Two weeks ago I introduced a great way for home-owning Canadians to proceed with investing after filling up their TFSA and RRSP accounts: the Smith Manoeuvre.
Shared by a Canadian financial planner, the late Fraser Smith, this strategy converts your boring mortgage into a perfectly legal, tax-deductible, investment fuelling, self-directed, get-rich machine. If there is such thing as "good debt", this my friends is it.
It is a bit complex, although nothing your average Moose-following, enthusiastic wealth-desiring Canadian can't grasp with a bit of guidance. Over the coming weeks, with some minor interruptions, I am going to thoroughly explain how this strategy can be implemented, increasing your wealth over time without costing you any more money in monthly cash flow.
Step 1: Obtaining a Readvanceable HELOC
The first critical factor is having sufficient equity in your home. While you can borrow up to 80% of the value of your house, only 65% of your house value can be borrowed in a revolving-style loan. This means a true Line of Credit where, if you desire, you can make interest payments only and never actually pay off the loan as you would in a traditional-style loan.
This means you must have at least 35% equity in your home. Simply multiply your estimated house value by 65%. That's the max you can borrow (including the mortgage portion). There are ways to get to 80% loans while you still have a mortgage, but for simplification down the road and added risk management through the entire process, we will stick to 65% for now.
If you don't quite have the 35% equity, don't forget to add in money you have in a Cash/Margin account, savings account, or chequing account that you could potentially apply to your mortgage.
To obtain a new loan, you will probably need to get an appraisal done--especially if your home value has changed a lot since you purchased it. Don't rush this on your own though, the bank you choose will likely absorb the cost of the appraisal in exchange for giving them your business. A mortgage broker can help you with this.
To keep a clean paper trail for tax purposes, the Smith Manoeuvre demands a very particular HELOC loan structure. Your HELOC account must have two distinct portions.
Portion 1 is for your mortgage. This portion is not used for investing, it is your "house mortgage". The interest expense is not tax-deductible. Typically, for the SM, you want a variable rate mortgage with generous prepayment privileges. This should include doubling-up monthly payments and annual prepayments which are penalty free. You will be paying down this "mortgage" portion quickly. If your expected payments are higher than 2x your regular mortgage payment, you may opt to go with an Open Mortgage that has limitless prepayment privileges but a higher interest rate.
Portion 2 of the HELOC is your investment loan. This portion is used for investing only! (Not buying new porcelain bathroom tiles). Done right, the interest will be fully tax-deductible so there must be a clean separation and accounting for this portion. Also, as you pay down Portion 1, the available credit amount in Portion 2 should automatically increase proportionally. That means it is "readvanceable". This portion will also have a variable interest rate (should be Prime + 0.5%), but you will theoretically never pay off this loan. Why would you when you can get a nice tax break?
Each portion of the loan will have its own distinct account number to make payments and accounting easy to manage.
Good Loan Options
Here is a list of options available in the Canadian market which can meet the above stated requirements at a low cost.
- RBC Homeline Mortgage
- TD HELOC
- BMO Readiline
- National Bank All-in-One
- Vancity Creditline
You should consider using a mortgage broker or mobile mortgage person when setting up these HELOCs. They can help guide you through the process, set it up for you correctly, negotiate better prepayment and interest terms, and negotiate coverage of an appraisal fee.
Be aware though, mortgage salespersons are generally paid more when selling you longer term fixed-rate loans compared to variable-rate loans. You want variable, you want prepayment privileges, you want no account fees. Simple.
Next, we will go in detail on Step 2: the chequing account.