The Smith Manoeuvre - A Wealth Strategy (Part 2)

Hey QCash!

That is a very interesting point of view!

I would need a spreadsheet to calculate the difference between using the SM or just paying down the mortgage. Actually, I believe that http://www.smithman.net has some scenarios that does the calculations for us.

From my point of view though, why not pay down the mortgage faster using the Smith Manoeuvre and use the portfolio to invest in dividends which give you more cashflow? Using the tax refund at the end of the year towards the mortgage should help speed the process. The SM does not cost you any cashflow as you can “capitalize” the interest meaning you can use the loan for pay for the loan interest payments.

FrugalTrader

BTW

I have added your blog to my daily read, so I wish you all the best.

You asked earlier what other saving strategies I used, well, we are definitely in agreement with the used car approach (although deep down I still want one of those pontiac solstices :-)

My wife is a fan of garage saling and it is her summer hobby. Every Saturday morning she gets up at some ridiculous hour to go scavenge through other people’s junk. But she has managed to get tonnes and tonnes of kids stuff dirt cheap (books, toys, big plastic things that clutter up our back deck) but at a hugely reduced cost.

I also set up an ING account with a direct deposit on the same day as my paycheque to save towards a rainy day.

I use Microsoft Money to track investments and cash flow and spending. I am entirely too obsessive about it, but it keeps me happy knowing how much of our monthly grocery budget we have spent so far each month.

Q

Hi, Frugal,

Great summary of the SM. We are the main Smith Manoeuvre advisors in the Toronto area and have implemented it for more than 100 families, including many variations and enhancement strategies.

You summary is quite good. A couple of tips:
1. You can do it with as little as 10% down, as there are a couple of sources for 90% readvanceable mortgages.
2. No institution will capitalize the interest, but you can do it yourself with one simple transaction a month. This way, the SM uses none of your cash flow. The reason for this is that any of your cashflow used for debt should pay non-deductible debt.
3. After the mortgage is gone, the most effective strategy is to keep the investment credit line for ever. Once you are retired, there you will be very thankful for both this tax deduction and for having a large non-RRSP portfolio. For our retired clients with large RRSP’s and a large non-RRSP portfolio, tax planning is full of options. This is in contrast to those with only RRSP’s and pensions, who have no cash available they can take without paying full tax.
4. You’re right that the only real risk is the investments. Your dividend stock idea is sound, as long as you diversify enough. We tend to use tax-efficient mutual funds with what we call “all-star fund managers” (the Wayne Gretzky’s of the the investment world). We get good diverification, a long track record, stats to measure risk, and many have been 100% tax-efficient.

Good luck and I hope you find this helpful.

Ed

FT

A couple of comments about the SM. I did a little (very little) reading about it and it seems to me that while the idea is sound, I am concerned that it still involves leveraging your personal residence to make investments.

Taking what you posted in your Net worth post, wouldn’t it make more sense to flip your 38K in non-registered portfolio into the SM and then just keep paying down the non-interest bearing debt?

Also, you have a rental property. How much is that leveraged for currently? (if you don’t mind me asking). If you have room on the property, you probably can use that extra equity to leverage some investments, if you feel comfortable doing it.

Also, I remain skeptical of “capitalizing” the interest. You pay 500 in interest, you get a deduction of 500, but at 46% tax bracket you see a net cash flow of -270 (500 interest out - 230 tax reduction in). Plus the 500 is now adding extra interest costs.

I think you have to look at as “I have a mortgage of 75% of my house value and the payment will be X for the next 25 years” part of that X will be deductible, part will not.

I am probably more conservative in that I don’t believe in leveraging my principle residence to invest.

Just some added extra thoughts. Not to disuade you from investing using the SM, but just make sure you plan it out and look at the real cost/benefits.

Q

This is an interesting blog. I use leveraging to make my mortgage interest deductible. Obviously, I think it is a good strategy, but I am already into the fray for a few years now, and the project is providing handsome rewards given the large returns in the equity markets the past few years, and incredibly low interest rates. It makes it look like a no brainer, but it was far from a no brainer when I dove in. You can’t predict what the markets are going to do (otherwise, you would be on a beach in Bermuda talking about your first 100 million rather than blogging about when your first 1 million will be). If it was a sure thing that the markets were going to go up, everyone would be levaraging. But as one poster indicated above, levaraging is risky business that cuts both ways. Optimists see handsome returns and large retirement portfolios. Pessimists see losses and cash calls. If you undertook this maneuver with a lump sum investment from a HELOC in January 1973, you would be wishing you never heard of the Smith Maneuver.

” I will have to take the time to review the risks carefully before I dive in.”

I think these words are very appropriate in this dicussion. The risk is a bear market at the beginning of your journey that could take two decades to recover from, all the while you are paying interest on a loan with only a fraction of the funds to show for what you borrowed. That’s a tough pill to swallow, and therefore, this strategy is really not for the faint of heart, and is far from a sure thing.

NF

If I were to start today, I would have the same portfolio I have now which is diversified globally and in market cap. When I started, I crossed my fingers, and hoped that if the US or Canada (or both!) tanked, EAFE and fixed income positions would limit the losses. Diversification is your only protection, but nothing is guaranteed since the only thing certain about the stock market is its unpredictability.

NF

I am a do-it-yourself investor using a discount brokerage. While I have dabbled in individual stocks in the past, I generally did not guess very well, and gave up that exciting game for a boring portfolio of diversified low cost ETF’s.

Very nice job on the article. You state (and I’ve seen it stated in other sites) that the strategy should be to pay off the non-deductable mortgage with cash or other non-RSP investments first and then re-borrow to fund the SM.

What if the non-deductable mortgage is less interest than the credit line minus the tax deduction? Eg. non-deductable mortgage at 4%, Line of Credit at 6% and 30% tax bracket = 4.2%. In this case, does it still make sense to sell a non-RSP investment to pay off the non-deductable mortgage and then reborrow to pay re-buy the non-rsp investment?

Hi, FT, Q & Neil,

I’ve just been reading all the comments. FT, yes, I think you have the capitalizing right. You pay the interest from your chequing and then take the money out of the credit line to reimburse yourself for paying the interest. And yes, there are of course CMHC fees involved if you go to 90%.

The tax rule is that, if the interest is tax deductible, then the interest on the interest is also tax deductible, which is why capitalizing is useful. Why use your cash to pay tax-deductible interest when you also have non-deductible interest to pay (such as your mortgage).

You all mentioned reviewing the risks carefully before diving in. The strategy and tax rules are simple and work. The only real risk is with the investments. If you invest effectively, can tolerate the risk and will stay invested for the long term, then the SM is very profitable.

Neil, you have exaggerated the risks of the stock market, like most people do. The figures often shown about the markets being down for 20 years always exclude dividends. The longest period the markets have been down since the 1930’s has been 6 years, when you take the total return. This was from 1973 and from 2000, which were the 2 largest bear markets in the last 60 years.

FT, your dividend strategy is sound, but dividend stocks have had a perfect storm lately. Long term, you should only expect 8-10% from dividend stocks, since they are very mature companies.

We tend to use equity mutual funds managed by managers with long term records of beating the indexes at low risks than the markets. There are managers with 15-30 year records of beating the markets by wide margins with returns of 15-19%after all fees) and lower standard deviations.

The advantages of mutual funds are that many come in tax-efficient corporate structures, so that they have never paid a distribution. With dividend stocks or fixed income investments, you lose much of the gain to annual tax on the investments. The risk is measureable when there is a long term track record and mutual funds offer all kinds of risk stats (such as standard deviation, alpha, beta, etc., and correlation between investments). The risk stats vary in different markets, but if you look at them in the worst times (such as 2000-2), you can be relatively confident that that is about as bad as it will ever get.

The main risk that you do-it-yourselfers face is trying to time markets or trade. Several studies show that the average investor only makes 1/3 of the investments they own, because they tend to always buy high (something currently “doing well”) and sell low (something currently “not doing well”). It is always tempting to sell when your dividend stock or ETF struggles and to buy something that has just had a few good years.

This is actually your main risk, since studies consistently show that the average investor loses most of their return by trading, because trading consistently means selling low and buying high. Your best strategy is to research your investments well and then hold them forever, especially if they go through a few bad years. Only own investments that you would be comfortable owning all the way through bear markets.

Hope you find this helpful.

Ed

Ed,

Where do you buy these mutual funds with 15%-19% return after fees? I’ve been looking for them. I searched through MorningStar.ca, the best funds with over ten years track record are mostly Canadian dividend funds managed by the banks. They only made between 13% to 14% for the last ten years.

FT,

Your article is marvelous.

There is only one thing I can add. Going through all the comment, I realize that a lot of people have the perception that the Smith Manoeuvre is pretty risky. It is not. It is much less risky than the original purchase of the primary residence.

Let’s thing about it. For the original home purchase, if you had put a 30% down, you had 3.3 times leverage on that investment. If you had put only 10% down, that was a 10 times leverage. And, the worse part, the whole quarter million to half million investment was made in a single shot, at one particular market price.

On the other hand, when you employ the Smith Manoeuvre, you are only taking out the portion of your home equity which you already paid off. Technically, you are not leveraging at all. On top of that, you can take out a fixed dollar amount every month from your HELOC to invest on your favourite stock or mutual fund. You get the advantage of dollar cost averaging. That is, it really doesn’t matter whether the market goes up or down in the short or medium term. If the price goes down, you accumulate more shares, if the price goes up, you accumulate less shares.

As long as your stock or mutual fund grows faster than your interest cost in the long run, you are ahead on the investment. You don’t even have to play the risky game of market timing like the purchase of your residential investment.

Let’s look at some hard number. Between 1978 and 2005, the average price of Vancouver’s detached house rose from 77,778 to 658,910, the volatility was 21.72%, annualized price increase was 8.24%. In that same period, the TSX Composite Total Return Index rose from 1,436 to 26,619, the volatility was 16.31%, average yearly gain was 12.58%, annualized gain was 11.42%. In that 27 years, the average detached house price in Vancouver rose 3.18% less than the TSX Composite Total Return Index per year, but the volatility (aka risk) was 5.41% higher.

So, if you were in Vancouver, the SM approach for investing is less risky than the detached house investment.

Let’s look at the investment return. In that 27 years, your average HELOC interest rate would be 10.84%. If you were in the 30% tax bracket, that would reduce your effective interest cost to 7.4%. Your investment funded by the home equity would have made a 4.02% annual return. That only beat inflation by a little, but that is extra return in addition to the price gain of your primary residence. And you did not invest any extra money out of your pocket. Thanks to Fraser Smith.

Best wishes on your million dollar journey.

EZ

I’m planning to implement the Smith Manoeuvre on a 65% mortgage totalling $215,000 (huge down payment) new condo unit here in Toronto.

Can anyone recommend a financial consultant who can take me through this? I don’t really feel like calling up the 60 or so qualified individuals listed at http://www.smithman.net :/

Hey Fred,

Thanks for your explanation. What is your investment strategy?

FT

Hey Splash,

Thanks for your comments.

There are some arguments that the risks involved outweigh the benefits. My counter argument is if you’re planning on living in the home for the long term, and investing for the long term (investing in strong dividend paying co’s), why would a down market in real estate or stock market bother you? Just keep collecting those increasing dividends (which are resilient to market down turns), and the market will turn around eventually.

FT

Tetris,

If you need help setting up the SM, we are the main SM advisors in the GTA with over 150 families doing the SM monthly. We are only looking for serious clients, though, so we will want you to attend one of our unique seminars before we would meet. It is not a waste of time, since we address the main issues (mainly emotional & investment). 2/3 of our seminar is not in the SM book.

If you are a do-it-yourselfer, we can still help you get the right mortgage. We know the pros and cons of every SM mortgage and have contacts with the banks (some of the big 5) with the best SM mortgages.

Click on my name if you want any more info.

Ed

Shaun:

Valid points, but you neglect to point out the effects of taxation @ RETIREMENT. With an RRSP, your portfolio is taxable as INCOME upon withdrawal. Your SM account though will face the preferential tax treatments of capital gains and dividends (my article on investment taxes).

You also give the RRSP an annual return of 15% and the SM an annual return of 10%. Is this realistic? If you earned $150 in capital gains in a taxable account, only $75 is taxable, which would probably leave you with around $120 after taxes. So 12% would be a fair annual return for the SM assuming 15% for RRSP.

On top of that, I believe that an efficient way to invest the SM money is through the purchase of dividend paying co’s (Canadian preferably). Buy strong dividend paying companies, never sell, collect increasing dividends/year. In certain tax brackets and provinces, you can pay as little as 0% on dividend income (article to follow). Does your analysis change then? So with this scenario, you get TAX FREE SM growth, a tax deduction / year, AND reduced taxation at retirement. I will bet that this scenario will beat the RRSP every time(providing that you invest in the same vehicles in the RRSP).

I’m not saying that the RRSP is a bad way to go. I think it would be prudent to build BOTH your RRSP and SM. Both have their advantages.

ED:

Thanks for your insights. However, I’m not sure that I agree with your statement that you’re “leveraging real estate”. I would agree with that statement IF you used the HELOC money to buy rental property, not stocks.

FT

Shaun,

Another great comment, thanks for sharing.

Say that your numbers are correct.  Perhaps the SM is NOT a method to REPLACE your RRSP, but to supplement it. Why not invest in both your RRSP AND the Smith Manoeuvre? Not just one or the other? You have a maximum contribution limit / year on your RRSP, and if you capitalize the interest on the SM (see article), you’ll never have to pay for it out of pocket.  So it will be kinda like what i’m doing now, maxing out my RRSP, and putting any excess into my non-reg account.  Except with the SM, instead of putting the money into my non-reg account, i’d pay down the non-ded mortgage and re-borrow to invest from the HELOC.

A more fair comparison would be SM vs traditional non-reg portfolio/paying down mortgage.

Another point about dividend paying stocks, as long as the dividends keep increasing, the stock price will follow. I doubt that we’ll see growth over the next 5 years as we did see during the last 5 years but they are stable and give you a guaranteed return (providing that you don’t sell on a down turn). If you buy the strong dividend paying stock on a DIP, you will get strong returns.
FT

FrugalTrader,

BTW - didn’t me to ignore your other points: I would love to see someone run some scenarios and numbers to see how this compares!

But for me, I know now, that I won’t be using the SM. I am currently 40 years old, married with two kids. We have a house valued at $700,000 and a mortgage of $150,000. From here, I am going to borrow against my HLOC to top up my RRSP deduction limit, and make my maximum RRSP contribution annually, while I pay off my house. Very conservatively at retirement in 20 years, I will have in excess of $2,000,000 in my RSP, and a paid up house worth about $1,200,000 million (assuming 3% annual growth in it’s current value). I think that will keep us happy until death. :-)

I really have no significant experience in dividend paying stocks, but if you have a system that works, just use those numbers in your calculations. The major issue for me has been finding enough growth in the Canadian markets. My portfolio is usually 80% us, 20% cdn; therefore, with my approach, I see no disadvantage to continue investing in my sheltered RSP. I will say the major disadvantage to investing in the US markets within my RSP, is by law, the account can’t hold US cash, so I am always getting dinged on the conversion. There also has been reduced earnings due to the currency fluctuations in the past few years.

Shaun: Congrats on building up your nest egg! Regardless of if you use the SM or not, you will come out just fine in the end. With regards to your USD conversion problem. Apparently, TD bank will allow you to sell your US stock and transfer the money to a USD money market fund, thus avoiding FX fees. I believe it’s called wash trading. Here is the link on Canadian Capitalist for more info.

Chris: Thanks for posting the spreadsheet.

Ed,

Thanks for the insight on how to pick the high return mutual fund. It is a very smart idea to choose the jockey rather than the horse.

Yes, the Vancouver real estate market was pretty volatile in the last three decades. The figures I used was the detached home, the figures for attached home and condos was less volatile. And, with less appreciation of value, it was about 5.8% per year over the last two decade.

EZ

Ezboy: Yes, although the SM offers a tax refund, it is NOT a replacement for the RRSP. If you work out the numbers, the RRSP will out perform the SM in the long run.

CK:

1. You are right with the mechanics of capitalizing the interest. Simply withdraw the interest payment required for your heloc FROM your heloc, and redeposit.

2. You can utilize the SM with your new mortgage, IF you have substantial equity in your home (>>25%). The only disadvantage now is that you wont’ be able to get an increasing credit limit on your heloc as you pay it down. If you want to do the SM at this stage, pay down your mortgage as much as you can, or as much as your terms will let you, and obtain a new HELOC. You “could” pay down your mortgage every year, and re-apply to get your HELOC limit increased, but I believe that this will require a new application every time. Another alternative is to take the penalty and move to another mortgage, which is undesirable. If your mortgage is already with RBC, perhaps they’ll switch you to the homeline mortgage for no penalty?

3. Can you clarify this question? Did you mean that if you’re income increased, who should claim the tax deduction?

4. IF you like mutual funds, go to http://www.morningstar.ca, they have a great rating system and screener available.

Hope this helps, FT

Thanks for the answers. It is a little unfortunate (for us) that we have decided to give SM the green light the night we signed our mortgage (i.e., last night), thus limiting our options on HELOC. Our mortgage is with TD, and I don’t think they have a mortgage product similar to ManulifeOne or RBC’s Homeline.

As it currently stands, we are only borrowing about 65% for the mortgage, leaving us with roughly 10% available credit if we apply for HELOC now. I’m not sure if TD’s HELOC automatically adjusts the available credit every month. If they don’t, how often do we draw money out from the HELOC depends on the hassle required to ask credit increase.

Since it’s RRSP season, we’ll probably wait a month or two before jumping into the market. On the bright side, if we zealously pay off our mortgage for the next quarter, including the capital originally set aside for investment and tax refund (but excluding the RRSP amount), we probably have another 10-15% credit available. It may be better to get our HELOC then.

I was more concerned about reduction of household income than a huge raise. This reduces the amount available for mortgage payment, slowing the process of mortgage-to-HELOC conversion.

On an unrelated note, the math we did to arrive at the decision to go ahead with SM is different from what I’ve read so far.

CK

CK,

TD Bank has a readvanceable mortgage that works better for the SM than Manulife or Royal. They just call it a HELOC, from which you can lock in a portion. They don’t have a variable rate on the mortgage within the HELOC (which saves you the most money), but they might well backdate your request to change to a HELOC. Manulife and Royal are actually more awkward for the SM than some of the other banks.

If they won’t backdate a change, I believe TD will convert your mortgage to a HELOC without charging a penalty. Let me know if you have trouble with this, because I have a good contact at TD (the one mentioned in the SM book).

If nothing else, I’ve done the calculation many times and I think you will find the SM benefit over 5 years will be significantly more than your penalty.

By the way, did you take a 5-year fixed? I saw a study going back to 1950 that shows that 5 1-year mortgages or variable mortgages would have saved you money 100% of the time over 5-year fixed?

Ed

EZ,

I have a better suggestion for you. RRSP and SM are not either/or. If you decide on RRSP, add it to your mortgage - don’t use the HELOC. Even if your mortgage is not due, several banks allow multiple fixed mortgages within the same readvanceable. The mortgage will be a lower rate than the HELOC, and this will allow you to also do the SM.

As for your calculation comparing the SM & RRSP, I think you will find the best choice is based on optomizing your tax brackets each year. The SM doesn’t use any of your cash flow, so there is no reason not to do both. In all likelihood, you will both fully convert your mortgage and max your RRSP during your work life. Just figure out how much of each will maximize your tax refunds over your work life based on your tax brackets.

The actual difference may vary depending on your circumstances and assumptions. RRSP gives you a bigger refund sooner, but is only a tax deferral. The SM can give you refunds possibly all your life, depending on how tax-efficient your investments are.

If you want to have a clear benefit, combining the SM with additional leverage can make it clearly better than RRSP’s. For example, the “Rempel Maximum”, where you calculate the maximum additional leverage on which you can make the payments completely from your readvancing mortgage payments. With an enhancement like this, the SM will clearly be better than RRSP’s. However, you can still do both, since the SM requires none of your cash flow.

FT,

Since when have you been concerned about the risks of the SM? I thought you were very confident in your dividend strategy. The risks of the SM are really only in the investments. And the break even point is quite low.

Based on studies by Talbot Stevens, the breakeven point for leverage in general is 2/3 of the loan interest rate over 5 years, or 1/2 the interest rate over 15 years. So, if your HELOC is at prime, you only need to make 4% over 5 years or 3% over 15 years to break even. This is because of the different tax treatments and because the investment growth is compound growth while the loan interest is simple interest.

While I prefer a different investment strategy than you, your dividend strategy should also work just fine.

I was just surprised to see you comment on the risks of the SM, FT.

Ed

Ed

Ed,

Are you sure you have your information correct? The subaccount’s limit does not have to be “increased”. Provided the combined value of your M1 main account and subaccount do not exceed 75% of the appraised value of your house, there is no need to call.

My transfers are done monthly and automatically between my M1 account and my investment account (i.e. at the beginning of each month $1500 is removed from my M1 account and invested in 15 stocks with my Shareowners account - I then increase my Investment Line of Credit by $1500 by using it to credit my main M1 account). There is no phone call, one of the transactions is done automatically, and the other is done manually online, taking all of 30 seconds. Again, I’m not sure why you’d call this “awkward” and I don’t really get what you mean about about a subaccount “limit”.

With respect to mortgage rates, you are correct - M1 tends not to be as competitive. However, I can live with that given that everything that I deposit into that account is automatically applied to the mortgage, rather than me having to manually make the “extra” payments at a traditional bank myself, and being limited in my pre-payment options (which was the case with my old RBC mortgage). Given that our expenses vary on a monthly basis (CPP limits reached, insurance due, etc), it was a pain in the rear to have to do this manually every month and ONLY on the payment date. That’s my definition of awkward.

Anyway, I think you may want to revisit the Manulife One product - based on the inaccuracies of your previous post I get the impression that you may not completely understand it.

Chris

Ed,

Thanks for the suggestion on the Rempel’s maximum. I just finished the spreadsheet and confirmed that the Rempel’s maximum make a big difference on the investment return. It beats all other strategies I came across.:)

The only setback I found so far is that I may have to sell a tiny portion (about 0.2% of a $200K portfolio for 17 months) of the investment in some odd years to cover for cash defficiency. Also, there are years which I might have a bigger credit line loan than my investment portfolio’s market value.

Nevertheless, the strategy yields almost twice the return of the other strategies in a 25 year investment span. I apply the Rempel’s Maximum to a Vancouver detached house purchased at the average price in 1981, and invest the loan money on a TSX Composite index fund. After 25 years, in 2006, the Rempel’s Maximum strategy produces an annual yield of 2.81% after tax and inflation while my next best strategy yields only 1.74%. The conventional mortgage yields only 1.34%.

WORD OF CAUTION: If you are an investor who is considering the Rempel’s Maximum, make sure you fully understand the math behind it. In some odd years or poor implementation, it may not look pretty on paper.

Ed,

Thanks for the tip. We have already set up another meeting with TD on Saturday, and I’ll ask the FSR if we can switch to the HELOC without penalty.

With just the HELOC, I wonder though, for taxation purposes, how do you differentiate the tax-deductible debt from the non-tax-deductible part?

FT,

I have to clarify that we are comfortable with investment in general. Due to the small capital we (individually) had in the past, we have only held a small number of stocks at any time. We are just not familiar with mutual funds.

CK

FT & EZ,

The Rempel Maximum is an enhancement to the SM that is the maximum possible benefit of the SM, without using any of your cash flow. The benefit is usually triple the Plane Jane SM (but depends on the situation). It is for people that believe in leverage and are comfortable with their investments, even when they get to be large amounts.

It involves the maximum leverage that can be financed from the SM. For example, if you are paying down $500/month principal on your mortgage, instead of investing the $500, you multiple by 12 and divide it by the loan interest rate (say 6%) to get the maximum loan you can finance from the $500/month (in this case $100,000).

In short, instead of investing $500/month, you would borrow $100,000, but the payments are all made from within the SM, by readvancing the principal portion of the mortgage payment. So, you have a $100,000 investment on which you never have to make any payments from your cash flow.

The $100,000 will grow much faster than the $500/month would grow. And while the $500/month will increase as you pay increasing amounts down on your mortgage, you can use this to increase the loan every year or 2, still without ever using any of your cash to make any payments.

The investment loan could be from using your secured credit line within your readvanceable mortgage (if you have enough equity), or it could be a separate investment loan (or some combination of the 2).

EZ, I don’t know how you did your calculations, since you mentioned requiring the use of a bit of cash flow in some years. Also, my simulations get rates of return about 5% (about 4.5% after tax if you assume total liquidation after 25 years, which we wouldn’t actually do), which is slightly higher than the Plane Jane Smith Manoeuvre, but on a much higher dollar amount. These rates of return are quite good, considering that they are on a large loan, that they are after all loan interest payments, & that none of this is from your cash flow.

The projected benefit of this is surpisingly high. For the SM, it is typically about double the starting mortgage over 25 years. The projected benefit of the Rempel Maximum is typically about triple that number, or about 6 times the starting mortgage.

Ed

Ed,
I understand the Rempel Maximum now, it is mainly for people who have close to 25% equity in their home and are looking to invest the maximum amount right away instead of waiting until they pay off the mortgage. How would the rempel max work if someone already had a LOT of equity in their home? Or someone who has their mortgage paid off? Also, is it difficult to get ANOTHER LOC in ADDITION to your HELOC?

FT

Hi, Chris,

Manulife One obviously works well in your case. I’ve just found there are better choices out there for the average person. Where I have used it is for the odd cient with no mortgage. Let me give you an example.

Let’s take a client with no mortgage and money in savings that wants to do leverage. If the credit limit is $300,000, we can invest the full $300,000. But since he has $20,000 in savings, the Manulife One balance is $280,000, but the subaccount is $300,000. The advantage here is that his chequing account is getting about 4% daily interest.

Now the home rises in value. Every 2-3 years, we like to get the house reappraised to increase the value. If the limit is now $350,000, we can either invest the extra $50,000, or we can keep it to use to capitalize the interest on the leverage account. Now if I want to increase the subaccount from $300,000 to $320,000 to capitalize $20,000 of interst, it requires a phone call to Manulife and they actually need to collapse the subaccount and create a new one with the higher balance. We would like to capitalize this interest monthly, but it is too difficult. We just do this once each year.

Does that clarify the situation, Chris? Yes, this is an unusual situation and I’ve done hardly any of them.

So, you say Manulife reappraised your home and increased the total limit without charging you legal fees? I’m impressed. I was not able to get them to absorb the fees, even for my own Manulife One mortgage. What’s your secret, Chris?

So, I just get a 2nd HELOC put on after the Manulife One. Some banks will do that for free, if you use it.

Yes, we are talking about the same Manulife One. I understand why you like it. I realize the subaccount tracks your tax-deductible interest, but that is only as long as you make sure that you match transfers from the subaccount to automatic investment purchases. We tend to work with some bank HELOCs, where the investment purchase is directly from the credit line.

You are doing it yourself, Chris, so you can make sure it works. I am working with clients and have to hope they follow my instructions and make sure they transfer the $100 every month, for example, from the subaccount to the main account, when the investment purchase of $100 is made from the main account.

I’m not suggesting you change it, Chris, since you seem to know what you are doing. I just find I can get mortgages with more competitive mortgage rates and less risk that the client will screw up the tracking or their tax deductions.

Ed

Ed,

Thanks for clarifying - it all makes sense to me now. With respect to “my secret”, if I remember correctly, provided the re-appraised value results in an increased valuation greater than a certain threshold (I think $20K is the magic number), then M1 bears all of the costs. In my case we went from $425K to $580K (thanks to the crazy real estate market out here), so they didn’t charge me anything. I imagine in most situations, an increase of $20K every couple of years is not realistic.

Again, thanks for taking the time to clarify the points I wasn’t understanding.

Regards,

CF

If the above understanding is correct, the essence of SM is that you invest with a loan secured by your home property. The only benefit of SM is that it allowes you to invest without putting extra cash.

So you must be very careful to ensure that you can earn enough money to cover the interest paid. X must > Y.

FrugalTrader,

Thanks for the reply! Actually your answer is another way of what I said.

Say your annual income is A, tax rate is 40%, your HELOC investment profit is X, interest is Y. Your overall income is A+X, then you deduct Y. The tax you pay is: (A+X-Y)*40% = A*40%+(X-Y)*40%. If you don’t do SM, your tax is: A*40%. The difference is (X-Y)*40% (the 50% tax exempt rule for capital gain may be applied). If X>Y, you win and pay more tax (no impact to your income A).

If X less than Y, you lose and pay less tax, but that’s definitely not what you want from SM.

So SM is still a way to invest with loan. There is no tax benefit of doing that. The tax rule makers are not stupid. I never doubt that.

Of course, SM still has the advantage of NO CASH OUT OF POCKET.

John: “So you must be very careful to ensure that you can earn enough money to cover the interest paid. X must > Y.”

John, you are correct that one must try his/her best to make ensure that the rate of return on the investment (X) is greater that the cost of fund (Y). However, even if the return on investment is slightly lower than the interest cost, it will still be financially beneficial.

Let me explain it with an example. Let’s say you are in the 40% marginal tax bracket. Your investment interest cost is $1000 for the year. On your investment, you earn $800 as capital gain. Since capital gain is only 50% taxable, so only $400 is taxable. Therefore, for tax purpose, you pay $400 x 40% = $160 for the capital gain, and the after tax gain will be $800 - $160 = $640 .

On the interest cost part, the entire $1000 is tax dedeuctable, so it reduces your income by $1000. This translates to $1000 x 40% = $400 tax saving. When you add together the after tax gain of $640 and $400, you get a total of $1040. This is $40 more than your interest cost.

So, despite your investment earn $200 less than the interest cost, you still make a small after tax profit of $40.

EZ

Does anyone know or deal with CIBC and employ the SM along with a HELOC? I’m considering M1, but struggling with the .9% difference in rates.Seems silly to me to give up a better rate for the convenience of one blanket account

Hi ED & EZ:

Thanks for the comments! But I still have some questions.

“Capital gains are only 50% taxed, while the interest is fully deductible (as EZ mentioned).” But deduct from where? By my understanding, if you have loss or expense from investment, you can only deduct it from investment gain, either backward or forward, but not from any other income sources. For example, if I loss in stock, I can only claim the loss first and deduct it from future gain in stock. I can’t deduct it from my permanent job income.

So is the rule different in SM? Did anybody confirm it with an experienced accountant or CRA agent?

Thanks,
John

John:
If you have an investment loan, according to CRA, you may deduct the interest against your income IF you have an expectation of income from your investments. According to the finance department(2003), they require an expectation of “profit”. So, according to Tim Cestnick (a tax pro), CRA will not enforce the finance departments decision to only allow tax deductions IF the investments are profitable.

In Quebec however, you can only deduct the investment loan interest against your investment income.

Hi, John & FT,

You guys are confusing capital losses with interest costs. A capital loss can only be netted against capital gains. You cannot claim a capital loss against other income on your return.

However, interest from the SM is claimed as a “carrying charge”, or investment expense, which can be claimed against other income (except in Quebec).

Your formula may be approximately right for year 1, John, if you sell the investment every year on December 31. However, if you keep it and it is tax-efficient, the tax on the gain can be deferred almost indefinitely. Also, your formula understates the gain, since the investment profit compounds on itself, this profit will be higher every year, and far higher after 20 years of compounding.

Ed