By this point in the business cycle, we are solidly in a rising rate environment. Since last summer, we've jumped from essentially no interest to a little bit of interest on debt. Our interbank overnight rate is still a meagre 1.25%. That's about half the rate of inflation in Canada right now.
On the other hand, borrowing money from your bank has gotten quite a bit more expensive than it used to be. Remember, banks always earn a spread of approximately 2% on the each secured loan they issue. After all, that's how they earn billions in profits each year.
As it stands today, the popular 5-year term mortgage will cost you around 3.3%. That's a 50% jump from just 2.09% a little more than a year ago. Since last fall, bank prime rate has jumped nearly 30% from 2.7% to 3.45%. Of course the banks typically add 0.5% on top of prime rate for your revolving HELOC--the main loan of your Smith Manoeuvre strategy.
Does the jump in interest rates, combined with the continued expectation of rising rates for some time yet, make it a bad time to employ the Smith Manoeuvre?
Impact of Interest Rates vs. Taxes
Interest rates do have an impact on the profitability of the Smith Manoeuvre, that is certain. In an ideal environment, interest costs will be nothing and investment returns will be stratospheric. However, it is important to separate fantasy from reality. Over the long run, we can expect stocks to return somewhere in the range of 5 or 6% above the rate of inflation. Short-term debt on the other hand will return about 1 or 2% above the rate of inflation. That equals a nominal return of 9% or so over the past century, versus an average nominal borrowing cost of less than 5%.
The Smith Manoeuvre partially capitalized on that difference. As long as the investor can manage their risk adequately, borrowing at 5% and generating returns of 9% are a good deal for anyone. That's a long-term return of 4% on money that is not yours!
It's also important to note that you borrow at simple interest but your investments grow with compounding interest. This means the size of your loan amount is capped and the interest costs do not compound. But your investment account will grow exponentially over time.
In the above graph, debt is capped at the red line ($300,000) while your investment portfolio compounds over the years to $1.5 million. That's the power of simple vs. compound interest. In the Smith Manoeuvre, you actually don't directly pay the interest from cash flows because the strategy utilizes "guerilla capitalization".
However, the interest to investment return difference is just one factor of the Smith Manoeuvre. The other--arguably more important--component is profiting from the provisions of our tax system. Our tax system is designed to favour investments over income and productive debt over consumer debt.
The interest expenses on money borrowed for investing using the Smith Manoeuvre is 100% deducted from your income which significantly reduces your taxes. This tax deduction has a massive impact on the effects of the Smith Manoeuvre. If you have a $300,000 Smith Manoeuvre loan and you earn $80,000 a year in Ontario, at 3% interest you save $3,000 a year on taxes. At 5% interest you will save $4,700 on income taxes. After the tax adjustment, your net interest rate after tax deductions is much lower than the posted interest rate.
Meanwhile, profits from your equity investments in your Smith Manoeuvre non-registered investment account are taxed at much lower rates than regular income and, in the case of capital gains, can be deferred for a long time. At the same $80,000 income in Ontario, Canadian dividends are taxed at 8.92% after the dividend tax credit and capital gains are just half included for tax purposes when you sell your investments at a profit. A savvy investor can realize capital gains in retirement at extremely low rates by harvesting the gains strategically.
While the best way to approach the Smith Manoeuvre with regards to your investment mix depend on your personal situation, generally speaking working individuals using the Smith Manoeuvre should try invest primarily in low-yielding Canadian stocks. Of course diversification over your broader portfolio cannot be ignored.
While rising rates might seem scary to the young Canadian, or recent new home buyer swimming in debt that totals many multiples of their annual income, interest rates in Canada are extremely cheap today. In the late '90s and early 2000s when Fraser was using this strategy commonly with his clients and then promoting the Smith Manoeuvre through his popular book, interest rates were well above 5%.
It would take a massive spike in HELOC rates for this strategy to become unprofitable for middle to higher income Canadian families. For now, if you have a lot of equity in your home and are interested in growing your wealth exponentially beyond what your home could ever provide, use the Smith Manoeuvre to save on taxes and build a big portfolio.
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