The Smith Manoeuvre: After the Mortgage is Gone

Edited Photo. Source: Flickr - Alan Kotok

The Smith Manoeuvre is a mortgage-to-investment loan conversion strategy popularized by the late Fraser Smith. We detailed the steps of implementing and executing this strategy in detail on this blog. What happens though when our mortgage is paid off and we're just left with the investment loan?

There are two main options: 1) pay down the loan to reduce risk, or 2) keep the loan for its tax advantages.

Wind Down the Loan

Paying down the investment loan is a good strategy to reduce your risk. However, it should not be paid off aggressively in most cases and do not sell your investments to pay it off. Your extra disposable income should first be used to build your wealth.

Loan pay-down is a good choice for low-income people and those who are anticipating retirement in the near future who have no other debt. The SM loan is the last debt you should pay off.

I would still make new investing your first priority. With the mortgage principal paid off (Portion 1 of the HELOC), you now have additional cash flow freed up for saving elsewhere. Make sure your retirement investing is on track.

Adding a couple grand each month to an investment account can be a huge boost to your savings. Just make sure you open a new joint Cash/Margin account and keep it separate from your SM accounts.

In your new cash/margin account you should set it up so the contributions and income are claimed by the lower income partner. This is tax advantageous, but it is the opposite of what you're doing with the SM accounts. Make sure that contributions to this investment account don't exceed the lower partner's income. More about that in this post.

To figure out how much you need to save each month to retire at your target date, use a compound interest calculator. I like this one for it's simplicity. Plug in 6% as your interest rate. It's reasonable and covers inflation costs in most circumstances.

After you've ensured you are on track to retire when you want to and have all your other debt paid off, then consider paying down the investment loan. Use the dividend income from the SM Cash/Margin investment account to pay down both the interest owing and the loan principal (Portion 2 of the HELOC). Increase the loan pay down by throwing extra cash at it if your dividends are not sufficiently large enough to make a meaningful dent after interest costs.

I don't think it's very advantageous to pay off a tax-deductible and (currently) low interest loan in a hurry, so take your time with it.

Keep the Investment Loan

Once Portion 1 of your HELOC is paid off you are no longer really executing a Smith Manoeuvre. At this point you simply have an investment loan secured by the value of your residence. There is nothing wrong with this when done responsibly.

If you have a high income and still anticipate working for the foreseeable future, you should keep the investment loan for its tax advantages. You would likely have chosen a lower dividend income strategy for your SM investing. Keep this going so you can deduct the interest expenses from your income at your marginal tax rate.

Keeping the investment loan is also a good option for retirees with large RRSP accounts. RRSP withdrawals are taxed at your full marginal rate; offsetting that high-tax income with interest expenses can be advantageous and help keep your overall tax rate down.

If you can handle the risk and up-and-downs of the market, consider growing your investment loan as your home value increases. You can do this by applying for a HELOC limit increase with your bank every few years and getting an appraisal done (if required).

Maintaining 35% equity is important as it implies your house value would have to drop 35% before you are underwater on your house loan. Though not impossible, it would be a substantial drop. Because your loan is backed by stocks it is still nearly impossible that you would experience a negative equity situation.

Housekeeping

If you are not going to increase your investment loan, you can save all the statements from your SM chequing account in a safe place (in case of an audit) and then close down your SM chequing account.

You can rearrange the account settings so that dividends remain in the SM investment account. Just use your regular income to pay the interest on the investment loan.

You will still need to make the necessary adjustments to your loan at tax time for RoC income, but you can make those adjustments with your normal income. This means your investment loan will slowly shrink over time by the amount of your RoC distributions.

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