The Smith Manoeuvre: Steps 8 & 9

Edited Photo. Source: Flickr - Vina Caliterra

The Smith Manoeuvre is a leveraged investment strategy where home equity is put to work buying dividend paying stocks. The main objective of the strategy is to convert regular debt into tax-deductible debt--reducing taxes and increasing overall wealth.

We do this by paying off the traditional mortgage as fast as possible, but borrowing that money back in an investment loan worth up to 65% of your home's appraised value. It is important to point out that, done right, the SM strategy can be lucrative, but it also increases risk.

Step 8: Use Dividends to Pay Off Mortgage

As we discussed in detail during Step 7, the Smith Manoeuvre Cash/Margin account will hold stocks or ETFs which pay dividends. However, these dividends will not be directly reinvested into more stocks, or used for DRIPs.

Instead, the dividends will be directed straight into the SM chequing account. This dividend income is going to be used to reduce your mortgage (Portion 1 of the HELOC).

The dividends can be incorporated into your regular topped up mortgage payments. Remember, a good mortgage will allow regular doubling of payments penalty free.

The dividends can also be used to make annual lump-sum payments on your mortgage. A good mortgage will allow annual prepayments equal 15-20%  of the original principal penalty free.

For this reason, if you're anticipating to be very aggressive in prepaying your mortgage through extra investment contributions and dividend income, you might be better off with a higher interest open mortgage which allows penalty free, no restriction mortgage paydown. Locking into 1 year, fixed mortgage terms is another option.

Just remember, regardless of the mortgage structure, you want to put extra money to work as soon as possible without paying the bank any penalties for being a good saver. (It goes against our banks desire of having everyone wading in as much as debt as humanly possible).

Step 9: Borrow Back and Reinvest

Following the extra payments made to Portion 1 of your SM HELOC mortgage, the available credit in Portion 2 (the investment loan portion) of the HELOC will increase by the same dollar amount. This should happen automatically.

You will again borrow back this money, as soon as it's available, to invest in stocks or ETFs. It's important to put this money to work as soon as you can.

To do this, make a transfer from Portion 2 of the HELOC to your SM Cash/Margin investment account. Then purchase more of your desired investments. Remember, Canadian dividend paying ETFs or stocks are usually the best choice. But don't focus on higher yields unless you are in a low tax bracket to begin with. Even if the ETF or stock yields less than 1% dividend, that's okay.

Try to keep your investment cycle moving as fast as possible, especially once you make the transfer out of the HELOC. You want to keep all the interest tax deductible, so don't have piles of cash sitting idle in your Cash/Margin account. It's not likely to attract much attention from the CRA, but why invite the issue in the first place.

Next time we will go in detail on capitalizing your HELOC loan interest. This is the part where we explain why the Smith Manoeuvre strategy will not cost you any more money out of your normal monthly cash flow.

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