I agree with most of what you said, but margining still looks very risky. You have faith in the long term growth of the market, which makes sense. You are leveraging 3:1, which will likely magnify your long term gains.

The issue is that you can get wiped out by short term, temporary declines.

For example, the worst 1-year decline with monthly data in the TSX in the last 25 years was 38%, yet there was a 4-month decline from the peak in July/08 to the trough in Nov./08 of over 50%.

How do you protect yourself against very sharp, but very brief drops?

The fact that it more than 1/2 the loss was recovered in the next year is great news if you don’t have margin call, but all it takes is one very short sharp drop and you can be forced to sell that day.

Your protection seems to be to only use about 1/2 the leverage you have available. That can be a very sound protection against a margin call, but are you not missing out on much of the profit? If you could have a “No margin call” loan, you could leverage twice as much and stay invested all the time.

The biggest benefit from leverage from our experience is when you can leverage a higher amount, but stay invested by maintaining faith in the long term growth and make sure you will never be subject to a margin call.

I do disagree about being a “buy and hold” investor. Studies consistently show that it works. Your experience has been quite short term and was mainly from near the bottom of the market through the first big leg of the recovery. So, your trading may have worked, but would you not have made more by being fully invested with double the capital (without having to hold back large amounts to protect yourself from a margin call)?

I do agree that you can’t really get rich without leveraging. I looked at the Forbes 400 richest people and found that every single one is there because of leveraging into equities. They all borrowed to invest in a company or in the stock market (except a few that inherited from someone that did).

The moderately wealthy made it through various ways, but the truly wealthy all made it by leveraging into equities (companies).

It is a common misconception that successful actors, musicians, or athletes are the wealthy, but not one of the Forbes 00 richest people made their money that way.

Leveraging into equities is the only way to serious wealth.

Ed

I see your point about margin loans. Margin like anything else is a matter of preference based on your risk tolerance and is another way of leverage just like the smith manoeuvre. To enrich the discussion i will point out the following reasons, why i don’t mind margining:
1.If one is comfortable leveraging one’s money when they buy a house with 5% down, then we should also seriously consider why we are so uncomfortable with getting a margin amount where you put 33% of the equity and the broker puts 66%. Is the stock market more riskier? Probably not, given your own analysis. I think the key here is to understand what type of equities you want to buy, if you are using margin, you should try not to be overspeculative by buying penny stocks and should just stick with blue chips and index funds, which is mostly what i do (unfortunately i can’t say i do this 100% because i do get a bit carried away and place some speculative bets).

2. The other thing i like about using a margin account is the ability to pay off interest costs through my brokerage account. I don’t need to worry about ‘manual procedures’ to capitalizing interest and what not – which is how people people are using the SM. From a cash flow perspective its completely neutral for me. Every month like clockwork, the brokerage reduces my outstanding equity with the carrying costs of capital that i have used to borrow, i.e. the interest ($140 or so)….since i have already made significant capital gains, so this money is negligible for me. I also own a large holding in a REIT as one of my primary holdings, so the interest costs are also balanced out by the dividend paid out by this investment.
3. I try to mantain about $10,000 in extra margin, this amount goes up and down every month, but thats my threshold. If it goes up significantly, i know i have more equity that i can use to buy more stocks. if it starts to fall below, i can use my HELOC to increase the amount, so for example if it dips to $5000, i will take about $5000 from my investment HELOC, and the equity available to me in my margin account is now $20,000 (5K*3+5K) – i do like to do some trading as a buy low and sell high kinda guy, so depending on how the market is going , i might use $10000 of that extra cash to buy some equities and make a quick $1000 or so and then get out. I have done that numerous times. The important thing here is to dollar cost average your $10K investment because you are never going to pick the exact bottom and then not get too greedy and lock in your gains once you’ve made some decent money. I believe this strategy has been extremely useful to me. In early 2009, i decided one can’t be a buy and hold investor, where the VIX is going crazy and the market was characterized by 10% swings either way in a few days, so even though the market tumbled from oct (when i started investing) to march, i was still making money during this period riding the crests and troughs.
4. Another reason is purely psychological, my wife who is much more risk averse than me doesn’t want to carry such a large LOC, so in a way i reassure her as i have used only half of the equity available to me in my HELOC ($30K out of the $60K) admittedly this is a bit of a fool’s gold as we have leveraged the $30K to $80K – for some odd reason, its more comfortable for her to know that we have not taken out out a huge LOC.
5.Finally I don’t think one can get rich without margining. Yes its risky but then so are other things in life…setting up a small business is probably even riskier. However i’d like to caveat this whole discussion by saying that we make about $3000 of free cash flow every month, we don’t have any car debt, credit card debt etc. So in my case, i can afford to take the risks i am taking. I certainly wouldn’t be as aggressive if i had any major debts (other than a mortgage and LOC). Its important to get your house in order. In my mind, great opportunities always come along every 5,6 years or so, but then you got to have the ability to take advantage of the opportunities….if ppl think they have missed this boom, well its not exactly over and the stock market will fall again – the question is will someone be positioned to take advantage.

You seem to have a very good outlook. I agree with almost everything in your post.

Short term predictions are always difficult, but in general we are even most bullish than your “flat and rising” scenario. The recovery from the global recession has not really happened yet.

The one thing you should be careful of is protecting yourself from margin calls. While the market has consistently recovered much more quickly than people realize, shorter term periods tend to have larger declines.

A 1-year decline of 30% is rare, but a 3-6 month decline of 30% is more common.

The worst case scenario is a margin call chain. You are forced to sell, but that reduces your investment collateral, so you end up being forced to sell much of your portfolio.

The disaster scenario for the Smith Manoeuvre is being forced to sell at a market low.

Any leverage we do, we always make sure we protect against margin calls. Using your credit line is good, because there is no risk of a margin call. When we add additional investment loans, we almost always use only “No Margin Call” loans.

With margin accounts, you don’t have that protection, so I would suggest to make sure you are able to cover a margin call of 40-50%.

We do think a large decline now is less likely than normal, since the global stock markets are still relatively low, but a quick sudden decline can be a big problem for you – even if it is brief.

Ed

I have also read your articles on the irrational fair people have about the stock market….it is just plain stupid. The market in general grows 10% a year – this is a proven fact and just like the house always wins, and therefore you shouldn’t bet against it – you should not bet against the world economies.

Meanwhile i’m going for a variable mortgage, diminishing my cash flows and put every $ into the market.

No pain , no gain – don’t miss out folks!

Based on what you said, the interest on both the credit line and margin account would be deductible.

It was easy for you because you started investing at the buying opportunity in decades. You had the faith to invest at the low. Most investors even now did not see last February as the best buying opportunity we will likely see in our lifetimes.

In our view, the market is still very low. The global stock markets are only just over 1/2 recovered. The huge rally in 2009 was just a relief rally from the irrational pessimism last year and that we survived the banking crisis. The rest of the recovery is still too come as the economy returns to normal growth.

Buying on lows is smart.Just don’t get carried away. Investors that make money easily often get too aggressive after that.

If you sell to pay off the mortgage, remember that you have to always pay the amount invested (book value) from each sale onto the credit line/margin account and only the taxable profit can be paid onto your mortgage. Otherwise, you lose the tax deductibility.

I’m with you on paying off the mortgage. It is this weird Canadian thing about paying off the mortgage. We believe the reason there are so many more millionaires in the US than in Canada is primarily because Canadians tend to focus almost their entire working life on paying off debt, while Americans tend to keep their tax deductible mortgages and focus on building wealth.

Receiving taxable dividends in order to pay off a cheap mortgage is questionable – I agree. The majority of our clients’ mortgages today are at 1.4%, because they have variable mortgages from a couple years ago. Paying that off does not seem like priority.

The idea, though, is that you stay invested. You take the dividend, pay down your mortgage and then reborrow to invest. That is the only way it makes sense. To take money out of stocks to pay down a cheap mortgage and not reinvest is nuts.

The other issue is the taxable dividend. This works for low income investors, since dividends have negative tax rates for people with incomes under $41,000. However, the “tax leakage” is a drag for investors with moderate or higher incomes.

Ed

i basically had a readvancable LOC of $60,000 that i have broken up into 2 segments, one that i am keeping for any untoward expenses ($20K – current balance $0) and the other that is my investment LOC. I have used 30,000 $ current limit ($40K) of the investment LOC and have put it into a margin account and leveraged again (1:3) to invest about $80,000….i started doing this in the latter part of 2008 and invested bit by bit till i reached the $80,000 threshold. My portolio as of yesterday was about $130000 (market value). At this time, i have only being paying the interest charges on my HELOC which are still pretty minimal in my mind (~$80 per month). From what i understand these interest charges as well as the interest i’m paying on my margin account with questrade (about $140 or so) are both tax deductible…is my understanding correct? Can anyone suggest any issues in my interpretation of the smith manouvre?

My plan is to aggressively pay the mortgage by cashing out some of the positions i hold once interest rates start to rise and i feel the stock market is overvalued…at present i think we can see the TSX hitting 13500 ish in the next 2 years and i fully plan on making hay while the sun shines.
Meanwhile I’m eager for the market to correct a bit more so i can dump the rest of my $10,000 ifrom my HELOC….leverage it with my margin account and watch it do wonders….i think i’m getting a bit ahead of myself though, it seems too easy!!

When i read on the smith manoeuvre such as here, it seems that a lot of ppl here invest in dividend stocks and use the cash flow to pay the interest on the mortgage and tax breaks rom smith manoeuvre to pay off the mortgage. Why are people so eager to pay down their mortages in such uber low interest rate situation? Am i missing something?

You should keep the credit line separate from your mortgage. If you intermingle the amounts, you run the risk of losing the deductibility.

And you are right – if you merge them, you are paying both down. It is much more effective to pay down the non-deductible mortgage only. You can compound the credit line interest to avoid using your cash flow.

You should be able to get the credit line portion at prime +.5%, which is not that much more than the 1.99%.

Ed

FT is right. CIBC does not have a readvanceable mortgage. Home Power is just a credit line. You need a mortgage linked with a credit line.

If you want a good recommendation, we are still offering Ed’s Mortgage Referral Service as a free service to MDJ readers. It is on this site. If you send us the answers to the questions listed, we will refer you to our contact for whichever mortgage is best in your situation. We have negotiated very low rates. Today, we are getting 1.99% on a 1-year fixed and prime +.5% on the credit line. We believe the 1-year fixed to be the smartest term today.

Ed

I have approached CIBC branch, I was told that I will not be provided sub-account to withdraw funds for invetment purpose! What I will be having is only one HomePower account, I need to take from there as the principle grows.
Any ideas? Is anybody here with CIBC Home power implemeting SM ? Please advise.
Thanks

I just noticed your posts. FT is right that you need 20% down to be able to get a readvanceable mortgage. There are creative ways to get there, such as using a larger RRSP loan to get a big refund or borrowing from an unsecured credit line for your down payment.

With your mortgage at 5.2% with 4 years left, it is almost definitely worth breaking the mortgage to refinance. We are getting 1.99% on a 1-year fixed, which is what we are recommending now.

Call your bank and ask them for the penalty. They may say it takes a while to get in order to stall you, but their computer has the number on the screen.

Your mortgage is $297K x (5.2%-1.99%) x 4 years = $38,000 in interest saved. If your penalty is less than this, then it is worth breaking.

You may have a problem though, because the penalty needs to be paid or added to the mortgage. Considering you can save $38,000 in interest, it is worth it to try to find a way to do this.

Unfortunately, you have fallen into the “5-Year Fixed Mortgage Trap”. Banks and mortgage brokers try to get people to take them because they make far more on a longer term. But studies show that virtually every person that has ever taken a 5-year fixed mortgage wasted money on interest.

In the future, we would recommend sticking to 1-year or variable mortgages.

Ed

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I’m assuming you are using V2 of the SS dated August 22, 2009.

If that is the case, you have to try and compare “apples with apples”. In other words, if you are going to be investing periodically alongside a traditional mortgage, then you have to include that in the cash flow consideration for both.

For the traditional mortgage, I uncheck every box and treat the dividends as simply being reinvested. The dividends come from the fact that if you are going to periodically invest $131 during the SM on top of the SM itself, then you need to factor that into your comparison.

Thus, the mortgage is retired in 14.26 years requiring a cash flow of $427,955 and also producing a portfolio worth $106,196. If we project out to 25 years, we see a total cash flow of $498,498 producing no debt and an investment portfolio of $347,578. Thus, paying out just under $500k over 25 years eliminated $260k in debt and resulted in an investment portfolio just under $350k.

Now, if we check steps 1, 2 and 4 and change the dividend treatment to Reborrow & Invest, take out $30,000 from the HELOC right away and add it to the non-registered assets (we are investing it to ‘jump start’ the SM) we get quite a different answer.

The mortgage is retired in 9.51 years requiring $275,471 in cash flow but our portfolio is under water (since it is projected to grow its capital base at a lower rate than our HELOC) of $12,413. But, if we project out to the full 25 years we see some big numbers.

The cash flow is quite high because instead of ceasing our mortgage payments as in a traditional mortgage, we keep investing them. The total is $829,362 which produces a tax deductible HELOC of $290k (with annual tax deduction of $16,675 which will be soon offset by the growing dividend income tax) and an investment portfolio of $1,612,356.

So, for a cash flow of less than double we see an increase in investments net of LOC about 4x in the traditional mortgage scenario.

glad to hear you are finding the SS useful. The way I look at the total benefit is to run the scenarios as traditional mortgages first. Once you settle on one then I run some SM scenarios. After choosing the one most appropriate I compare networth and cash flow numbers IN THE SAME TIME PERIOD. If your networth went up by 50k and the cash flow was lower by 25k that to me speaks of a 75k benefit.

The reason the house value growth rate would be in there is a commercial version required a periodic revisit to the maximum LOC value. It is not really used in this free version.

Assume the following (All input fields on Cannon Fodders Calc);
Principle: $260,000
Annual Prepayment: $5,000
Compounding: Semi-Annually
Amortization: 25 years
Payments/Year: 26
House Value Growth Rate: 2%
Interest Rate: 5%
Mtg Payment Increase Annually: 2%
Home Equity: 80%
Non-registered Assets: $0
Periodic Investments: $131
Annual Investment Increase: 3%
Growth Rate: 5%
Dividend Yield: 3%
HELOC Starting Value: $30,000
HELOC Interest Rate: 5.75%
Taxes: AB, 36%
Refund Date: 4/30

Using the above values I calculate paying my house off in 9.97 years.

Derived from the above values the calculator has determined:

Scenario A (SM):
Total cash required to pay for mortgage: $287,520
Tax deductions: $25,541

Scenario B (“Regular” mortgage, zeroed out everything except mortgage value)
Total cash required to pay for mortgage: $367,464
Tax Deductions: $0

Can I calculate the total savings (without reinvesting the savings) using the SM by:

Delta between interest paid in Scenarios A & B: $367,464 – $287,520 = $79,944
Sum total tax savings: $25,541
Total estimated savings: $105,485 (or a savings of $10,549 / year)

Do any of the inputs look aggressive or overly optimistic? With the current financial climate I would rather base my potential savings on a conservative approach.

Have I missed anything important in my above calcs?

On another note, how does a depreciating house value factor in to this?

Many Thanks,

James