The Smith Manoeuvre: Risks and Benefits

Leveraged Investing Risks

The Smith Manoeuvre is a form of leveraged investing. When using leverage, the upside potential and the relative size of the drawdowns on your equity increases.

Most opportunities for leveraged investing come in the form of margin loans. Margin loans are provided by investment brokerages and are secured by the stocks or ETFs that you hold.

Interest rates on margin loans can be quite low (see Interactive Brokers) and are fully tax deductible when the proceeds are invested in ETFs/stocks that pay some form of income.

However, margin loans are also tricky and can wipe you out financially if you are careless.

You must maintain equity in the account that is above the maintenance requirement (generally 30% or 50% of the investment value). If not, you will face a margin call where you must either contribute new funds to the account or your position will be promptly liquidated by the broker.

Smith Manoeuvre Leverage

The Smith Manoeuvre is very different. You borrow money for investing in the form of a HELOC—a callable loan secured against the value of your house. This means it is very unlikely that you would be faced with a margin call event forcing you to liquidate your stocks at a huge loss. However, as with a margin loan, the loan interest on your HELOC is still tax-deductible if it's used to purchase investments which generate some form of income.

You can only borrow up to 65% of the value of your home in a revolving HELOC loan. This means you maintain substantial equity in your house—a nice margin of safety.

Although the downsides are very real, the upside potential shouldn't be ignored. Using any form of loans to purchase investments can be lucrative over the long term. You can purchase much more investment exposure with less of your own cash.

Returns Without SM: Example Scenario

Mr. Smith is a single Ontarian, earns $150,000 each year, and owns a house worth $600,000. It has increased in value in the last few years, so his mortgage is just $300,000 with 20 years left.

Mr. Smith already has a full RRSP and TFSA and can still save an additional $1,000 a month after paying his mortgage. He currently has $50,000 saved in a Cash/Margin account.

Mr. Smith will slowly pay off the mortgage over the next 20 years and contribute the extra $1,000 a month to his $50,000 Cash/Margin account.

Then, after paying off the mortgage, he contributes the full $2,410 a month for the last 5 years to compare over a 25 year period.

In this case, after 25 years Mr. Smith has a fully paid off house with zero loans. He would also have a $1,000,000 investment account if we use a 6% annual return.

Returns with SM: Example Scenario

Mrs. Smith has identical stats to Mr. Smith. She is single, also lives in Ontario, earns $150,000 a year, and lives in a house worth $600,000 with a remaining $300,000 mortgage.

Mrs. Smith wants to save money on taxes and be richer than Mr. Smith (her ex) when she retires in 25 years. She chooses to implement the Smith Manoeuvre.

Mrs. Smith sells the investments worth $50,000 in her Cash/Margin account and immediately uses the money to pay down the mortgage so there's just $250,000 left on the mortgage balance. She goes to RBC, sets up a Homeline HELOC and a Tangerine chequing account.

With a Homeline HELOC, she splits the loan into two accounts: a flexible mortgage with great prepayment terms of $250,000 (her mortgage portion) and a readvanceable, revolving interest-only LOC portion (the investment loan portion).

Right now, Ms. Smith can borrow $140,000 for investing from her HELOC ($600,000 x 65% - $250,000). The interest on her LOC portion is 100% tax deductible, so at her tax rate she gets back 43.41% of the interest paid each year. Every month her investment loan amount goes up by $1,000 plus the principal portion of the mortgage.

Right from the start Mrs. Smith saves around $2,000 a year in taxes which she applies to her home loan and borrows back for investing. She invests in an ETF that pays 2% in dividends each year.

In this scenario, Ms. Smith's mortgage portion of the HELOC will be paid off in less than 7 years! At this time, her investment account, compounding at 6% each year, will be worth $410,000. 

Mrs. Smith now has a tax-deductible HELOC loan of $390,000. This gives her a "paid-off" $600,000 house, plus $20,000 in net investment equity.

With a maximum investment loan of $390,000, Mrs. Smith will save over $5,000 annually in taxes alone. She wisely directs this to her Cash/Margin account to purchase more investments.

In 25 years, Mrs. Smith's investment account is worth a massive $1.81 million. She still has the $390,000 HELOC so her net assets $1.42 million plus the "paid-off" house.

By using the Smith Manoeuvre strategy, Mrs. Smith is 42% wealthier than Mr. Smith 25 years after their separation—even though they both started in the exact same financial position. They have the same income and savings rates throughout the entire 25 year period. The extra $420,000 in wealth didn't cost Mrs. Smith a penny more in cash-flow each month.

Comments & Questions

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4 Replies to “The Smith Manoeuvre: Risks and Benefits”

  1. Finance Newbie says:

    I’ve been enjoying your posts on the Smith Manoeuvre, as this is something I’ve contemplated more than once before. This post provides a good comparison of using the SM vs not using it while paying off a mortgage. But wouldn’t the amount of interest payments refunded be closer to the average tax rate of 29.3% rather than the marginal tax rate of 43%?

    We’re in a slightly different situation as we are selling our paid off house and buying a new one that is slightly more expensive. We have quite a bit of equity and are trying to decide how much to put into the new home vs investing some of it. If the tax refund is calculated based on average tax rate, the difference in interest between HELOC rates and current 5-year variable rates makes the rates roughly equivalent after tax deduction on the HELOC. Am I missing something? Of course there is also the bigger question of whether we want to invest such a big chunk in the market right now, as we are working on a 5-10 year horizon to retirement and not a 25 year horizon.

  2. Mr. Rich Moose says:

    Thanks for the comment!
    The interest is considered a deductible expense, so it comes off the top of your taxable income. For this reason, the refund should be calculated at your marginal tax rate.
    In this case, fictional Ms. Smith’s taxable income drops from $150,000 down to $137,520. (Interest expense is $12,480 @ 3.2% on $390,000).
    Throughout this month I’m going to be doing a lot of posts diving into each step of the Smith Manoeuvre. In the investing step (7), I talk about investment options. Because investments have to be made in a Cash/Margin Investment account, Canadian stocks are the way to go from a tax perspective.
    Don’t forget that your investment horizon is until the day you die. At retirement you generally want to switch to a tax-efficient income focus and reduce risk, but this can be done with property allocations to bonds, a cash cushion, and diversification. Proper leverage in retirement is still appropriate if it fits your volatility tolerance, doesn’t put you in a margin call situation, and helps reduce taxes. It’s all about proper management.

  3. Finance Newbie says:

    Thanks for responding! I never know when to use average versus marginal tax rate. Are capital gains taxed at marginal as well?

    I look forward to reading the rest of your Smith Manoeuvre posts. Your posts are always so detailed and informative.

    As for the time horizon, I agree with you. Our situation is complicated and holding a large mortgage/HELOC affects our cash flow so I think I’d want at least some of it paid off before we retire.

  4. Mr. Rich Moose says:

    Capital gains are taxed at the marginal, but only half of the gain is included for tax purposes.
    One of the benefits of the SM is the compounding effect on your portfolio side. In 25 years, with a $1.8M portfolio, fictional Ms. Smith would get around $50,000 in dividend income each year. That more than covers the interest costs.
    It’s my personal belief the decision to pay off the HELOC would be more of a risk tolerance and tax driven decision than a cash flow decision. Until you’re at that stage and have experienced managing a HELOC investment loan for many years, it’s difficult to speculate on the pay-off decision.
    It definitely makes for some interesting planning in the years immediately preceding retirement. I would probably drag an accountant into the picture at that point for professional tax advice.

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