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The Smith Manoeuvre – Q&A


As a recap, the Smith Manoeuvre is a wealth strategy that converts a non tax deductible Canadian mortgage into a tax deductible investment loan. As promised from Part 1 of this series, I will be going into more detail regarding the Smith Manoeuvre(SM) and some common questions that people have. I am by no means an expert in the SM where I’m not even using it myself. I do, however, plan on implementing this technique in the near future and I’m usually pretty analytical when it comes to big financial decisions.

One popular question I often read about is how a person is supposed to pay for both the mortgage AND the HELOC at the same time?

  • This is a probably among the biggest concerns as the borrower will be responsible for BOTH payments while implementing the SM. This includes your primary mortgage (principle + interest) along with your HELOC (interest only). Seems a bit steep hey? Say you get a $100k HELOC @ 6% (prime), that’s an extra $500/month on top of your existing mortgage payment.
  • I’ve actually emailed Fraser Smith about this issue and he said to “capitalize the interest” on the HELOC. Scratching your head yet? Capitalizing the interest simply means to withdraw the monthly interest due from the HELOC account and redeposit the amount as a payment. Apparently, most credit unions will allow this but some banks will not. You’ll have to check your specific lender for the details.
  • If you capitalize the interest, you will never make the extra interest payments out of your own pocket while your primary mortgage exists.
  • You will only start paying the HELOC interest out of pocket/cashflow when the primary non-deductible mortgage is paid off. So as you can see, using the Smith Manoeuvre, you will always have a payment. It never goes away. However, the payments are now tax deductible.

Another popular question is why would you need 25% 20% down to start the Smith Manoeuvre?

What are some investment options for the Smith Manoeuvre?

  • As you already know, I’m just some obsessive compulsive personal finance guy who is NOT a financial planner. So take my advice at your own risk. However, with that said, when I start using the Smith Manoeuvre I plan on using the money to purchase steadily growing dividend paying stocks/mutual funds/ETFs.

Why dividend stocks do you ask?

  • I believe that investing in mostly Canadian dividend paying stocks/mutual funds/ETFs is the most efficient way to implement the SM. The reason being is that Canadian dividends of strong companies (like the big banks) have a history of increasing dividends that can be used to pay down the non-deductible mortgage. Why not just buy interest bearing bonds or GICs? Publicly traded companies that pay dividends in Canada are eligible for the enhanced dividend tax credit which results in a substantial tax break for dividends compared to interest bearing income.
  • To summarize, the strong dividend company (if history is any guide), will increase their dividend on a regular basis AND you will receive a tax credit for any dividend income that you receive. Putting the dividend income and the annual tax refund towards the non-deductible mortgage will make the conversion from bad (non-deductible) to good (deductible) debt even quicker.

So that’s my strategy for my next home. Sell off my non-registered portfolio, put >20% down, obtain a re-advanceable mortgage, take the HELOC money and invest in dividend paying stocks (mostly Canadian).

If you are currently using the Smith Manoeuvre, I would appreciate any comments that you may have regarding your experiences and if my strategy is sound.

Other articles related to The Smith Manoeuvre Strategy:

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FrugalTrader About the author: FrugalTrader is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 541 comments… add one }

  • JT April 23, 2014, 1:30 am

    Thanks, Ed.

    That is what I suspected.

    JT

  • K April 30, 2014, 1:30 am

    Hi Ed,

    Thanks for the advice. I have reconsidered my investment choice.

    I will likely go with low fee, D series, corporate class funds. This will give me a diversified, low cost, tax efficient portfolio.

    I plan to balance the funds as follows:

    Fixed Income – 40%
    Canadian Equity – 20%
    US Equity – 20%
    International Equity – 20%

    What do you think?

    Thanks,

    Ken

  • K May 15, 2014, 1:29 am

    Hi Ed,

    This week I started the modified smith maneouvre. I went with a corporate class portfolio for the investment.

    I went over everything with an independent accountant and financial planner before starting.

    Thanks very much for all your input.

    Cheers,

    Ken

  • Ed Rempel May 18, 2014, 1:04 pm

    Hi Ken,

    Way to go. The first step is the hardest.

    I have a few thoughts for you to consider:

    1. What do you mean by a “modified Smith Manoeuvre”? How have you modified it?
    2. I’m not a big believer in bonds, especially with the Smith Manoeuvre. The returns are generally lower than your interest rate and are fully taxable, so they don’t really contribute anything. More importantly, for periods of time over 20 years, bonds are actually riskier than stocks. They are less predictable in 20 year periods, have a higher standard deviation, and often have periods when they lose purchasing power (don’t even keep up with inflation). People invest in bonds to reduce risk, and they definitely reduce volatility short term, but they can actually add risk for long term investors.

    In your case, you are going with some balanced funds because that is your risk tolerance for short term volatility now, so perhaps it makes sense in your case. Just don’t underestimate the risk of bonds.

    3. When you are choosing mutual funds, the first thing to look for is “closet indexers”. In Canada, about 3/4 of mutual funds are closet indexers (especially many bank funds), which means that you are paying for active management, but the fund manager is really just hugging the index.

    Closet indexers obviously will lag the index. They are the main reason that the average mutual fund lags the index.

    We see it all the time in fund manager presentations or fund fact sheets where the holdings and allocation are similar to the index.

    Investors often focus on low fee funds, but end up with low fee closet index funds, which are a bad deal. I would suggest that avoiding closet indexers is far more important than low fees in getting

    The way to avoid them is to look at the top 10 holdings. If more than 3 are the same as the index, you probably have a closet indexer. Then check the industry allocation. If almost all are close to the index allocation, then you should probably avoid the fund.

    I hope that is helpful for you.

    Ed

  • On the fence May 18, 2014, 1:48 pm

    I am on the fence about HELOC or not HELOC.

    Here is my situation: my mortgage is up for renewal in October.

    I have about 100K mortgage left on a currently 800+K valued house.
    I also have about 80K LOC, used for my daughter’s education. We paid the interest (prime+1%), she is finishing school now, the plan is that eventually she takes over the loan. Interest on LOC is lower than on student loan.

    My options:

    1) Renew and continue mortgage, either with 3-5 yrs variable or fixed low rate, finishing it up by the end of the term.
    2) Start SM for the 100K mortgage.
    3) Consolidate the 100K mortgage + 80K LOC into 180K mortgage and start SM.

    I have been doing self-directed RRSP for over a decade, with stocks only.
    I actually enjoy trading, I have a good risk tolerance. I was making good return – but who did not in the last ten years? There is no guarantee for the future, I am aware of that.

    What would be your advice?

    Thank you.

  • K May 18, 2014, 8:49 pm

    Hi Ed,

    I setup the Rempel Maximum with $50,000.

    Good point on closet indexing.

    Thanks,

    Ken

  • RJ May 24, 2014, 4:52 pm

    Hi Ed,

    I have a few questions for you…

    1) What happens when the mortgage is paid off? Does the calculator assume you invest the equivalent mortgage payment biweekly still?

    2) I know you said you aren’t a fan of keeping the HELOC in retirement. I guess the best bet would be to spread the pay it off over the first few years of retirement to keep the taxes paid on investment redemption lower?

    3) As far as AA goes, I am currently 100% equities. I have no problems with risk and long term thinking. I would probably keep my SM portfolio at least 80/20. The only issues I have are making adjustments after the fact. To maximize the long term growth, you definitely want to keep the adjustments to zero or an absolute minimum, right? I guess if you utilized a corporate class mutual fund setup, there would be no issues in making adjustments though. I was thinking about using ETFs for the ultra low MERs and no commission purchases, but then any adjustments could cause huge tax liabilities. Any portfolio suggestions?

    4) With the new rules on HELOCs, what would you suggest once we get down to the final 20% of the mortgage? Do you have a strategy that works best?

    Thanks!

  • Ed Rempel May 27, 2014, 12:16 am

    @On the fence,

    To answer your questions:

    1. We are recommending a 2-year fixed at 2.59%. That is likely to be the least expensive of all the terms today. The longer terms you are considering are noticeably higher rates and all require a fairly significant interest rate rise, or they will cost more than the 2 year. We never recommend the 5-year fixed, since it has never worked out for any living Canadian.

    Variable rates are only slightly lower than today’s 2-year and require a long lock-in. We think that, once rates rise a bit, larger discounts from prime will likely become available. That is why we think the best strategy is to take 2-year fixed until cheaper variable mortgages arrive.

    2 & 3) You know your daughter. Is she going to be able to take over her loan? Kids need to learn how to handle money. You have an agreement with her. Unless you have changed your mind, you should split off her $80,000 into a separate sub-account within your readvanceable mortgage so you can track her portion.

    You can do $100K or $180K or any amount up to $600K based on your mortgage. Your decision here should relate to your goals and your risk tolerance.

    Reading between the lines, I would recommend you stick with $100K. Leveraging is not the same as your RRSP. It can be scarier when your investments are down lower than your loan balance. This can lead to all kinds of common behavioural investing mistakes.

    I don’t know your situation or your goals or risk level, but probably inching into it with a lower amount is safer for you.

    Ed

  • Ed Rempel May 27, 2014, 1:31 am

    Hi RJ,

    To answer your questions:

    1. The SM Calculator only calculates the projected benefit up until the current amortization based on your current mortgage payment. It does not calculate past that point.

    Obviously, the benefit of the SM would continue past that point and through retirement, depending on which retirement option you choose.

    2. Actually I am a fan of keeping the HELOC through retirement. That is the most effective strategy and will likely lead to the highest retirement income.

    With this option, you generally keep the HELOC as long as you own your own. When you are 85 or 90 and moving to a retirement home, you can sell your home and pay off the HELOC. Think of it as an advance on the money you would otherwise not access until you are old and sell your home.

    Some people are uncomfortable with always owing money on the HELOC and prefer to slowly pay it down. There is a savings, as well, since mortgages are at lower rates than credit lines.

    Once you have fully paid off your mortgage and converted it all to a tax deductible HELOC, you can convert it back into a mortgage (which is still tax deductible) at a lower rate and slowly pay it back with a long amortization like 30 years.

    These 2 options feel differently. Even if the amortization is 30 years, knowing that you will eventually pay it all off feels different than knowing you will always have the HELOC. You also may or may not want to leave a large inheritance with your home equity in addition to all your investments.

    Converting back to a mortgage does mean a higher payment, since it includes the principal portion, so it does cut into your retirement lifestyle.

    The best option depends on your situation.

    3. We have been doing the SM only with corporate class mutual funds. I have to admit I’m not really a believer in indexing. It’s fine for people that don’t know much about investing, but we are always looking for all the ways to outperform the index. There are quite a few. Finance professors now almost unanimously know the “efficient market theory” is false.

    The All Star Fund Managers we have been using for years have all outperformed their index over their careers after all fees. We call it “negative MER”. These guys exist. What is the “cost” of a fund that has an MER of 2.5% but has beaten its index by 3%/year compounded after all fees for the last 15 years?

    In our case, the difference is larger. Our advice generally costs 1% of investments. If we used index investments or ETFs, our clients’ returns would be the index less our 1% less the MER. The “ultra low MERs” are generally not that low with the global indexes (which should dominate index portfolios). We would much rather beat the index.

    The main reason the average mutual fund lags the index is because of closet indexers. Closet indexers are not trying to beat the index – just to be close to it. Don’t buy them. The most in-depth study on the topic (Active Share sturdy) shows that if you take out the closet indexers, then the average mutual fund beats the index.

    In addition to being able to beat the index, the tax on corporate class mutual funds is far lower than on stocks or ETFs. The largest tax advantage is not even the ability to move between funds without tax consequences or the ability to spread capital gains to other funds in the structure.

    The biggest tax advantage of mutual funds is the “capital gains refund mechanism”. There is an article about it on MDJ. In essence, gains in the fund are allocated to those that hold the funds for short times, which means the long term investors tend to pay hardly any tax.

    The capital gains refund mechanism is why you can own a fund for 10 years that triples in value while turning over all the holdings in the fund more than once and receiving healthy dividends and still pay virtually nothing in tax.

    For example, last year was a great year. Most of our clients’ portfolios were up almost 30% (they are mostly global funds), yet the taxable portion was less than 1%.

    The secret to success with the SM is to focus on long term compound growth. I think the best way to do this is to beat the index (negative MER) with almost 100% tax efficiency, while still claiming your full interest deduction.

    4. Once you are down to a mortgage of only 15% of your mortgage, you cannot continue to readvance the credit line. There is an easy fix, though, by just fixing all or a portion of your tax deductible credit line.

    Ed

  • On the fence May 29, 2014, 9:08 pm

    @Ed

    Thank you for your advice.

    I trust my daughter, she is very responsible person, she finished her undergrad studies debt free, contributing her education cost by working in the summers. This current debt is the cost of two post-grad diplomas, completed at the same time, full time – not leaving any opportunity to make money on the side.

    My considerations are related to finding the best financial solution.

    Originally I was considering only the mortgage for the SM, the consideration was, whether it’s worth starting SM for the remaining 100K – or should I just lock in for five years at the current record low rates and pay it off by the end of the term.

    The argument for just finishing up the 100K with regular mortgage is that the outstanding amount is relatively low, regular mortgage rate probably lower than the readvancable mortgage, the overall gain from SM at the tail end of the mortgage is relatively low. It also provides a completely risk-free, known financial obligation until the end of the mortgage.

    The argument for SM is that however small is the gain – it is a still a gain, in exchange of some risk.

    Combining the 100K mortgage with the 80K LOC into SM would potentially realize better gain – in exchange of taking on a risk.

    Splitting off the 80K into a sub-account within the readvancable mortgage is an interesting idea, I did not know it was possible to do it.

    It makes me wonder if it is possible to have a “hybrid mortgage” option: regular mortgage for the 100K and SM for the 80K, as a second mortgage? (Or 80K for regular mortgage and 100K for SM.)

    Thank you again, Ed.

  • VK June 10, 2014, 9:08 pm

    Hi all,

    From reading all the comments and posts on the SM, it seems like a lot of people employing the SM are investing in (i) blue-chip, dividend paying TSE-listed, Canadian companies, (ii) various Index ETFs or Mutual Funds (incl. Ed K’s All Star Fund Mgr funds).

    Is there any particular reason few are using their SM investment portfolio to invest in blue-chip companies outside of Canada, namely our neighbours down south?

    Is this perhaps due to following:
    i) cost of FX conversion (this perhaps could be avoided with norberts’ gambit), or
    ii) less favourable tax credit treatment of non-Canadian dividends?

    It seems if one were willing to invest in companies outside of Canada there leading companies in sectors, industries, etc., that aren’t available on the TSE…

    Thanks!

  • Globetrotting Dreamer February 11, 2015, 11:40 am

    Hi Frugal,

    I was wondering if I can apply the Smith maneovre to my current home where I have rental income coming in from a tenant who shares property with me, or does it by law/structure have to be a separate investment property/entity.

    Thank you,

    Celio

    • FrugalTrader FrugalTrader February 11, 2015, 9:39 pm

      Technically, if you borrow against your current house and invest the proceeds in eligible investments, the interest should be tax deductible. It’s the same scenario if you owned a rental property, refinanced it, and invested the proceeds. However, best to double check with a tax accountant.

  • Tito February 18, 2015, 12:31 pm

    If someone has low risk tolerence and would like to apply the smith manoeuvre,is seggregated funds the right option and suitable for smith manoeuvre?

  • Ed Rempel February 20, 2015, 1:37 am

    Hi VK,

    I agree with you. The “home country bias” that dominates most Smith Manoeuvre portfolios misses out on much of the potential growth. Canada is only 4% of the world’s market, so most of the best investments are outside of Canada.

    The TSX is also a mid-cap index. Only 12 of the 60 companies qualify as large cap by global standards. Canada is also significantly underweight with few good choices in 11 of the 14 sectors (because 3 sectors are 75% of our market).

    You are right that the dividend tax credit and currency conversion are 2 of the main reasons, but focusing on income instead of growth, simple home country comfort and lack of knowledge of non-Canadian investments are also major factors. In my opinion, these factors all limit growth potential.

    Our clients doing Smith Manoeuvre are generally invested about 80% outside of Canada. We invest to avoid dividends (or at least don’t focus on them), in order to maximize tax deferral, so the dividend tax credit is not a factor.

    Good point about the benefits of avoiding home country bias, VK.

    Ed

  • Ed Rempel February 20, 2015, 1:41 am

    Hi Globetrotting Dreamer,

    FT is right. No problem doing the SM on your home if you rent out part of it. All the Smith Manoeuvre does is create home equity that you can use as collateral to borrow to invest.

    You can’t do the Cash Dam on your home in this situation, but no problem with the Smith Manoeuvre.

    Ed

  • Ed Rempel February 20, 2015, 1:55 am

    Hi Tito,

    If you have a low risk tolerance, then the Smith Manoeuvre is not right for you. It is borrowing to invest, which is a risky strategy.

    Segregated funds can guarantee your principal after 10 years, but that means you have to stay in the fund for the 10 years. If you are a low risk tolerance and your fund falls a lot in value, are you really going to be able to hold on for 10 years to be able to get your principal back?

    My opinion is also that the principal guarantee of segregated funds is not really worth the cost. The MER is higher to include the cost of insuring the principal. Stock markets are rarely down after 10 years, so you are insuring a quite unlikely event.

    The Smith Manoeuvre, like other leverage strategies, should really only be used by more aggressive, long term growth investors.

    Ed

  • SST March 17, 2015, 11:11 am

    Open question to Ed, FT, and other SMers: would you advise a homeowner to impliment the Smith Manoeuvre considering the current economic environment — stocks at almost all-time highs and mortgage rates at almost all-time lows?

    (Bonus question: FT, have you ever, just for fun, calculated what your SM portfolio would have been if you started it one year later, at the 2009 bottom, instead of the 2008 peak?)

  • FrugalTrader FrugalTrader March 17, 2015, 12:22 pm

    @SST, I try not to think about if I had to just wait one year longer. :) This was my article back in 2010 on “should I start the SM?”

    http://www.milliondollarjourney.com/should-i-start-the-smith-manoeuvre.htm

  • Ed Rempel March 17, 2015, 10:52 pm

    Hi SST,

    The Smith Manoeuvre needs to be a long term strategy, which means you go through up and down cycles. To be successful, you need a long term outlook and should not be focused on short term factors such as trying to time the start.If you borrow to invest for 30 years, where you start is not that important.

    The SM is a risky strategy, because you are borrowing to invest. The stock market returns vary a lot short term, but returns have been reliably high over long periods of time (20-30 years).

    The issues you mentioned do not really concern me. The stock market historically hits all-time highs about 2 out of 3 years (since it rises over time). The stock market is roughly fairly valued and cheap compared to other investments like bonds. Interest rates are low, but expected to stay relatively low for a long time. A rise of 1-2% is not really a concern. The interest is tax deductible and investment returns should still be higher over the long term.

    If the market was hugely overvalued, say P/E over 30, or interest rates were very high, say 8-10%, I would be more cautious. Today’s levels don’t concern me. In fact, the entire mood of investors is still overly cautious, ever since 2008, which is a good reason for optimism.

    In short, if the Smith Manoeuvre is a suitable strategy for a client with a long term outlook, I would have no hesitation in starting today.

    Ed

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