Many of the personal finance sites I visit like to share their own financial situation in with their readers. I have shied away from this, in large part because my finances are pretty boring. I currently don’t have much invested, and I have very little debt. My only real forays into feeding the voyeuristic tendencies out there were in detailing how I came to the decision to buy a new vehicle, and a cry for mercy when I found out that I was wanted by the IRS (good news recently on this front as it looks like Uncle Sam only wants me to do several hours of paperwork every year, and not completely cripple me financially). I believe I finally have something that might stir some thought one way or another – The Smith Manoeuvre. A couple of weeks ago I did a post about using leverage to invest in equities. As I predicted, a large number of readers (including many authors of financial blogs) were uneasy about my use of house-backed leverage to say the least. With all these details they will now really have ammunition to fire away with!
In The Red Corner… Weighing In At a Net Worth Of…
Before we really get into the nitty gritty of my “risky” venture, we should probably put the financial move in a little context. I am about to turn 24 (that felt weird to type). I am a teacher that earns about $55K a year, and will max out on my pay scale at approximately $82K a year. I am currently pursuing my master’s degree in education, and hope to take on a position on some higher level in the long-term. I live in a rural area in Manitoba, Canada and own a house that cost me $95,000. It is a 1000 sq. ft, with a large 3 car garage, finished basement, and an extra lot beside. I live with my significant other who has 2.5 years left of school, and then she too will be a teacher. We may have children at some point, but have no short-term plans (or even mid-term plans for that matter). I have no student debt, she has about $20K right now. I recently purchased a new car, and have about $16K left on the loan. My portfolio is so small it is not even worth talking about, and my main concentration right now is in upping the equity I have in my home to a level that allows me to start the Smith Manoeuvre.
Fraser Smith, His Quest To Beat The Taxman, and The Smith Manoeuvre
So what is the Smith Manoeuvre and who came up with this? The guy that “invented” or more accurately – popularized – the SM is a man named Fraser Smith. He was motivated by the tax credit in the USA that gives homeowners a tax-deductible mortgage. The question was, how to get a tax-deductible mortgage in Canada, without government policy changing (as an interesting sidenote, it appears the mortgage tax break may be going the way of the dinosaurs down in the States)? Smith came up with an investment/accounting strategy that accomplished just this goal. The basic idea behind the Smith Manoeuvre is that the Canadian government allows the interest paid on investment loans (loans that are specifically used for investments that have a reasonable expectation of producing income) to be tax-deductible, and this tax credit could be used to in effect make a larger and larger portion of a person’s home tax deductible over time.
…and Then The Prophet Smith Turned The Non-Tax Deductible Into Tax Deductible
The mechanics behind the Smith Manoeuvre are fairly straight forward and can be modified in several ways. The original idea is that a person uses the equity they have in their home (after transferring any existing investments they have into home equity) to secure a Home Equity Line of Credit (HELOC). The person that invests this entire line of credit into investments that have a reasonable expectation of producing income, and they keep this investment in non-registered accounts (no TFSA, RRSP, or RESPs allowed). As a person pays off their mortgage, they re-borrow the same amount on the back end (there are various types of mortgages that will allow you to do this) and keep investing. There is really no limit on what you can invest in as long as it satisfies the income-producing requirement. Many people advocate for dividend-producing Canadian companies and then use the dividends to supercharge the entire transaction, but this is not part of the original strategy. What you are left with in the end is a portfolio of non-registered investments that is equal to a HELOC that should be the exact size of your original mortgage. The difference is that this HELOC is now an investment loan and the interest you pay on it is completely tax deductible. If you use these tax savings to accelerate the down payment of your original mortgage you can cut years off of your amortization period and save yourself thousands of dollars. As I mentioned before, there are some cool add-ons (some of which I will be pursuing), but let’s just keep it simple at this point, and I’ll talk some more about that in another post if you all are interested in reading about it. When you’re entire mortgage is converted into a HELOC you can begin paying down your line of credit while allowing your investment portfolio to compound on itself, or you can do as Smith advises and keep the HELOC (as well as the associated interest tax credit) until you die. As long as you think of money as a tool, this strategy makes a lot of sense because it will keep the taxman out of your pockets going forward.
Rules Are Made To Be Broken – That’s Right, I’m a Rebel PF Writer!
So, how will I apply this to my situation? Well, unlike what many PF bloggers (including myself in the majority of cases) advocate for, I purchased my house with the bare minimum down, and paid the CMHC housing insurance since I only have 5% of the down payment and not 20%. I can hear the howls of anguish and the questioning of my PF blogger credentials (I’ll save you the time – I have none) from here! How dare I break this commandment of PF law you ask? Well, for starters, the small purchase price of my house meant that the CMHC was not that onerous. In fact, when I calculated it out, I would lose more equity in paying rent for two years (while building up the 20% down payment) than I would in paying the CMHC. Another consideration is the fact that I hate moving. I am a true animal of routine. I definitely want to move as few times as possible in my life, and this is worth a fair amount to me. Finally, another consideration was the fact that I got a pretty great deal on the house because the prior owner was a teacher who had already accepted a job someplace else and was in a hurry to sell. When I combined that with the fact that a large potash mine was due to open in 2 years only 20-30 minutes away from the area I am in, I decided that the increase in home prices (likely in the 30-50% range from the precedent I’ve seen in similar areas) was another mark in the “buy now” column. All this to say, I did my homework and that it was not an impulse buy. I have not regretted my decision for a single minute!
RRSP – I Don’t Need No Stinkin’ RRSP
Upon leaving school I had a small amount of credit card debt, and I borrowed a little money from my parents for the down payment on the house. My first year was spent paying this down, and putting aside some money to replace my old trusty Grand Prix that had faithfully got me through university, but was now due for a more fuel-efficient and less maintenance-intensive upgrade. Aside from this, I managed to put aside my substantial (4K) tax return for my mortgage and build up a small emergency fund. For the last few months, and into the short-term future I will be working at pre-paying down my mortgage to the 20% equity level in order to start the Smith Manoeuvre. At the moment I am virtually ignoring my TFSA and RRSP contributions, but even this has a strategic upside in that the contribution room in those accounts is not going anywhere. In 4-5 years when I hope to see my income increase substantially, I will be able to use that contribution to my maximum advantage. Also, it is not as if I am completely ignoring my retirement savings because of what gets deducted from my cheque automatically as part of my teachers’ pension.
The Only Thing To Fear Is… Letting Fear Stop You From Making Money
While the initial idea of the Smith Manoeuvre scares a lot of people (we have a tendency to think about it as “gambling your house on the stock market”) I believe that with a long enough investment time horizon, you pretty much cannot lose. The thought that investing my housing equity in the stock market is somehow riskier than using home equity to buy rental properties is hilarious to me. Those of you that truly believe that real estate is much safer than equities need to look at the past 5 years as proof that both markets have an inherent degree of risk. I think right now is a great time to begin a Smith Manoeuvre as we are looking at sideways markets for the foreseeable future. Certainly the ideal time would have been on the market lows in 2008/2009, but hey, I can’t complain. If I can get a fair amount of equity into the markets over the next few years as governments continue to deleverage and come to terms with the new world order (and developing nations continue to…well… develop) I should be well positioned to make some nice gains to my net worth in my 30s, 40s, and 50s, before I start taking some more conservative financial positions that are less vulnerable to short-term market fluctuations. I reckon that by conservative measures I will easily save $100,000 in taxes over my lifetime with the Smith Manoeuvre, and it could be much higher than that, especially if you calculate in the compounded effect.
So, what do you think? Would you like to hear more details about the specifics of my Smith Manoeuvre plan going forward, or is it just some weird accounting crap that doesn’t really matter to you? Or is it just fun to watch some dumbass lose a bunch of money thinking he knows more than he actually does?
As you know, I’m not a huge fan of the Smith Manouevre…mainly because I doubt investors can commit to it for the long term, regardless of their intentions at the start.
In your case, you’ve got a stable career and fairly small mortgage. There’s not a ton of risk, but that could mean that there isn’t much upside either. So you make a small investment loan tax deductible…big deal. Maybe you’ll come out slightly ahead of where you would end up if you just maxed out your RRSP and TFSA every year…but maybe not.
All I know is that I had a much different investing philosophy when I was 24 with no kids. I was more aggressive, I made mistakes, and I changed my mind on investments (i.e. sold them) when I had every intention on holding for the long term.
Thanks for comment Echo. While it’s true the investment loan would be small to start, within a 6-7 year period, my goal is to have the entire mortgage converted into a HELOC. Keeping the $95,000 investment loan for the next 80 years (hopefully) is no small tax matter in my opinion, and obviously when I upgrade my house (no immediate plans, but it will likely happen one day) the benefit would be even greater. If I had the investing philosophy that I was the next Warren Buffett and was using the HELOC to speculate and pick stocks I would be much more concerned about the risk factor. I’m pretty mathematically driven when it comes to investing and I know my limits in terms of trying to “beat the street” (I read PF blogs all day… this gets hammered into your head!).
With your mortgage size I’m not seeing a huge benefit for you.. Actually I see more down side than upside. I’m never a fan of putting one’s home at risk for a interest deduction.
Where does the risk element come in YFS? If the equities I choose perform poorly I somehow lose my house?
You won’t lose your house per se but, you’re putting the equity of your home at stake.
Meaning if you have a home worth 200k, mortgage of 100k and an equity loan of 100k. You still have to pay your mortgage and you equity loan regardless of how good or bad your investments perform. if you lose a job or something bad happens where you cannot pay your mortgage or equity loan your home will be at risk.
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Right, so as along as I can keep my union-protected, permanent government position, and don’t care how the equity market does for the next 20 years, I should be just fine eh?
I definitely have to think about this one. I’ve never heard of it, so thank you for sharing! I am in the US, so we have the tax deductiion on our home (woohoo!). By the way–what do you mean it might go the way of dinosaurs? Did I miss something while I was traveling over the last week? I hope it doesn’t…
Happy Holidays!
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It has been tossed around the last few months that with all this tax-reform talk, the mortgage deduction might get the axe. It is kind of a weird when you think about it. It was obviously inserted into the tax code because it was very favourable to courting the middle-class vote, but in a purely economic sense it doesn’t really deliver a good long-term incentive (aka the cult of home ownership).
I’m in the US too and it’s quite interesting to me. I guess if the home mortgage deduction goes away, then I’d look at this as an alternative too.
I doubt the tax payer will let this go quitely though. I’m sure the investment interest deduction will go away long before the home interest deduction, but who knows…
retirebyforty recently posted..Make Your Mortgage Payment Before the New Year
I will almost guarantee that the investment interest deduction will never go away! Almost all people who build wealth use this one pretty liberally. Also, from a macroeconomic perspective, it makes sense to give people financial incentives to invest domestically, but buying homes isn’t necessarily a positive in the long-term. Besides, as a landlord, you stand to profit handsomely from increased renters!
I’m also in the US and had not heard of this – which is why I like reading your blog b/c I always learn something new :)
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I’m glad there is always something worth your time!
In the US your mortgage interest is already tax deductible (lucky!).
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Maybe not for much longer. In fact, it would be one of the first tax deductions I’d do away with.
My hubby and I have discussed doing this with our property. We are a little weary of the risks but we may consider it down the road. Currently we have to pay more of our house off before we can qualify to do this. We are still a little short on the equity.
I hope it works well for you though. Best of luck.
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I’ll keep you updated on how it goes!
We practice the SM. We have more mortgage debt than you but no other debt aside from that. I started our SM about 18 months ago bought some stocks (dividend payers) and haven’t touched them since. I also haven’t been using up all of our available equity – especially of late as the markets have been far too turbulent for my liking.
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I’m glad to hear that not everyone thinks we’re crazy! Any specific reason why you went with dividend stocks as opposed to ETFs? I assume your looking for the dividend income to supercharge the whole transaction (reinvesting the dividends?).
Precisely – dividends get attributed to the principle on our loan which frees up more equity to invest.
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Yah, that seems to be the way more people have done it. Did you check out Ed Rempel’s services at all (from Million Dollar Journey)?
First time reading about the SM (being in the US). Can see why you say this won’t fly too well with the anti-debt crowd. Especially in this overly conservative, debt first society we’re living in. But I’m kind of digging it.
I’m assuming there is an eventually limit that is reached (either income being entirely tax deductible or debt payments are maxed by income limits) unless you go full blown real estate mogul with rental properties. So you probably would want to have some margin of safety built in as a percent of income? Or am I totally off on that?
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The basic goal JP is just to get as much of your income tax deductible as possible. Eventually what happens is that you are left with a fully paid-off mortgage and (in my case) a $95,000 investment loan that is tax deductible and has (hopefully) been compounding in on itself. The debt servicing charges on this wouldn’t be that much relative to my income (which is about as stable as you can get).
Check out Million Dollar Journey’s SM update today. In the comments he mentions why ETF’s aren’t a good idea because of Return of Capital, rather than receiving straight dividends. Adds a bit of complexity to the paperwork.
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Ah… this makes a lot of sense. Thanks for the link. I left a question there about mutual funds as well.
Hmmm… Interesting! As a lower-48 type, I also hadn’t heard of the Smith Manoeuvre.
Strikes me as a lot like investing on margin. That was what got people in trouble on the eve of the Great Depression, when the stock market crashed in 1929. Borrowing money to invest in securities had become the popular thing to do, the theory being you could earn more in the market than you would pay in interest to the lender. When the market collapsed, one lost one’s “principal,” which of course was not principal at all but debt. A lot of people were left owing a LOT of money, with no way to repay it. Lenders called the loans, and those who had borrowed to invest were ruined.
Not for a minute do I believe it couldn’t happen again. For that reason, I’d be extremely careful with this scheme.
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Not really anything like investing on the margin since you have an asset to back it up. When you take an original mortgage with 20% down you are already leveraged 4-1 right? This just uses that leverage much more productively. My stocks can go up or down, I’m still never going to get kicked out of my house (only if I lose my job, which I would then be in trouble anyway).
Hey Teacherman – I have been doing a “partial” SM for about 3 years now. I say partial, as I don’t borrow the max amount available – I have been cherry picking my investments, and only investing when I am very happy/comfortable with an investment, both in terms of quality and price. I was lucky enough to pick up 3 or 4 investments during the 2009 early recovery, and they have done nicely since. I also tend to pick dividend payers, as they throw off income to make more investments, and keep me from getting concerned if prices go down, as I know they keep paying me every quarter. I’m hoping to make a few more investments in early 2012 when things get ugly on the markets again with more European uncertainty – that’s what I’m “hoping” for anyway, as I have a little buildup of capital to put to work and want to get in at a better price.
As a teacher with a teacher spouse and two good pensions, I say you have little to lose, but maybe don’t go all in all the time, pick your investments and entry points carefully. Also, I would think that putting some money into the TFSA would be good as a pot of investment cash you can access if needed – if for some reason you need access to some cash quickly, you can get to it without touching your longer term money.
Anyhow, that’s my 2 cents.
Happy New Year, hope it’s a prosperous and peaceful 2012.
Yah, we’re definitely thinking along the same lines here Chris. Most of the successful people I’ve seen do the SM use dividend players, and the Canadian dividend plays definitely make a lot of sense from a tax perspective. It’s also a great way to gradually build up a non-registered account, and then get your ETF and Index buys in your TFSA and RRSP account. Thanks for sharing. We’ll have to compare numbers in a few years. What do you do for a living?
Is there a formula for determining whether a mortgage should be converted to using the “Smith” Manoeuver?
There must be an ideal risk and reward level.
Thanks.
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Well it depends what expenses you want to take into consideration right? In theory, it is always worth doing for the long term because of the tax savings. But each person calculates their banking costs and time spent to get the mechanics up and running differently. Also, some people choose to keep the investment loan their entire life (thereby collecting the tax savings their entire life) while others prefer to pay the loan down since debt=bad ;)
Teachers in Canada can make $82K a year? I need to tell some of my teacher-friends. They’ll be on the next flight north. :-)
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It’s all public information. Check this out for full details.
Just like Nurses trained in Canada can make $80-$100k in Texas – it takes forever to make that here!
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Now that’s an interesting comparison I hadn’t considered.