pay it off over time with the dividends while the interest on it continues to be tax deductible.
Jun 7th, 2010 @ 10:38 am
3. FrugalTrader
@ Traciatim: What you are referring to is the “Singleton Shuffle” where you take your existing Non-reg portfolio to pay down the mortgage which is then used to reinvest via HELOC. The core SM, is simply taking the small mortgage paydown/credit increases to reinvest with a readvanceable mortgage.
Jun 7th, 2010 @ 11:06 am
4. DG
@Traciatim — That’s the way its usually sold, and it is a gentle way to sell it because overall there is no change in total leverage. However I think very few people fit into the large-unregistered-investment-with-mortgage category, because if they are saving they are probably plowing it into an RRSP or their mortgage.
I think the way FT describes it more realistic and relevant to most people, even if it not the 100% traditional definition.
Jun 7th, 2010 @ 11:15 am
5. DG
I got into the SM big time in Sept 2008, literally a day before Fannie May and Freddie Mac went boom. The following months were quite a gut check, but I held firm. The market value is back in the black now, dividends never went down, and interest rates on the LOC were very low, so it has been very profitable so far.
Jun 7th, 2010 @ 11:22 am
6. ldk
How we started was to take the amount we would have otherwise been investing each year anyway, put it on the HELOC (to reduce the ‘mortgage’ portion of the debt) and then borrowed back the same amount and put it into investments. After about 5 years we had ‘converted’ all of our house-related debt into ‘a loan for investment purposes’ (ie. tax-deductible) but we were no further extended/leveraged than we would have been otherwise.
Now that all of our house debt has been paid off we regularly use our HELOC for various investment opportunities.
Jun 7th, 2010 @ 11:27 am
7. Scott Peckford
Great article. Any discussion on leverage should always include a realistic evaluation of risk tolerance. Kudos to you.
One point of clarification you can no longer get a secured line of credit unless you have 20% down/equity. CMHC is no longer an issue. :)
Jun 7th, 2010 @ 11:38 am
8. Financial Cents
Hey Frugal,
Good on you to state this: “When the going is good, the gains are great, and you are a investing genius. However, when markets go into bear mode, things can get ugly fast. Not only is your portfolio now underwater, you have a loan balance that’s greater than the value of your portfolio.”
I couldn’t agree more, the SM is all about managing risk, including your own and comfort level with it.
Sure, leveraged investing can work (well) in the long term, but the average investor is emotional and cannot handle market volatility. As a DIY investor, I’m learning everyday and learning more about why I make certain investment choices (or don’t) and how that equates into our net worth growth. While I consider myself “above average” for financial acumen, I recognize I have a great deal more to learn and because of that, I avoid using any significant amout of leverage for investment purposes. I invest in what I know and fully comfortable in. Maybe when our house is almost paid off, I will feel differently, and borrow some equity. Until then, while I remain curious about SM, I’m “out”. :)
This said, keep your posts about SM coming, as I’m sure it will drive many discussions – who uses it and how they are doing with this strategy. Cheers!
Jun 7th, 2010 @ 1:22 pm
9. The Passive Income Earner
Correct me if I am wrong, but doing the Smith Manoeuvre will also add to your monthly cost by needing to pay the HELOC interest monthly. Which means you need to pay for your mortgage + HELOC interest which will grow over time while your mortgage payment will not necessarily decrease. Or is there something I am not seeing in a ‘readvancable mortgage’ that prevents you from having to pay the monthly interest on the HELOC?
Although the intention is to make your mortgage tax deductible, I would have way too much leverage to apply it by the book. My HELOC is currently 250K$ and I still have a mortgage of 300K$. At which point do you look at paying it back? If you were to look at doing any venture requiring capital, you become limited in your options since you are very leveraged. In my case, I want to do real-estate at some point and I need to be able to borrow. Therefore, I don’t do the Smith Manoeuvre but I could take an investment loan at some point.
Jun 7th, 2010 @ 1:26 pm
10. DG
@ Passive Income Earner: The interest on the interest is also tax deductible, so you want to let the HELOC debt compound. My bank charges LOC interest to my chequing account, so I just manually move funds from the LOC to chequing every month to cover the interest. When I asked my bank about this they said they might not like it, but I do it anyway and they haven’t said anything.
There’s nothing inherently illiquid about the SM, you can sell all investments, pay off the LOC, and then proceed with your real-estate opportunity. Of course if you would be selling at a loss then that might not be much fun…
Jun 7th, 2010 @ 1:43 pm
11. ethan
Does investing into td-eseries canadian index, canadian bonds, us index, intl index (coach potato) count as tax deductible ? I read somewhere that some investment might not be tax deductible.
if it is tax deductible, what else can I deduct ? can I somehow factor in the MER ?
Jun 7th, 2010 @ 5:06 pm
12. Henry
I think that one should not use the Smith Manoeuvre with DSC (back load) funds. That is a real no no, since you will not be able to sell when the market condition changes. However, there are financial advisors out there who likes to do this. They get a commission from helping you get a loan and make an upfront fortune with DSC funds commissions.
A lot of no load funds have a three month early redemption penalty of 2%. That can be a concern as well. I would prefer ETFs unless you are investing in a diversified portfolio of small cap stocks. Valuation and market timing are ways to manage risks at all times.
Jun 7th, 2010 @ 6:03 pm
13. No Debt Guy
Although I wanted to fully pay off the mortgage before I started leveraged investing I am thinking I may get all of my ducks in a row and start earlier.
Besides MDJ what are some good resources for the Smith Maneuver?
It is fully DIY or do you advise getting a planner and accountant involved?
Jun 7th, 2010 @ 6:31 pm
14. FrugalTrader
@ passive income earner, I suggest only leveraging as much as you are comfortable. As I stated in my article, I have almost $200k credit available, but have only leveraged $50k thus far.
@ ethan, yes you can use the td-eseries for leveraged investing. I’m not sure about the MERs though, but I doubt you can claim them.
@ no debt guy – I would suggest reading the book and reading the archives here regarding the SM. Other than that, if you want to DIY, I would suggest some advice from an accountant if you are already investment savvy.
Jun 7th, 2010 @ 6:58 pm
15. Rachelle
It may seem a little weird to say this but before you do any type of Smith Manoeuver I believe that you should know your way around the stock market.
IMHO if this is being pitched to you by your Financial Advisor and he/she is the one who picks your mutual funds, you’re way out of your league and you probably shouldn’t do it.
If you have a decent track record investing in the stock market and you’re making money doing it and would like to continue your plan then consider the Smith Manoeuver.
Jun 7th, 2010 @ 9:12 pm
16. Devin
Hey guys, just recently got a new townhome with a Scotiabank STEP line of credit for it. Does anyone have experience doing the Smith Manoeuvre with Scotiabank. Also curious if they let you use available line of credit to pay the interest off?
Cheers
Jun 7th, 2010 @ 11:34 pm
17. csplice
When I quit smoking I wanted to benifit from the money I wasn’t spending on cigarettes. Those that tell you to quite always say you can save $100’s of dollars a month, and those that quit say they never see the savings accumulate.
My solution was to start the SM with a balance where the interest payments equaled my monthly nicotene habit. I paid the interest and watched my portfolio grow for months. This was in 2003.
Over time I have started to compound the interest instead of paying it monthly, and I have also increased my SM portfolio as I felt comfortable and my HELOC room increased. Things are going well, all things considered.
As for the time to start, in my opinion you need a catalyst, a reason to start the SM. What ever your reason, that will give you the determination to get through the initial hump, and then you are off the the races. Market conditions will improve you results, but determination will help you stick with it for the long run.
Jun 8th, 2010 @ 2:12 pm
18. ethan
So if I use TD e-Series as the investment portion (coach potato), CRA would allow me to deduct the HELOC interest rate right since it has a reasonable expectation of returns via the yearly distribution. For those distribution, are they all dividends or would there be interest or capital gains ? How do I calculate which is what.
Jun 8th, 2010 @ 2:50 pm
19. FrugalTrader
ethan, the prospectus for the funds will tell you what the distributions are. I believe the equity indices will distribute primarily dividends, and the bond fund will distribute interest. You don’t need to calculate each indivdiually to prove that your investment loan is deductible – simply holding equities with investment loan money does the trick.
Jun 8th, 2010 @ 3:06 pm
20. nobleea
Are bond funds eligible for this? I didn’t think they were since they are essentially interest. In that you doing so would not make the interest on borrowed funds tax deductible.
Jun 8th, 2010 @ 3:38 pm
21. Traciatim
Nobleea, I’ve tried to find an exact list of what investments are eligible and which are not. The closest thing I can come up with is anything that generated income, which I’m sure if you stuck with just interest and dividends you’d be pretty safe. Even if you have capital gains in there, as long as the stock in question payed a dividend I’m sure you’d be OK. Just ask the auditor when they show up :)
Jun 8th, 2010 @ 4:35 pm
22. Ed Rempel
Hi Traciatim & DG,
FT is right. The Smith Manoeuvre is borrowing back on a credit line the amount paid down from each mortgage payment to invest.
The “large-unregistered-investment-with-mortgage” strategy is NOT the SM. If you have seen people selling it that way, then they have not even read the book.
Ed
Jun 8th, 2010 @ 7:02 pm
23. Ed Rempel
Hi Passive,
No, you don’t need cash flow to pay the interest on the credit line. This is because you normally capitalize it with the SM. The tax rule is that if the interest on a loan is tax deductible, then the interest on the interest is also tax deductible. Therefore, you can reborrow from the SM credit line to pay its own interest.
This makes sense as well, since it is more effective to use any of your cash flow to pay off your non-deductible debt first, such as your mortgage.
Nobody says you have to invest ALL your available credit. If you have a mortgage of $300K and available credit in your credit line of $250K, you could start with zero and reborrow your mortgage principal, or you could start with any lump sum you want.
The normal strategy with the Smith Manoeuvre is to maintain the tax deductible credit line for life. Some people pay it off at retirement by selling some investments. Most pay it off whenever they sell their home, perhaps in their 80s. In general, maintaining the credit line and keeping the investments should give you a significantly higher income after retirement than if you sell investments to pay off the credit line.
Also, there is a popular misconception that seniors are in low tax brackets. When you include the various clawbacks on income that affect seniors, many seniors are in a higher tax bracket after they retire. Depending on your situation, the tax deduction from the interest may be as beneficial to you after retirement as before. This is another reason many people maintain the credit line after retirement.
Ed
Jun 8th, 2010 @ 7:13 pm
24. Ed Rempel
Hi Henry,
If you are a market timer and would sell your investments when market conditions change, such as a market crash, then the SM is probably not the right strategy for you.
As Financial-Cents said, it is all about risk control. It is also about knowing yourself. If you are not able to handle a market decline, then you are too conservative of an investor to consider leverage strategies.
Market timing might reduce a loss if you sell during a decline, but studies like the Dalbar study consistently show that market timers have far lower returns. This is the reason that women are far better investors than men!
Ed
Ed
Jun 8th, 2010 @ 7:18 pm
25. Ed Rempel
Hi No Debt,
The SM is a leveraged investment strategy, which means it is a risky strategy. Leveraged investing significantly increases both your gains and your losses. If you are not a seasoned investor with a solid investment strategy, then you are much better off working with a professional.
Ed
Jun 8th, 2010 @ 7:21 pm
26. Ed Rempel
Hi noblea,
Bond funds are fine for tax deductibility. It is not necessary that the interest you get be more than the interest you pay on the loan, based on IT-533.
Leveraging into a bond fund is not a very profitable strategy with the combination of low returns and fully-taxable interest. However, it might make sense in a diversified portfolio.
Ed
Jun 8th, 2010 @ 7:25 pm
27. Ed Rempel
Hi Traciatim,
There is no specific list, but IT-533 describes what is necessary. An investment must have a “reasonable expectation of income”. This means that as long as your investment can reasonably be expected to pay a dividend at some point in time in the future, it is probably fine.
IT-533 specifically says that generally any common share or mutual fund is fine, as long as it’s prospectus does not specifically prevent paying a dividend. It describes shares in a growth company that is not paying a dividend for the foreseeable future, but may some time “when operational circumstances permit”, and says shares of that company would be fine.
We generally invest in tax-efficient mutual funds that pay little or nothing in taxable distributions, but deducting the interest to invest in them is still fine.
Ed
Jun 8th, 2010 @ 7:34 pm
28. Scott Peckford
Devin,
The Scotia STEP is a great product. Although it may not automatically readvance. You may have to request an increase when you pay down your princple.
Scotia was allowing the auto-readvance, but last month they stopped doing it. :(
It will depend on how your mortgage was set up from the beginning.
Also you can capitalize your interest as long as you stay below your authorized limit.
Hope that helps
Scott
Jun 8th, 2010 @ 8:27 pm
29. Andrew F
One thing that’s bugged me is the claim that withdrawing capital gains income from your SM portfolio to apply to the mortgage would affect the deductibility of the investment loan. I can see why this is the case with return of capital, but I don’t understand this for capital gains. Can anyone explain the rationale?
Jun 9th, 2010 @ 1:26 pm
30. jungle
Interesting about the Scotia STEP, I ask for the auto-increases last month, signed paper and nothing happened. They rep even said they took that feature away but then she rebutted it and said it should work.
We’ll see what happens this month.
To keep this on topic, I believe the best way to profit from this strategy is to buy the stocks at great prices. This is after you do your homework to ensure the stock is a solid company, ok debts, profits, etc and that has increased dividends over a long period of time. Then wait for the stock to come at a great price. You get a higher dividend and more value.
There is a stock right now that I want to buy, problem is, I’m not ready. I don’t have a proper HELOC now. Scotia is not the best choice for this.
Jun 10th, 2010 @ 11:05 pm
31. Ed Rempel
HI jungle, Scott & Devin,
Scotia STEP was always more complex for the SM than a few other banks. They didn’t do the automatic readvance until a couple of years ago. We had not heard that they stopped offering it. The SM is still possible with it if you just go into the branch every month (or every 2 weeks) and sign a paper to have your credit line limit increased.
This is such a pain that most people only do it once or twice a year, which makes the SM tricky.
There are a few other banks that offer readvanceable mortgages that work better for the SM.
Ed
Jun 11th, 2010 @ 1:07 am
32. Ed Rempel
Hi Andrew,
In general, if you remove taxable income from your leveraged SM investment, it does not affect the interest deductibility. ROC is not taxable income, which means you are withdrawing the principal.
The issue with capital gains is the mechanics. If you have a mutual fund pay out a capital gains distribution, you are fine.
However, if you borrow to invest $100,000 and later sell it for $150,000 at a $50,000 profit, and then withdraw $15,000 to get some income, you are actually withdrawing $10,000 of your principal and $5,000 of the capital gain. Then the interest on $10,000 of your investment loan would no longer be deductible.
There are a couple of ways to deal with this:
1.Accept you fate and keep the calculation of how much of the investment credit line interest is still tax deductible.
2. You could pay sell the $15,000 and pay $10,000 onto your investment credit line and keep $5,000. Then you could reborrow the $10,000 to invest again. Now your investment credit line remains fully tax deductible and you have withdrawn the $5,000 capital gain.
3. You would buy investments like tax-efficient mutual funds that allow you to pay out a capital gains distribution.
Ed
Jun 11th, 2010 @ 1:45 am
33. Andrew F
So realized capital gains can be harvested if every time you make a gain, you withdraw the entire sale price, pocket the gain (by paying against non-deductible debt), pay the original purchase price against the investment loan and reborrow it? Seems odd to me that you have to repay/reborrow the loan–is that just caution or does CRA actually frown on just withdrawing the capital gain on a sale. Seems like this would make it practical to liquidate the entire portfolio periodically if just to make use of the capital gain.
Jun 13th, 2010 @ 4:11 am
34. Ed Rempel
Hi Andrew,
The issue is that it is difficult to withdraw just the capital gain. When you sell the investment, the proceeds are a mixture of the original borrowed principal and the capital gain. That is why paying down the full amount is required, even though it is awkward.
If you sell investments and withdraw the capital gain only. then that amount of the loan becomes non-deductible and you would need to track this and calculate your interest deduction with this.
If you liquidate the entire portfolio periodically, pay off the loan and reborrow, you can restore full deductibility. However, this will have a tax cost, so it may not be worth doing.
Ed
Jun 18th, 2010 @ 1:03 am
35. Spectre7
A few questions from a potential investor (just looking to get in) with a HELOC.
I have a HELOC as a way to manage debt and cash. Anything I buy, like renos or a car, is purchased and the funds borrowed at mortgage interest, not car loan interest. As it stands, basically house and renos are paid off, but not the car, so I have lots of room to borrow. Which brings me to my first question:
1. Should I be thinking of a SM as a more risky manoeuvre than cutting a cheque to my broker to put into mutual funds for me? It comes from the same cash flow. My paycheque goes in, my groceries and interest come out.
2. Given same said cheques cut to my broker for my RRSP and RESP contributions, would the interest on these not also be tax-deductible? Contributions are made to both registered and unregistered accounts. Looking for some cheap tax advice here.
3. I’m thinking of doing some DIY investing, starting with, like, $2K. Is this too small to make a difference, or is it a good way to get my feet wet?
Thanks.
Spectre7
Aug 9th, 2011 @ 6:40 pm
36. FrugalTrader
@Spectre,
1. if you use the HELOC to invest, call your bank to setup a sub account. You do not want to intermingle personal expenses and an investment loan.
2. SM is leveraged investing, so both your gains and losses are magnified. Say you put a significant portion of your HELOC on the TSX, and it has lost around 10% YTD.. say your $100k turns into $90k in a couple weeks, would you be able to sleep at night? What if that $100k of borrowed money turns into $70k but you still owe $100k?
3. no, borrowed money for resp and rrsp are not deductible.
4. Look at buying index mutual funds like the td e-series to start off. Consider moving into index ETFs once you have $20k-$50k (imo).
Aug 9th, 2011 @ 10:26 pm
37. Spectre7
@FT: Thanks for the wisdom. As I said, I plan on starting with only $2K or so. I used to work at a racetrack/casino, so I saw the lesson: don’t bet more than you’re willing to lose.
Aug 10th, 2011 @ 3:07 am
38. Ed Rempel
Hi Spectre,
The Smith Manoeuvre is best done as a long term, preplanned strategy, not just a trial. Borrowing to invest is a riskier strategy. If you are going into it to “see how it goes”, then it is probably best not to do it at all. If you go in as a trial, you will probably do it until the first down market and then sell at a loss.
My suggestion would be to either commit to it as a long term strategy and plan how you plan to do it, or don’t even start.
For only $2K, this may not be worth the effort, either. The tax refund will probably be only at $20/year, which is not much reward for setting up a separate credit line to track the interest, having a separate investment account to keep the investments separate, and recording it all on your tax return.
You could make $20 by shoveling your neighbour’s driveway or mowing their lawn! :)
Ed
Dec 7th, 2011 @ 4:50 pm
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