Million Dollar Journey

So I have been convinced that Smith Manoeuvre is a good strategy for our financial situation and risk aversion. We have our Manulife One account setup and everything consolidated and beginning to borrow back to invest. My question pertains to RRSPs now that we have committed to this strategy. I read Fraser Smith’s book and have seen other comments that in general you should be investing outside of your RRSP until your entire mortgage is converted into a tax-deductible investment loan. Together my wife and I have about $80,000 in RRSP “room” and it does seem tempting to contribute say $15K this year and then put the $8K tax return towards our M1 account and then reborrow back to invest outside or inside of our RRSP.

So I understand that we want to convert our mortgage as quickly as possible but it seems to me that the interest savings will not be enough to outweigh the large tax return and sheltered growth involved with our RRSP. Can someone please explain to me why we shouldn’t do any RRSP investing until we convert our mortgage into good debt?

Good insights. A few questions. First do any investment vehicles qualify. I have seen some guaranteed investments paying 8.75%. Second does the interest paid on the HELOC count as a tax break every year. Lastly, my home is worth approx. 350k and the mortgage is about 230k, how much can I get without CMHC calling and how much and how do I get the Remp max. Thanks

frugal trader,

a couple more questions:

firstly i noticed a few times that people have mentioned that the RBC homeline plan can accomodate the SM, but after speaking with an advisor there she stated that RBC will not allow u to capitalize the interest. Just wondering whether she is misinformed and is anybody employing that mortgage product for the SM.

Secondly I noticed ED mentioned that taking a distribution from your SM investment and not paying it down on the loan(is he refering to the mortgage debt?) will in turn cause part of the interest on the loan to become non-tax deductible. Is he just speaking of capital gains or monthly distributions of preferred investments (that you state could be part of your plan) as well.

Jay Day, as Ed mentions, you can do a “manual” capitalization where you pay the amount due from your chequing account, then manually withdraw the same amount from the HELOC.

In order to keep your HELOC tax deductible, you should only withdraw either dividends or interest distributions. Do not withdraw anything else, even capital gains. Please read this article:
http://www.milliondollarjourney.com/key-tax-considerations-on-an-investment-loan.htm

JD, with re-advancable mortgages, as you pay down your non-ded mortgage, your HELOC credit limit increases. So basically, you don’t want to borrow more from your heloc than what the increases will pay for. This is the premise behind the “rempel maximum”, you divide your annual principle payment amount by prime, which determines how much you should borrow from your heloc.

For example, say on your regular mortgage payment is $500 in principle which equates to a $6000 annual principle payment. Divide your $6000 by prime (6.25%) gives you: $96,000. The $96K is the maximum amount that you can borrow from your HELOC while capitalizing the interest.

With regards to their distributions, you’ll have to read their prospectus. If the fund is giving distrubutions of 10% or more, then you can be assured that they are giving ROC. A typical dividend paying company usually pays from 2 - 5% yield.

Check out Part 2 of the Smith Manoeuvre Series. At the bottom of Part 2, I have included a lot of useful links that will hopefully clear up the concept. I would also recommend that you pick up the book.

Hope this helps.

Hi Jay,

Almost all funds that pay a fixed distribution have ROC in the distributions. This is because funds will EITHER payout whatever taxable income they have or they will pay out a fixed amount that is usually higher.

The Renaissance fund you mentioned is one of the few exceptions. All of those distributions are taxable. The fund pays a 7% distribution, but you would have been taxed on 23% over the last year. This is very high, considering the fund only made 5%! Where do you find these examples, Jay?

I don’t believe Globefund details the tax cost. We have it in a database, but you might have to call the fund company to get it.

It sounds to me like you do not have a readvanceable mortgage, Jay. If you have one, then the credit limit on the credit line increases after every mortgage payment.

To capitalize the interest, you pay it, but then immediately withdraw the exact same amount from your credit line. In effect, the credit line pays its own interest. None of the banks will do this automatically, so it needs to be done manually.

If you want to pay your taxable income onto your mortgage to pay it off more quickly, try doing the math on an example. We have found that NOT paying tax by compounding all the growth means the mortgage takes a bit longer to pay off, but the additional growth is far more than the extra you would pay down on your mortgage.

Are you trying to build wealth, or do you just want to pay your mortgage off? What will you do with your extra cash flow once the mortgage is paid off?

Ed

Also keep in mind I haven’t read the book yet (still waiting for it to come in) so all I have to go is what I have read from here.

Thanks for your help

Jay Day

Thanks FT

So you don’t use your principle to re-invest but to pay off the interest portion of the debt? Sorry if it seems redundant, or that I’m slow but this sounds closer to the Rempel Max than the SM. However capitalizing works it seems like that would free you to invest the entire principle increase in new investments and in turn increase your SM and taxable benefit. Number example are good for me if possible.

Have you started your SM yet? Your comments are very useful and the story is great. One other thing, short of reading prospectus all the time is there any other way (meaning easier) to find good income paying tax preferred funds that allow you to do what you and probably myself want to do with the SM.

Thanks again

Jay Day

I think I see now. Where you explained it at the top of this blog it says “so with every regular mortgage payment you will invest the new money in your HELOC.” This new investment amount must mean princible less interest cost. This is the amount your good debt goes up each month, not the full amount. Is that where I was going wrong? I see in other comments that some were saying to simply pay the interest cost from your chequing account and then simply take that amount back out of your HELOC to pay back into your chequing account.

thanks

FT

For simplicity sake, these numbers are examples only, (I still need to look at the exact amount of the principle) if my interest on the heloc is say 250 and principle on mortgage is 300, you are saying you are only going to pay off the 250 and not increase your portfolio. Are you just going to wait until year end and increase your investments with your tax refund and income dividends paid on your mortgage then withdrawn to increase heloc. Have you considered the advantages of dollar cost averaging?
Just wondering about the strategy?

thanks

Jay Day

Hi Julie, your situation sounds a little complex and if CRA audits you, you will need to show a proper paper trail. I think that your best bet would be to speak with a tax professional to get advice.

But yes, what you explain is the correct process of “capitalizing the interest”.

Hi Ed,
Can you tell me if the service charge for setup the HLOC is tax deductable?
thank
ben

As David says, take advice that you read on the internet with a grain of salt. There is no substitute for talking directly with a tax/financial professional.

Hi Julie,

Your advisor not explained to you how to implement it properly? Yes, your process sounds correct. FT is right, though, that it is important to keep an audit trail. If you are ever audited, you need to be able to prove that all the money you took out of your chequing went directly to investments or to pay interest on investment loans.

Unfortunately, you have a Scotia mortgage. Scotia is the most difficult bank for the SM, since they don’t automatically increase the credit line limit or allow investing directly from the credit line. At several of the other banks, you would be able to have B2B and your Visa charge their interest directly to your tax deductible credit line.

My suggestion would be to open a separate chequing account (or you could use an unsecured credit line) only for transferring all the cash. Put in some money from your SM credit line and then give B2B and your Visa a void cheque to have all their interest charged their directly. Get one from PC to avoid fees.

At Scotia, you will need to go into the branch every month (unless you have more credit available) to request that they increase your credit line limit.

Then use the SM CL to replenish your separate chequing account as necessary.

The advantage of this is that there is no mixing of money, like there is if everything goes in and out of your main chequing account. You have several accounts and all tax deductible money stays together - B2B, SM CL, Visa, and your separate chequing account. Never have any other money go in or out of any of these accounts. Then your audit trail is just showing all transactions in these accounts.

My other suggestion would be to discuss this all with your advisor (unless he is just a mutual fund salesperson) and to insist that your advisor does your income tax return and puts his name on it. This way, you can sue him if you ever lose an audit.

Your situation is more complex, since your mortgage is at Scotia and you have the Visa as well. Did you have a mortgage broker do the mortgage? Scotia is far more complex for doing the SM than the other banks, but it is the only major bank that makes their SM mortgage available through mortgage brokers.

Ed

Thanks Ed, FT, FB and David for the very useful comments.

Yes, I implement SM by myself according to everyone’s intelligence (thanks Ed and FT again) and my financial planner just help me do investment. As I mentioned at my previous email, I just use Scotia Visa Line Credit for the first six months (2.9% interest rate very attractive) then switch to HELOC.

Julie

With the recent events, interest rate might stay at 6.25% for a while. However, predicting interest rates is a very dangerous game. You have to look at the SM over a long period of time. As you are about to start it, your interest cost won’t be much in term of dollar for now until interest rates go down later on in time. You are better off starting now a 6.25% and benefit from a lower rate later on.
Keep in mind that any rate increase is affecting you by 60% of the increase only (assuming that you are in a 40% tax bracket).
Cheers,
FB.

Cannon_fodder,

Great formula. So assuming a 40% marginal tax rate and a 6.25% LOC rate, then the “breakeven” point is an investment vehicle that yields only 3.75%. That seems too low, but if true then it definitely eases my concerns about what level of return I would need to get in order for SM to still make sense. I thought it would be much higher than that.

Thanks for the comments.

Craig

Craig,

I don’t agree with your breakeven point. If you take a simple case: $200,000 mortgage, mortgage interest rate at 6.25%, LOC rate at 6.25%, 25 year mortgage, 3% inflation, no dividends, tax refund from LOC reinvested into mortgage, 40% tax bracket, no movement of investment funds until year 25 you get a breakeven investment growth rate of 8.25%.

This is assuming you completely liquidate your investment portfolio, pay off your $200,000 LOC at year 25. You get credit for the tax refunds you applied to your mortgage at the mortgage rate minus the year difference (i.e. tax refund in year 1 would be compounded 24 years at mortgage rate) and you also have to pay for the months / years you couldn’t capitalize on your LOC interest get the mortgage was already paid off plus inflation. This also assumes all rates are fixed and constant. When you look at it that way the risk is a bit higher.

Regards,
Manipulating Smith

Cannon_fodder,

Regarding the LOC interest, I was referring to not being able to use the LOC to pay for the interest since the LOC is maxed out. I assume you don’t get your LOC increased by having your house reassessed.

I have to apologize, I made some very poor assumptions in my previous’ post analysis, so I will try to correct myself and make it a bit more clear. I tried to match your numbers but the closest I could get was 156989 instead of 156481 and 47607 instead of 47564, so I will use rounded approximate figures.

The point I was trying to make was that using the SM to reduce your total mortgage cost and develop an investment portfolio is great. In the above example the mortgage is paid off in 3.5 years (42 months). So no more mortgage payments right? What would be the breakeven point if you decided to use the mortgage payments (~$1309) for something else instead of the SM after the mortgage was paid off? So you still have to pay the ~$1000 per month for the LOC and you still get the tax refund which you reinvest in your portfolio, so after 25 years if you cashed in your portfolio (after tax), paid your LOC, and included the 42 interest payments at about $1000 plus inflation, what effective growth rate on the investments would you need, I calculate about 6.7%. I consider the $1000 per month a loss because that’s after tax money out of your pocket. I define breakeven as having yours earnings equal to your losses in an investment.

Should it not be considered a cost if you continue to inject the equivalent of your mortgage payments (i.e. pay off the interest on the LOC and invest the rest) into the SM after your mortgage is paid off? This is out of pocket money that you saved because you reduced your mortgage doing the SM and should not be required in the SM. If you include this money and do not consider it a cost then yes 3.67% (I got 4.2%) would be the breakeven point but you just used about $54,000 (~1309*42) of your own money to inflate your portfolio! I think if you’re going to include this in the SM then you should also include the loss of $1309 per month in determining the required breakeven point (I get 7%).

Does this make sense, I’m no expert this is only my question/opinion/research?

MS,

Great discussion. First, I should point out that the mortgage would be retired 3.51 years EARLY, not IN 3.51 years with the SM! I know you corrected yourself later, but just thought I’d point that out to other interested readers.

As David pointed out, the real explosive growth in the portfolio is putting all of the mortgage payment - LOC interest into the portfolio. I would wager that others (e.g. Ed Rempel) would suggest that you might be better of getting another or bigger HELOC that has an interest cost which eats up whatever is left from the mortgage payment after the original LOC.

In this particular scenario, if you assume that you start at the beginning of the year and you apply your tax refund at the end of June (I can adjust my calculator for different refund dates) you would still only have an additional investment of just under $31k to make during those remaining 3.51 years. The $31k is the total of mortgage payments - LOC interest + tax refunds. (In reality, there is an additional $5k that might form part of a refund in the year following.)

Anyway, it seems to me that the argument you are making is really against the SM post mortgage termination, not during the entire 21.49 years previous to that.

I was taking the position with Craig about looking at the entire run of the SM over the amortization period of the mortgage and looking what the investments would need to return in order for one to say that the SM neither helped nor hurt me. The simple way to do that was to keep plugging lower and lower returns until the portfolio was basically $0 after the 25 years. Because, if I hadn’t implemented the SM that is exactly what I would have seen - the same amount of cash leaving my pocket with the same result - no mortgage and $0 worth of investments.

I certainly would support the argument that the risk involved in implementing the SM to only break even would not be worth it, thus there should be an expected additional return to justify it. But that would be up to each individual to determine.

I would disagree with your position because you are changing tack - on the one hand you are implementing the SM and then when the mortgage becomes zero, you then want to suggest that the additional mortgage payments are out of pocket costs. However, if you didn’t implement the SM you would still be making those same payments to pay down the mortgage.

Personally, if I paid down the mortgage I would not keep just feeding the money against the LOC and into the portfolio - I would increase my LOC to purchase more investments and continue to make those same ‘mortgage’ payments as I had always intended to. Once I start slipping into retirement and both my income and marginal tax rate start slipping, it may be time to start paying down any LOC value because I might have to, or perhaps if I’ve done well enough (I haven’t really thought this through) I would have started to move into income producing investments like blue chip dividend stocks to help cushion the loss of work income.

I look forward to your response - always good to hear different perspectives, especially since I haven’t implemented the SM - yet!

Most Home Equity (secured) LOC are at prime, and most of the accounts that you would use to set up the SM would allow you to split the HELOC into multiple streams. These are the form of LOC that Smith suggests using.

Unsecured LOC are available from Prime +1 (or better)if you have a good FICO score. If you are being offered Prime +4, possibly you should look into improving your credit rating as part of your overall financial planning.

Read around a bit more, there’s lots of information available on this topic or contact a Financial Planner if you need greater detail.

DAvid

Ronb-hi,

A great comparison of all HELOCs was done in the following post: http://www.milliondollarjourney.com/smith-manoeuvre-maneuver-mortgage-comparison.htm

Thanks for the link CF.

It’s interesting to note the contrast between the conservative advisors who basically don’t like leveraging of any kind (which I don’t agree with) and the pro-SM mortgage guy who talks about “blue-chip stocks paying 7 per cent a year” which is ridiculous.

All the more reason to learn as much as you can about investing and risk and then decide how much leverage (if any) is appropriate for your situation, independent of a commissioned salesperson (FA or mortgage personnel).

Mike

Hi Connie,

I would definitely suggest you to read Ed Rempel’ series on his best picks for the Smith Manoeuvre (see comment #68).

From what I read so far, it would be preferable to combine a regular mortgage along with a HELOC in order to benefit from a low mortgage rate on the fix portion and still use the variable part to invest.

Connie,
maybe you should get help from a local mortgage broker that knows how to manage a SM. A guy like Ed could definitely help you out!

Generally, they know more about all the product characteristics and will determine with you which product suits you best.

Hi Connie,

Your Scotia STEP shows your credit available rising with each mortgage payment, but you generally need to go into the branch to sign a form to increase the limit on a credit line in order to access it. You also cannot invest directly from the credit line. It can work, but almost all our clients there found it to be too much work.

I have seen a couple of cases where a local Scotia branch manager was willing to do all the manual work every month in order to avoid losing the mortgage, but this is rare.

Will you have a penalty to get out of your STEP? If so, it is worth doing the math to figure out whether or not it is worth it to move now or get a 2nd readvanceable mortgage and do as much of the SM as you can until your mortgage comes due.

Ed

Ed,

I thought you were doing everything, sorry about that. Maybe you should add it to your practice? I heard that mortgage broker were making great commission on mortgages ;-)

I am a real novice as far as investing goes so would like some advice on the following. I am 52 and recently took early retirement with a small pension of $15000 annually. I have 2 rental properties with rents of $475 and $650 each have mortgage payments of $250 and $450. The higher rental property has a BNS Step Mortgage with HELOC of $23000 now. My boyfriend and I have bought a house together ($155000)but most of my income is going toward expenses. I also have about $30,000 in savings as well as $70000 in RRSP. Any suggestions with what I should be doing in this situation?

If I need some extra income from my rental, would it be good to make a prepayment before the end of Dec.07 and then another 1 in Jan.08 so that I would have about a year more to pay off. This would deplete some of my savings and then affect the tax deductions I have now as well as having to pay tax on that extra income so is it really a good idea?

Yes, I am interested in real estate,the only problem being is that my current main residence I qualified for when I was working has a mortgage in my name of $950 per month locked in for 10 yrs and only 10% downpayment and 1 year paid off. All expenses are shared with myself and boyfriend. Because it is in my name and my retirement income is so low I cannot get a loan from the bank.

Ann, Yes, that’s what I mean by cash flow positive properties. That is, the net rental income is positive after all expenses. Personally, I only buy a rental property if it’s cash flow positive and amortize it for as long as possible. The reason being is what you said, I can write off the mortgage on a rental property.

Congratulations on your money management skills so far!

Many of your questions have been answered in previous postings in this and the anti-Smith Manoeuvre thread.

Firstly, Smith does not consider paying the interest from earnings of the investments. You can have a tax efficient investment that pays no distributions. This option is promoted by many SM advocates. Interest is effectively paid from your pocket, by investing less that the total reduction in principal each month. The tax refund is quite simple to calculate: interest paid on investment x marginal tax rate. it is recieved on the entire investment interest cost.

As a skeptic, I asked the same question as you: “Why not just put the $xxx on the mortgage, and I was shown that I would be ahead to apply the Smith Manoeuvre (by some tens of thousands of dollars) See messages 45 and 48 in the Anti-Smith Manoeuvre on this site.

Also, have a look for cannon_fodder’s spreadsheet on this site. It is easy to understand, and will help you determine if this option is indeed for you.

DAvid

thean, sorry, it was a broken link from my upgrade a few days ago. The spreadsheet is now available for download.

Hello all

Been reading for the last couple of hours and have some very basic and uneducated questions around the Smith Maneuver / Readvancable Mortgages.

I’m being transferred with work and as such they will be buying my house and cover all costs associated with purchasing a new one - including discharging the mortgage so this seems like a great time to make the switch.

My house is selling for $173,000 with $115,000 outstanding on the mortgage, so $58,000 in equity available. The town I’m moving to is up north so property values are lower and I’m expecting to be able to get something in the $140,000 to $160,000 range.

I’m single, debt free, monthly income after taxes and such is $4150-ish (of course monthly expenses are paid out of that).

My question is which mortgage / LOC product would suit this situation. I was originally thinking of the Manulife All in One but as I read through here is seems not to stand up well compared to some others. Also I’m not sure I fully even understand all the principles involved. I worked through with Canon Fodder’s spreadsheet and while I really like the outcome I’m not sure if I’m applying all the numbers correctly.

Oh, and lastly, I am hoping to get a duplex or at least a single detached with a separate and legal apartment to generate some extra income to help pay down the mortgage and I was wondering if there are any restrictions with a readvancable mortgage and having tenants.

Sorry for so many questions and thanks for an excellent resource for the financially impaired

Greg

Hi Ann,

I just noticed your posts. Your issue with being retired and having equity but not enough income or tax deductions is common.

I have a couple of suggestions for you. First of all, you can use your 2 rental properties and your home to do the SM 3 times. This should also give you a much healthier amount of equity (stock market) investments, since almost all of your money is tied up in real estate now.

Do you have a fair amount of equity in the rental properties? You can borrow against this equity to invest and have these and the SM investments pay you an income (similar to the Smith/Snyder strategy, which can be useful for retirees).

Taking this income does create a tax problem, since the leverage interest becomes non-deductible over time, but it provides you income from your equity.

Second, you can do the Cash Dam on both rental properties, in order to make your home mortgage tax deductible much more quickly. This can convert quite a bit of your home mortgage into tax deductible interest against your rental properties.

Third, you can pay your cash down onto your mortgage and then reborrow to invest. This way, you convert $30,000 of your mortgage to tax deductible.

Fourth, You can convert your RRSP’s to RRIF’s (after making whatever final RRSP contribution makes sense in your tax bracket), and then use the RRIF’s to pay your leverage loan interest. This is called a “RRIF Meltdown”. The RRIF withdrawals are taxable, but they pay tax deductible interest, so this off-sets the tax (although this tax deductibility declines over time). Then you can have the non-RRSP leveraged investments pay you income. This allows you to get money out of your RRSP’s in a tax-efficient manner.

I don’t know your full situation, but these 4 strategies will probably work well for you.

Ed

Hi Wade,

Sorry to tell you that it is not “up in the air” whether CRA will allow you to deduct the interest if the distribution is a return of capital. They will not.

CRA is concerned about the “current use” of money that is borrowed to invest (IT-533). Return of capital means you are getting some of your original principal back. Therefore, the current use of that money is that it is no longer invested.

For example, if you borrow $100,000 and get $8,000 in return of capital distributions, you have now taken back $8,000 of the $100,000 and it is not invested. Therefore, the interest on only $92,000 of the investment loan is tax deductible.

After 12 years or taking an 8% distribution, you have taken your entire $100,000 back and none of the interest on the loan is tax deductible.

That is also the same point where the book value of the fund reaches zero. Once the book value reaches zero, the entire distribution is considered to be a taxable capital gain.

The problems with that strategy is that you must do the math every year to calculate how much of the loan interest is tax deductible, and after 12 years, you end up with a tax problem - you have no interest deduction while the entire distribution is taxable.

If you sell after the 12 years, your book value is zero, so the entire amount you sell it for is a taxable capital gain.

Ed

Ed,

Thank you very much for reading my post carefully and for the clear answers. I now understand the mechanics of the SM and am also a believer.

I’m not sure that I’m going to attempt it myself yet, as its a long-term strategy. I’m about to start an EMBA, and am considering going back to school full-time after that (law school). In order to do that, I will need to sell my house, and invest the proceeds (and use that majority of that to fund school).

Having said that, if I do go back to school full-time, the SM could be quite risky. I would be assuming that I could make a return in the short-run (within 3~ yrs), which may be a risky venture given the fluctuations in the market right now. I think I will watch the market for a few months and contemplate before deciding firmly on this.

However, no matter what, it should help me build my capital back up as efficiently as possible post-full time school.

Then again, if I don’t decide to go back, I can start with this anytime once I’ve made that decision.

Thanks again!

I just spoke to a financial planner and she told me that it is not worth it for me to do the Smith Manoeuvre.

I have about 30k in equity in my home, and a mortgage of about 235k. I make about 60k a year. She told me that I would have to reapply for CMHC and that all the legal and administrative fees wouldn’t make it worth it. She said I should wait untill I have much much more equity in my home (over 100k) before I consider this.

What do you guys think of that - I personaly don’t want to believe it. I think the sooner I start the better…

I have a question which is affecting my analysis of the SM in my situation.

I have tried to simplify it below.

A rentaI property is purchased for $400,00 and $100,000 is put down.

Because it is an investment property, the interest on the $300,000 mortgage is tax deductible.

If the next day, after putting down the $100,000, it is decided to decrease the $100,000 equity theoretically to zero by taking out a $100,000 HELOC.

My question is, does it matter what this $100,000 is used for in order for it to have the interest on the increased mortgage to qualify as being 100% tax deductible?

It seems to me from a tax point of view, that freeing the original down payment is the same as having no down payment which should permit the interest on a new mortgage equivalent to the initial purchase price of the property to be tax deductible.

What if the decision to increase the mortgage occurs not one day, but 20 years after the property is purchased?

Does it matter to what use the money from the increased mortgage is put as long as it does not exceed the original purchase price?

I own a rental property in which I also live and I am wondering whether I might get prorated interest deductibility by simply pulling out my original down payment instead of using the SM to achieve tax deductibility on the prorated portion of my mortgage.

Hi Martyn,

Your question is a very common misconception. A lot of people mistakenly believe that any interest on money borrowed against a rental property is tax deductible.

In actual fact, what you borrow AGAINST is not relevant in determining if interest is deductible - only what the money is used for.

If you borrow against a rental property and spend the money, whether one day or 20 years after purchase, the interest is not tax deductible.

CRA will look for clear traceability that the borrowed money was used to invest and that it is still invested.

Ed

I was unable to edit my previous post possibly because its time stamp is incorrect.

I thought that I could give a better description below.

1. I have $100,000 cash.