The Smith Manoeuvre: Risks and Benefits

Edited Photo. Source: Flickr - swong95765

In my first SM post, I introduced this strategy for investing after filling up the TFSA and RRSP accounts. This strategy is for homeowners who have 35% equity in their property and understand the difference between risk and volatility.

The SM is a form of leveraged investing. This increases risk, but also increases potential returns.

Risk Realities

Most opportunities for leveraged investing come in the form of margin loans. Margin loans are generally provided by investment brokerages. Basically it is an investment loan which is secured by the stocks or ETFs that you hold. Interest rates on margin loans can be quite low and are fully tax deductible when the proceeds are invested in ETFs/stocks that pay income (dividends or interest).

However, margin loans are also tricky. You must maintain equity in the account that is above the maintenance requirement (generally 30% or 50%). If not, you will face a margin call where you must either contribute new funds to the account or your position will be liquidated. Not properly managed, this can result in substantial losses which are forced on you.

The SM is very different. You borrow money in the form of a HELOC--secured against the value of your house. This means it is very unlikely that you would be faced with a "margin call" event forcing you to liquidate your stocks at a huge loss. However, the loan interest is still tax-deductible.

Also, you can only borrow up to 65% of the value of your home in a revolving HELOC loan. This means you maintain substantial equity in your house--a nice margin of safety.

Returns Without SM: Example Scenario

Mike owns a house worth $600,000. It has increased in value in the last few years, so his mortgage is just $300,000 with 20 years left. Mike is a single Ontarian and earns $150,000. He has a full RRSP and TFSA and can still save an additional $1,000 a month after paying his mortgage. He currently has $50,000 saved in a Cash/Margin account.

Mike could just pay off the mortgage over 20 years and contribute the $1,000 a month to his $50,000 Cash/Margin account. Then, after paying off the mortgage, contribute the full $2,410 a month for the last 5 years to compare over a 25 year period.

In this case, Mike has a fully paid off house with zero loans. He would also have a $1,000,000 investment account (6% return).

Returns with SM: Example Scenario

Mike knows he is a perfect candidate for the SM, so he decides to see if it is worthwhile.

First thing Mike will need to do is sell his investments in the Cash/Margin account and pay down the mortgage, taking his balance down to $250,000. He goes to RBC and sets up a Homeline mortgage/HELOC. He also opens a Tangerine chequing account to keep track of the SM money movements.

With a Homeline HELOC, he splits the loan into two accounts: a flexible mortgage with great prepayment terms of $250,000 (his home loan portion) and a readvanceable, revolving interest-only LOC portion (the investment loan portion). Right now, he can borrow $140,000 for investing ($600,000 x 65% - $250,000).

The interest on his LOC portion is 100% tax deductible, so at his tax rate he gets back 43.41%. Every month his investment loan amount goes up by $1000 plus the principal portion of the mortgage.

Right from the start Mike saves around $2,000 a year in taxes which he applies to his home loan and borrows back for investing. He invests in an ETF that pays 2% dividends.

In this scenario, Mike's mortgage portion will be paid off in less than 7 years! At this time, his Cash/Margin account growing at 6%, will be worth $410,000 while his tax-deductible HELOC amount is $390,000. This gives him a "paid-off" $600,000 house, plus $20,000 in net investment equity.

With a maximum investment loan of $390,000, Mike will save over $5,000 annually in taxes alone. He can direct this to his Cash/Margin account for investing.

In 25 years, his Cash/Margin account is worth a massive $1.81 million. He still has the $390,000 HELOC so his net position is $1.42 million plus the "paid-off" house.

By using the SM strategy, Mike is 40% wealthier over 25 years. A massive wealth increase that didn't cost him a penny more in cash-flow each month.

It seems to good to be true, so over the next few weeks I'm going to dive into each step of the Moose-style SM so you understand exactly how this works.

4 Replies to “The Smith Manoeuvre: Risks and Benefits”

  1. Finance Newbie says: Reply

    I’ve been enjoying your posts on the Smith Manoeuvre, as this is something I’ve contemplated more than once before. This post provides a good comparison of using the SM vs not using it while paying off a mortgage. But wouldn’t the amount of interest payments refunded be closer to the average tax rate of 29.3% rather than the marginal tax rate of 43%?

    We’re in a slightly different situation as we are selling our paid off house and buying a new one that is slightly more expensive. We have quite a bit of equity and are trying to decide how much to put into the new home vs investing some of it. If the tax refund is calculated based on average tax rate, the difference in interest between HELOC rates and current 5-year variable rates makes the rates roughly equivalent after tax deduction on the HELOC. Am I missing something? Of course there is also the bigger question of whether we want to invest such a big chunk in the market right now, as we are working on a 5-10 year horizon to retirement and not a 25 year horizon.

    1. Mr. Rich Moose says: Reply

      Thanks for the comment!
      The interest is considered a deductible expense, so it comes off the top of your taxable income. For this reason, the refund should be calculated at your marginal tax rate.
      In this case, fictional Mike’s taxable income drops from $150,000 down to $137,520. (Interest expense is $12,480 @ 3.2% on $390,000).
      Throughout this month I’m going to be doing a lot of posts diving into each step of the Smith Manoeuvre. In the investing step (7), I talk about investment options. Because investments have to be made in a Cash/Margin Investment account, Canadian stocks are the way to go from a tax perspective.
      Don’t forget that your investment horizon is until the day you die. At retirement you generally want to switch to a tax-efficient income focus and reduce risk, but this can be done with property allocations to bonds, a cash cushion, and diversification. Proper leverage in retirement is still appropriate if it fits your volatility tolerance, doesn’t put you in a margin call situation, and helps reduce taxes. It’s all about proper management.

  2. Finance Newbie says: Reply

    Thanks for responding! I never know when to use average versus marginal tax rate. Are capital gains taxed at marginal as well?

    I look forward to reading the rest of your Smith Manoeuvre posts. Your posts are always so detailed and informative.

    As for the time horizon, I agree with you. Our situation is complicated and holding a large mortgage/HELOC affects our cash flow so I think I’d want at least some of it paid off before we retire.

    1. Mr. Rich Moose says: Reply

      Capital gains are taxed at the marginal, but only half of the gain is included for tax purposes.
      One of the benefits of the SM is the compounding effect on your portfolio side. In 25 years, with a $1.8M portfolio, fictional Mike would get around $50,000 in dividend income each year. That more than covers the interest costs.
      It’s my personal belief the decision to pay off the HELOC would be more of a risk tolerance and tax driven decision than a cash flow decision. Until you’re at that stage and have experienced managing a HELOC investment loan for many years, it’s difficult to speculate on the pay-off decision.
      It definitely makes for some interesting planning in the years immediately preceding retirement. I would probably drag an accountant into the picture at that point for professional tax advice.

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