Step 10: Capitalize the Investment Loan Interest
"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.
All loans come with interest costs. Your Smith Manoeuvre HELOC 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 today are designed to be paid off over 25 or 30 years.
Portion 2 of your HELOC is a different animal. As a revolving investment loan worth up to 65% of your home's value, you never have to pay-off the loan unless it's revoked by the bank. Unlike your traditional mortgage, if you borrow $300,000 in a HELOC structure 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. On the investment loan portion, 100% of the interest is tax-deductible from your income. That means it comes straight off your taxable income as an expense.
You will get a statement for your HELOC accounts each month. This statement will clearly show the outstanding principal of the mortgage in Portion 1, the next payment owing on Portion 1, the outstanding loan balance in Portion 2, the available credit in Portion 2, and the next interest payment owing on Portion 2.
To pay the interest bill on Portion 2, you will "guerilla capitalize" the loan. This means the interest payments are not made from your regular income. This is why you don't need the dividends from your Smith Manoeuvre investments to cover the interest costs on your investment loan.
You will take the interest owing out of Portion 2 of the HELOC and transfer to your Smith Manoeuvre chequing account. Then, before the payment due date, you will pay the interest bill by making a payment from the Smith Manoeuvre chequing account back to Portion 2 of the HELOC.
On the first day of each month, Mrs. Jones can log into her bank account and view her monthly HELOC statement.
This day, on May 1, Mrs. Jones sees that she must make a regular payment of $1,450 on her mortgage (Portion 1) due by May 31.
Mrs. Jones currently has a $250,000 outstanding credit balance on Portion 2 of the loan (used for investing) and must also make a $534 interest payment on this portion of her HELOC by May 31.
She normally can save an extra $550 each month which she uses to top-up her regular mortgage payment penalty-free for a total mortgage payment of $2,000.
On her HELOC statement, she also sees that her $2,000 mortgage payment made on April 30 was cleared. She paid down $550 in principal from her normal top-up, plus another $400 which was the embedded principal portion of the minimum $1,450 payment.
Mrs. Jones can also see that she has $950 available to borrow in Portion 2 of the HELOC as it is an automatic re-advanceable loan.
Keeping enough in Portion 2 of the loan to pay the $534 interest bill on May 21, Mrs. Jones transfers $410 to her Smith Manoeuvre investment account and quickly buys more ETF units with that money.
Then she also schedules a payment of $534 to her Smith Manoeuvre chequing account for May 22.
On May 25, Mrs. Jones logs into her Smith Manoeuvre chequing account and sees the $534 sitting there. She schedules a payment of $534 to Portion 2 of the HELOC to "pay" her interest bill there by May 31.
While it takes a few steps, this is how to "guerilla capitalize" the interest on your HELOC investment loan. As you could see in the example, at no point was any outside money used to pay the interest bill. The interest accrued on that temporary $534 loan from the HELOC to pay the interest is negligible.
When making your regular Smith Manoeuvre investment account contribution, always leave enough money there to pay the anticipated interest owing. That money just bounces back and forth between the HELOC and chequing account every few weeks, slowly growing as the size of the investment loan increases.
If the interest on an investment loan is tax deductible, the interest on the interest will also be tax deductible. That's why this strategy will not affect the deductibility of your investment loan.
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