Impact of Interest Rates on the Smith Manoeuvre

By this point in the business cycle, we are solidly in a rising rate environment. Since last summer, we've jumped from essentially no interest to a little bit of interest on debt. Our interbank overnight rate is still a meagre 1.25%. That's about half the rate of inflation in Canada right now.

On the other hand, borrowing money from your bank has gotten quite a bit more expensive than it used to be. Remember, banks always earn a spread of approximately 2% on the each secured loan they issue. After all, that's how they earn billions in profits each year.

As it stands today, the popular 5-year term mortgage will cost you around 3.3%. That's a 50% jump from just 2.09% a little more than a year ago. Since last fall, bank prime rate has jumped nearly 30% from 2.7% to 3.45%. Of course the banks typically add 0.5% on top of prime rate for your revolving HELOC--the main loan of your Smith Manoeuvre strategy.

Does the jump in interest rates, combined with the continued expectation of rising rates for some time yet, make it a bad time to employ the Smith Manoeuvre?

Impact of Interest Rates vs. Taxes

Interest rates do have an impact on the profitability of the Smith Manoeuvre, that is certain. In an ideal environment, interest costs will be nothing and investment returns will be stratospheric. However, it is important to separate fantasy from reality. Over the long run, we can expect stocks to return somewhere in the range of 5 or 6% above the rate of inflation. Short-term debt on the other hand will return about 1 or 2% above the rate of inflation. That equals a nominal return of 9% or so over the past century, versus an average nominal borrowing cost of less than 5%.

The Smith Manoeuvre partially capitalized on that difference. As long as the investor can manage their risk adequately, borrowing at 5% and generating returns of 9% are a good deal for anyone. That's a long-term return of 4% on money that is not yours!

It's also important to note that you borrow at simple interest but your investments grow with compounding interest. This means the size of your loan amount is capped and the interest costs do not compound. But your investment account will grow exponentially over time.

Edited. Graph made from Ontario Securities Commission Wesbite

In the above graph, debt is capped at the red line ($300,000) while your investment portfolio compounds over the years to $1.5 million. That's the power of simple vs. compound interest. In the Smith Manoeuvre, you actually don't directly pay the interest from cash flows because the strategy utilizes "guerilla capitalization".

However, the interest to investment return difference is just one factor of the Smith Manoeuvre. The other--arguably more important--component is profiting from the provisions of our tax system. Our tax system is designed to favour investments over income and productive debt over consumer debt.

The interest expenses on money borrowed for investing using the Smith Manoeuvre is 100% deducted from your income which significantly reduces your taxes. This tax deduction has a massive impact on the effects of the Smith Manoeuvre. If you have a $300,000 Smith Manoeuvre loan and you earn $80,000 a year in Ontario, at 3% interest you save $3,000 a year on taxes. At 5% interest you will save $4,700 on income taxes. After the tax adjustment, your net interest rate after tax deductions is much lower than the posted interest rate.

Meanwhile, profits from your equity investments in your Smith Manoeuvre non-registered investment account are taxed at much lower rates than regular income and, in the case of capital gains, can be deferred for a long time. At the same $80,000 income in Ontario, Canadian dividends are taxed at 8.92% after the dividend tax credit and capital gains are just half included for tax purposes when you sell your investments at a profit. A savvy investor can realize capital gains in retirement at extremely low rates by harvesting the gains strategically.

While the best way to approach the Smith Manoeuvre with regards to your investment mix depend on your personal situation, generally speaking working individuals using the Smith Manoeuvre should try invest primarily in low-yielding Canadian stocks. Of course diversification over your broader portfolio cannot be ignored.

While rising rates might seem scary to the young Canadian, or recent new home buyer swimming in debt that totals many multiples of their annual income, interest rates in Canada are extremely cheap today. In the late '90s and early 2000s when Fraser was using this strategy commonly with his clients and then promoting the Smith Manoeuvre through his popular book, interest rates were well above 5%.

It would take a massive spike in HELOC rates for this strategy to become unprofitable for middle to higher income Canadian families. For now, if you have a lot of equity in your home and are interested in growing your wealth exponentially beyond what your home could ever provide, use the Smith Manoeuvre to save on taxes and build a big portfolio.

Read my complete step-by-step Smith Manoeuvre guide posted on this blog.

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It’s a Great Time to Begin the Smith Manoeuvre

In 2017 house prices climbed once again in many parts of Canada. Of course the hot spots were Vancouver, the Lower Mainland and Fraser Valley, and Toronto condos. Even Montreal is getting warm.

Chances are if you bought in these areas even a few years ago, you have gained substantial equity in your home.

The Smith Manoeuvre is a great way to access this equity, use it to fuel your investment portfolio, and set yourself up for a nice retirement. Executed properly with a disciplined investment strategy, the Smith Manoeuvre can make you quite wealthy over time.

With enormous amounts of dead equity sitting in homes after this colossal price run-up, this year is a great year to begin the strategy. According to the Bank of Canada (that's the bank for banks), nearly half of all outstanding mortgages will be renewed this year! If you are one of the 47% of Canadian homeowners who will be walking into your bank sometime in the near future, you should seriously examine if the Smith Manoeuvre is right for your financial situation.

This way you can set up the proper mortgage/HELOC structure and shop around for a good rate while avoiding any cancellation penalties that might occur if you were breaking a mortgage mid-term.

Read my complete Smith Manoeuvre guide with detailed Step-by-Step instructions here.

Factors to Consider

Meeting the Equity Requirements

To begin the Smith Manoeuvre, you must have at least 35% equity in your house. While there are ways around this, I think it begins to get too risky if you're reaching for more money.

Maintaining at least 35% equity gives you a nice cushion to withstand stock market movements, especially when starting the strategy. This could prevent you from being in a negative net worth situation.

It's easy to calculate your equity percentage. Simply take your outstanding mortgage balance and divide by a reasonable house valuation. If the resulting number is lower than 0.65 (or 65%), you have at least 35% equity in your home. It's time to put this equity to work!

Being Financially Stable

If you're living paycheque to paycheque, hitting the line of credit every now and then for surprise expenses, are unable to pay off your credit card, or can't seem to save any money, the Smith Manoeuvre is not for you.

The Smith Manoeuvre is a form of leveraged investing. That means taking on more risk. It would be absolutely reckless to start a Smith Manoeuvre if you are not in complete control of your finances.

While over time the strategy should make you a lot of money, there are periods when stock markets drop 50% in a matter of months. The Smith Manoeuvre could wipe you out.

I believe the best candidates for the Smith Manoeuvre strategy are people who are financially stable and are already investing. This might be in a TFSA, RRSP, or some other account. It also works well if you are working a job that promises a pension—like a government defined benefit plan.

No Near-term Income Shocks

The Smith Manoeuvre is based on stock market investing. If you are able to put $100,000 of home equity to work using the Smith Manoeuvre HELOC account, you would buy about $100,000 worth of stocks or ETFs in your Smith Manoeuvre investment account.

However, we know that stock markets carry risk. It's entirely possible that a year after starting your strategy, your investment account could have dropped to just $50,000. If this happens, it's a nice time to try pump as much money as possible into your strategy and buy stocks or ETFs at a discount.

For this reason I think it's best to make sure you don't start the Smith Manoeuvre just before an income shock. Income shocks happen when you are pregnant and will be going on a reduced pay maternity leave. Or if your company is laying off and employment prospects are shaky at the moment. You get the idea.

When these events happen, people are often not prepared financially and can find themselves running into short-term debt situations. While accumulating debt is never a good thing, it's even worse if your investments are also tanking.

You might be tempted to access your Smith Manoeuvre HELOC to cover your daily expenses when it's needed most for investment purchases and this is a bad idea. It also means you are complicating your accounting situation for tax calculations every year for a long, long time.

Understanding Investing

Before implementing the Smith Manoeuvre it is very advantageous to have some familiarity with investing—particularly self-directed investing via stocks or ETFs.

You should have a self-directed TFSA going (I use Questrade which has free ETF purchasing), or maybe a RRSP. If you haven't invested yourself yet, but are using an investment advisor, it is easy to get started. Questrade has great tutorial videos to show you how to purchase stocks/ETFs in a step-by-step manner. Use Limit Orders and enjoy the learning curve!

It's also important to understand the nature of investing. After several years of comfortable to high investment returns, it's easy to be numb to loss. You must realize that you can lose a substantial amount of your investment account during market downturns. Despite this, you must be invested in something that generates income at all times! If not, you will run into tax problems.

You can pair Smith Manoeuvre investing with a momentum strategy. For example, you may buy XIC.TO if it is positive over the past 12 months but switch to XBB.TO if it's not. This could shield you from some downside risk but will potentially reduce your returns, especially after accounting for taxes on capital gains.

Understanding Personal Finance

You should also have a good understanding of personal finance. This means managing your bank accounts, paying your bills on time, avoiding unnecessary interest costs, and doing your own taxes (if you don't own a business).

The Smith Manoeuvre requires detailed accounting and tracking of money movement. A huge benefit of the Smith Manoeuvre is saving tens of thousand of dollars in tax over your lifetime.

It also requires moving money between a number of accounts. Your regular bank account, your Smith Manoeuvre chequing account, your Smith Manoeuvre investment account, and your HELOC. These need to be done in a timely manner every two weeks or month (depending on your mortgage payment cycle).

Check out the Smith Manoeuvre HQ and read all about it. If you have any questions, please ask! This strategy can make you much better off financially with no additional cash outflow.

Comments & Questions

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