It’s a Great Time to Begin the Smith Manoeuvre

In 2017 house prices climbed once again in many parts of Canada. Of course the hot spots were Vancouver, the Lower Mainland and Fraser Valley, and Toronto condos. Even Montreal is getting warm.

Chances are if you bought in these areas even a few years ago, you have gained substantial equity in your home.

The Smith Manoeuvre is a great way to access this equity, use it to fuel your investment portfolio, and set yourself up for a nice retirement. Executed properly with a disciplined investment strategy, the Smith Manoeuvre can make you quite wealthy over time.

With enormous amounts of dead equity sitting in homes after this colossal price run-up, this year is a great year to begin the strategy. According to the Bank of Canada (that's the bank for banks), nearly half of all outstanding mortgages will be renewed this year! If you are one of the 47% of Canadian homeowners who will be walking into your bank sometime in the near future, you should seriously examine if the Smith Manoeuvre is right for your financial situation.

This way you can set up the proper mortgage/HELOC structure and shop around for a good rate while avoiding any cancellation penalties that might occur if you were breaking a mortgage mid-term.

Read my complete Smith Manoeuvre guide with detailed Step-by-Step instructions here.

Factors to Consider

Meeting the Equity Requirements

To begin the Smith Manoeuvre, you must have at least 35% equity in your house. While there are ways around this, I think it begins to get too risky if you're reaching for more money.

Maintaining at least 35% equity gives you a nice cushion to withstand stock market movements, especially when starting the strategy. This could prevent you from being in a negative net worth situation.

It's easy to calculate your equity percentage. Simply take your outstanding mortgage balance and divide by a reasonable house valuation. If the resulting number is lower than 0.65 (or 65%), you have at least 35% equity in your home. It's time to put this equity to work!

Being Financially Stable

If you're living paycheque to paycheque, hitting the line of credit every now and then for surprise expenses, are unable to pay off your credit card, or can't seem to save any money, the Smith Manoeuvre is not for you.

The Smith Manoeuvre is a form of leveraged investing. That means taking on more risk. It would be absolutely reckless to start a Smith Manoeuvre if you are not in complete control of your finances.

While over time the strategy should make you a lot of money, there are periods when stock markets drop 50% in a matter of months. The Smith Manoeuvre could wipe you out.

I believe the best candidates for the Smith Manoeuvre strategy are people who are financially stable and are already investing. This might be in a TFSA, RRSP, or some other account. It also works well if you are working a job that promises a pension—like a government defined benefit plan.

No Near-term Income Shocks

The Smith Manoeuvre is based on stock market investing. If you are able to put $100,000 of home equity to work using the Smith Manoeuvre HELOC account, you would buy about $100,000 worth of stocks or ETFs in your Smith Manoeuvre investment account.

However, we know that stock markets carry risk. It's entirely possible that a year after starting your strategy, your investment account could have dropped to just $50,000. If this happens, it's a nice time to try pump as much money as possible into your strategy and buy stocks or ETFs at a discount.

For this reason I think it's best to make sure you don't start the Smith Manoeuvre just before an income shock. Income shocks happen when you are pregnant and will be going on a reduced pay maternity leave. Or if your company is laying off and employment prospects are shaky at the moment. You get the idea.

When these events happen, people are often not prepared financially and can find themselves running into short-term debt situations. While accumulating debt is never a good thing, it's even worse if your investments are also tanking.

You might be tempted to access your Smith Manoeuvre HELOC to cover your daily expenses when it's needed most for investment purchases and this is a bad idea. It also means you are complicating your accounting situation for tax calculations every year for a long, long time.

Understanding Investing

Before implementing the Smith Manoeuvre it is very advantageous to have some familiarity with investing—particularly self-directed investing via stocks or ETFs.

You should have a self-directed TFSA going (I use Questrade which has free ETF purchasing), or maybe a RRSP. If you haven't invested yourself yet, but are using an investment advisor, it is easy to get started. Questrade has great tutorial videos to show you how to purchase stocks/ETFs in a step-by-step manner. Use Limit Orders and enjoy the learning curve!

It's also important to understand the nature of investing. After several years of comfortable to high investment returns, it's easy to be numb to loss. You must realize that you can lose a substantial amount of your investment account during market downturns. Despite this, you must be invested in something that generates income at all times! If not, you will run into tax problems.

You can pair Smith Manoeuvre investing with a momentum strategy. For example, you may buy XIC.TO if it is positive over the past 12 months but switch to XBB.TO if it's not. This could shield you from some downside risk but will potentially reduce your returns, especially after accounting for taxes on capital gains.

Understanding Personal Finance

You should also have a good understanding of personal finance. This means managing your bank accounts, paying your bills on time, avoiding unnecessary interest costs, and doing your own taxes (if you don't own a business).

The Smith Manoeuvre requires detailed accounting and tracking of money movement. A huge benefit of the Smith Manoeuvre is saving tens of thousand of dollars in tax over your lifetime.

It also requires moving money between a number of accounts. Your regular bank account, your Smith Manoeuvre chequing account, your Smith Manoeuvre investment account, and your HELOC. These need to be done in a timely manner every two weeks or month (depending on your mortgage payment cycle).

Check out the Smith Manoeuvre HQ and read all about it. If you have any questions, please ask! This strategy can make you much better off financially with no additional cash outflow.

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The Smith Manoeuvre: After the Mortgage is Gone

Smith Manoeuvre Loan Options

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.

There are important considerations for each option. The right choice depends on your personal financial situation, your aversion to debt in a general sense, and your current stage in life.

Completing the Smith Manoeuvre is a great time to sit down, analyze your situation, and possibly bring on an accountant or fee-only financial adviser.

Regardless of the choice concerning the loan specifically, I would still make regular 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 and investing. Make sure your retirement investing and savings plan is on track.

As long as you have the SM loan in place, keep your joint SM Cash/Margin account separate from any other investments. If you have money to invest in a non-registered account, make sure you open a new joint Cash/Margin account for that purpose.

1. Wind Down the Loan

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. It's also the best option if you are more risk-averse and you want to cut down your overall expenses.

Since its fully tax-deductible interest feature, the Smith Manoeuvre investment loan is the last loan you should pay off. 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.

Wind down the SM investment loan slowly. Do not sell the investments in your SM Cash/Margin account to pay off the loan! It will trigger substantial tax costs.

Instead, use the dividend income from the Smith Manoeuvre investment account to pay down the loan principal. You can increase it by throwing extra cash at the loan if your dividends are not sufficiently large enough to make a meaningful dent after interest costs.

2. 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, still anticipate working for the foreseeable future, or are looking to maximize your wealth you should keep the investment loan for its tax advantages. You would likely have chosen a lower dividend investment 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 significantly reduce your overall tax rate.

If you can handle the ups-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.

Since your loan is also backed by the value of your investments, 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 Smith Manoeuvre chequing account in a safe place (in case of an audit) and then close down your Smith Manoeuvre chequing account.

You can rearrange the account settings so that dividends remain in the SM investment account instead. 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 Return of Capital 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.

Comments & Questions

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Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.