"Guerilla capitalization" of interest is one of the key distinctions and selling features of the Smith Manoeuvre. This makes the Smith Manoeuvre unique from a simple borrow to invest strategy.
Many people ask: what's the difference between the Smith Manoeuvre and just taking out a loan against my house to invest? Well, the Smith Manoeuvre is both more complicated and advantageous because all investment returns are used against the house mortgage and it doesn't require any extra cash flow to pay off the loan interest.
Step 10: Capitalize the Investment Loan Interest
As you know, all loans come with interest costs. Your SM HELOC mortgage is a two part loan. Portion 1 is your regular mortgage. You will make monthly, or bi-weekly, payments which combine interest owing and a portion of principal repayment. This will reduce the amount owing in Portion 1 over time. Most mortgages are designed to be paid off over 25 or 30 years.
Portion 2 of the SM HELOC is a different animal. As an investment loan worth up to 65% of your home's value, you never have to actually pay off the loan. Unlike your traditional mortgage, if you borrow $300,000 in a HELOC now, you can still owe that same $300,000 years down the road.
The only thing you are required to do is pay the interest owing each month. And this interest is 100% tax deductible. It comes straight off your taxable income.
You will get a statement for your HELOC account each month. This statement will clearly show both portions of the HELOC, specify the payment owing on Portion 1, the principal reduction on Portion 1, and the interest payment owing on Portion 2.
To pay the interest bill on Portion 2, we will "guerilla capitalize" the loan. Basically we will take the interest owing out of Portion 2 and transfer to the SM chequing account. Then, before the payment due date, we will "pay" the interest bill by making a payment from the SM chequing account back to Portion 2 of the HELOC.
Your monthly HELOC statement comes available on the 1st of each month. On May 1 you received your statement. Your monthly minimum payment on Portion 1 of the loan is $1,450 of principal and interest. Your monthly payment on Portion 2 of the loan, currently $250,000 outstanding, is $534. Both payments are due on May 31. You save an extra $550 a month which you normally use to top-up your regular mortgage payment.
Now, you just made a payment of $2,000 to Portion 1 of the loan on April 30. Your statement also shows that you have the $550 plus the normal principal repayment amount of the minimum mortgage payment (let's say it was $400 last month) available to borrow in Portion 2.
This means you can technically borrow up to $950 more dollars from Portion 2 right now. You make a $400 transfer to your Cash/Margin account for investing. Then you will make a $534 payment to your SM chequing account scheduled for May 22.
On May 25 (give it a couple days for the payment to settle), you log into your SM chequing account and make a $534 payment to Portion 2 of your HELOC scheduled for May 30. Always check a calendar to plan the dates right. You don't want to get stuck on weekends or holidays and miss a payment because of transfer delay or bank closure.
That's it. The interest payment is made with borrowed money and doesn't cost you anything. You do this each month and it's basically like that same $534 just moves back and forth between the two accounts. (In reality the interest owing will grow slowly each month as your investment loan gets bigger, but you get the point.)
Even if you don't make any extra payments on top of your minimum mortgage payment, the idea is the same. You always leave a small amount of available credit in Portion 2 of the HELOC that's enough to pay the anticipated interest owing for the next month.
In the next steps, we will discuss the tax considerations for the Smith Manoeuvre strategy.