Should I implement the Smith Manoeuvre?
I’ve got a bunch of debt – mostly from my mortgage. I wish there was a way to convert this mortgage debt into a tax-deduction, you know, like the Americans can, to kill off my mortgage faster. Sounds like fiction in Canada right? Well, this can happen to you and me if we follow The Smith Manoeuvre.
While The Smith Manoeuvre is tricky to set up and takes some significant financial discipline to keep it going, it is perfectly legal and complies with our Canadian tax code. I’ve been considering this approach for my portfolio for some time and a recent conversation with someone piqued my interest again, pun intended.
This manoeuvre has already been described across the blogosphere quite a bit; Google-it and you’ll find these great posts over at Canadian Capitalist and Million Dollar Journey.
Smith Manoeuvre Facts and Flow
The idea is to convert your existing mortgage debt into tax-deductible (investment) debt and use the tax deduction and income, if you choose from investments made to pay down your mortgage.
To make the idea a reality:
- You need a readvanceable mortgage whereby you can tap into your Home Equity Line of Credit (HELOC).
- As you pay-off the mortgage principle, like you’re doing today, the amount of equity available in the HELOC goes up over time. Mortgage goes down; available credit to borrow goes up.
- That available HELOC can be used fund investments. Refer to the figure below courtesy of National Bank:
Take available money out of HELOC and invest it – preferably into solid income-producing investments in a non-registered self-directed discount brokerage account. When you borrow money for investment purposes, the interest paid on the loan is tax-deductible.
Use the tax-deductions and investment income (e.g., dividends) to pay down your non-deductible mortgage debt.
So, mortgage debt does down; available HELOC keeps going up, as you use the HELOC to buy more income-producing investments.
Smith Manoeuvre Considerations
This type of leveraged investing is not for the uninitiated investor. This process has tax, investment and more than a few psychological risks.
On the tax-side, you must present a clear audit trail of your investment approach in case Canada Revenue Agency comes knocking. Simply taking money from your HELOC and using that money to invest is NOT the Smith Manoeuvre.
On the investment-side, you better ensure your income-producing investments are in your non-registered account. Using money from your HELOC to invest in your RRSP or TFSA will NOT give you a tax deduction. Also, be mindful, the essence of borrowed money – it must be repaid at some point. So, make sure your income-producing investments have the potential to exceed the interest burden you are taking on.
On more of the psychological-side, you must be aware you are re-borrowing money to pay down your mortgage. Canadian Capitalist, Million Dollar Journey and other prominent bloggers have stated time and time again when discussing this strategy, you need to be very comfortable with leveraging to perform this trick. What happens if your income-producing investments don’t cover your loan? What happens when house values drop and you need to move? What if you need money in an emergency? What happens when interest rates change and/or borrowing costs go up? Investing is not just about buying assets it is very much about psychology and planning for the unplanned too.
You must also consider the time and maintenance this process takes. Probably most investors who have a decent income, to perform this trick don’t need to do it anyhow.
Smith Manoeuvre Conclusions
The Smith Manoeuvre is tricky to set up and take some smarts to keep it going but it is a perfectly legal and an accelerated way to kill your mortgage debt while growing your investment portfolio. For those investors ready to take it on, great stuff and I wish you well but personally I’m not ready to take this leap yet. Although I’m very intrigued about using this strategy myself, it’s just not the right time for me. I want to thank my brother-in-law from inspiring me to write this post and I look forward to hearing from him if, when, how and how long he intends to use this process on his own journey to financial freedom.
Have you used The Smith Manoeuvre? Are you considering taking it on?