There is a fair bit of discussion going on about The Smith Manoeuvre (SM) in Jonathan Chevreau’s columns in The Financial Post and on his Wealthy Boomer Blog. To recap, the SM involves two parts: in the first part the mortgage is paid down as fast as possible and in the second part a loan equal to the principal payment of the monthly mortgage is taken to invest in the stock market. Note that interest on an investment loan is tax deductible whereas mortgage interest is not.
In his column that kicked off the discussion, Mr. Chevreau endorses the first half of the SM but warns against the pitfalls of leverage involved in the second half. Here’s how Mr. Smith responds to Mr. Chevreau’s criticism:
My only regret is that we do not agree on the importance of simultaneous management of assets and debt early in life. That’s what a well-run business does, and it is certainly what wealthy people do, which is why they are wealthy.
An individual or a household is not really comparable to a business as has been pointed out in this blog post. I also disagree that we should do something simply because wealthy people do it. I doubt that there is a causal link between leveraging and wealth and what wealthy people do after they have accumulated assets is immaterial to the argument.
Personally, I want to keep things simple. Sock away the maximum possible in a RRSP and pay down the mortgage with the rest of the savings. The way I see it, I can earn a guaranteed, risk-free, after-tax return of 5.25% (our mortgage interest rate) by paying down the mortgage, which I think is pretty darn good.
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22 responses so far ↓
1 0xcc // Sep 26, 2006 at 8:25 am
Personally I think the biggest issue with the Smith Manoeuvre is that people don’t really understand all the implications of it. When people are introduced to the SM the only thing they can see is “Mortgage Interest Deductability” and after that their eyes glaze over. Maybe anyone suggesting the SM to some one should explain that part last, after the part about borrowing money to invest amplifies your return on BOTH the downside and the upside and that in order to really make *any* money you need to have average annual returns in your investments that exceed the interest you are paying on the loan (which doesn’t tend to work out too well if you are investing in mutual funds unless interest rates are very low)
I have been using the SM for around 8 years (yes, that means that I rode it out through the 2000-2002 correction) and I really don’t think it is for everyone. It takes a moderately high tolerance for risk and the ability look past short term dips and wiggles.
2 Mr. L // Sep 26, 2006 at 9:48 am
Also, people may rationalize their choice to start this maneouvre by saying “I borrow to invest my home, I am merely keeping my borrowings at the same level, but acquiring the advantage of interest deductibility”. The flaw in that logic is human nature. If we saw the price of our home listed in the paper each and every day and it was easy to execute a buy or sell, we’d be buying and selling our homes left right and center. But we don’t and it’s a bit of work and disruption to sell or buy a home so we buy and hold for reasonable periods of time. Unfortunately buy and selling frequently is what does happen with stock market investments for most people. Most investors buy and sell indiscriminately and usually at the wrong times (buying during market euphoria, selling when times are tough), thereby becoming their own worst enemy. Leveraging in this type of short-term situation is the worst investment one can make. If one is really holding for the long-term, makes wise investment choices and can weather stock market storms while paying the interest every month, then this manoeuvre is a sound one. But the majority of people are unable to do this.
3 Canadian Capitalist // Sep 26, 2006 at 3:10 pm
IntThree: I am curious about your experience with the SM. In eight years are you ahead of the after tax return you could have earned by just paying down the mortgage?
4 Required // Sep 26, 2006 at 8:55 pm
CC (or anyone else),
Any chance you have seen a spreadsheet somewhere that goes through a mortgage schedule, but includes the SM?
TY
5 0xcc // Sep 27, 2006 at 8:52 am
I’m not actually using a ‘pure’ SM. Maybe I should go through the whole thing in detail on my blog but I’ll give a bit of an overview here. In 1997 or 1998 I took out my first investment loan based on the advice of my financial advisor (the basic idea being that RSPs get taxed at 100% upon withdrawl and if you can borrow to invest you can deduct the interest. If you borrow enough the interest payments will pretty much be the same size as a RSP contribution with the same tax effect). Well that worked out very well for a couple of years and then 2000 came along. I started getting margin calls which I was able to handle but could have been very bad if I wasn’t able to meet the margin requirements. In 1999 we bought our second house and this time we bought it with 25% down so we were able to get a home equity line of credit (which I think is a great tool if you are disciplined enough to use it properly). When we had the line of credit we were able to pay off the priciple and have the flexibility to borrow it back right away if we wanted to. Up until about two years ago (just before I read Derek Foster’s book, Stop Working, which really changed the way I thought about investing) I was periodically moving money from the HELC into investments but I was watching the returns very closely. Through the 2000-2002 period I actually lost quite a bit of money on paper. If I include all of my own capital I put in, including interest payments I only reached break-even about 12-18 months ago. Currently my overall gain (not annualized, this is the total return) is right around 8%. I currently have about 30% of my mortgage invested (and I am using that portion of the interest as a tax deduction) but I am hoping to be mortgage-free in 5-7 years. I guess the real test is whether I would have had as much in investments now if I just invested instead of borrowing to invest. I think it probably would have been pretty close one way or the other.
6 0xcc // Sep 27, 2006 at 9:10 am
Oh, I should mention that that 8% return doesn’t include the tax benefit from the interest payments and actually I just looked over the numbers again and that 8% return doesn’t include interest payments. If I include the interest I paid the total return is around -0.2%. I think that return has more to do with the quality of returns in the mutual fund industry than with the potential of the SM. Also that -0.2% doesn’t include the tax benefit of the interest payments so maybe, maybe it is just at break-even if the tax benefit is included…
7 Canadian Capitalist // Sep 27, 2006 at 10:06 am
Thanks for your detailed comments and I really look forward to the analysis on your blog.
Your experience seems to confirm my gut feeling that the benefits of SM are debatable. Here’s how I look at it: I can get 5.25% guaranteed, tax-free by just paying down the mortgage. Assuming an average loan interest of 5% and a tax rate of 40%, I need to make 8.25% after taxes just to get the benefit I am getting now. In an environment where bond yields are just over 4% that’s a tall order. I am expecting market returns of 6-8%, so the SM just doesn’t cut it for me.
8 0xcc // Sep 27, 2006 at 10:58 am
I am starting to think that one way to look at paying down your mortgage is sort of like a investing in a bond. If you have a choice between buying a 4.25% (or whatever the bond yeild is today) bond or paying down your 5.25% mortgage which one makes more sense? Even if you buy the bond in a registered account saving that 5.25% interest is a non-taxable saving so your net benefit is better on the mortgage no matter what. In other words, you don’t have to pay tax on interest you don’t pay (but you do have to pay tax on money earned to pay interest so you don’t have to pay tax on the interest savings you make by paying down your mortgage.
I’m not saying that you should direct all your retirement savings into your mortgage until your mortgage is paid off but maybe thinking about using the portion of your portfolio that you might consider investing in bonds to pay down your mortgage (until that is paid off) might make sense. Anyway, just something to think about I don’t claim to know whether it actually makes sense or not…
9 L // Jul 4, 2007 at 11:07 am
“I can get 5.25% guaranteed, tax-free by just paying down the mortgage. Assuming an average loan interest of 5% and a tax rate of 40%, I need to make 8.25% after taxes just to get the benefit I am getting now”
I think your math is wrong. Let’s say you have an extra $100.00
1. Put it down to mortgage principal - save $5.25 per year in interest, that you otherwise pay during the remaining part of the amortization period. You won’t see any money until you sell the house.
2. Invest it in some instruments. You will continue paying $5.25 interest on the mortgage, but you will hopefully get return on the $100 invested. Let’s say 7%, $7 per year, taxed (let’s assume pure capital gains and 40% tax bracket),
your after tax return after 1 year $7 - $7*0.4*0.5 = $5.6
bottom line $5.6-%5.25=$0.35 - you’re ahead by 35 cents on the 100.
3. put the $100 towards mortgage principal and borrow back to invest using the same numbers.
interest on money borrowed (let’s say prime 6%) tax deductible, your cost $6-$6*0.4=$3.6
return on money invested 7%, same as #2, return after tax $5.6, bottom line $5.6-$3.6=$2
As you can see #3 is the best, providing with $2 or 2% return after tax, AFTER reducing mortgage principal by the $100.
10 Canadian Capitalist // Jul 4, 2007 at 2:18 pm
L: Fair enough. It depends a lot on the assumptions you are making. I assumed that to get an after-tax guaranteed (like a bond coupon payment), you need to earn 5.25%/0.6 = 8.75%. I’m not denying that using the SM, you could earn excess returns because you are borrowing and investing the principal but personally, I am happy with making 5.25%.
11 DIY Smith Manoeuvre, Part 1 // Dec 10, 2007 at 6:16 pm
[...] Warning: The Smith Manoeuvre is a leveraging strategy. Leveraging to invest in the equity markets is risky. You could possibly earn less in the equity markets than your interest charges even over the long term. You should determine the appropriate amount of leverage that you will be comfortable with, so that you won’t panic and sell when markets tumble. Though I believe the information provided in this series of posts is accurate, check with your accountant that everything is kosher and you won’t have trouble with the CRA regarding the tax deductibility of interest. Handle with care, double check everything and please keep in mind that I’m just a guy with a website, not a financial advisor. In the interests of full disclosure, I should mention that I personally don’t, or have any plans to, implement the SM. [...]
12 ag // Jan 7, 2008 at 12:13 pm
Q: how does the SM involve leveraging, if a mortgage debt is converted to an investment debt? As I understand it, levereging is an option not recommended by the SM proponents.
13 Canadian Capitalist // Jan 7, 2008 at 2:44 pm
The SM converts a mortgage into investment debt over time. Also, while a mortgage decreases over time as you pay it down, a SM investment loan increases over time till it equals to the initial mortgage amount. Hence, SM is a kind of leveraging strategy.
14 The Internets Ghost // Jan 8, 2008 at 6:22 pm
Nice blog template!!!
15 tomw // Jan 24, 2008 at 11:43 pm
the SM is risky sure:
“if a mortgage debt is converted to an investment debt?”
You need to know how to invest to beat the prime rate, simple ” debt is converted to an investment” means you need to borrow to invest in stocks or mutual funds that return more then the prime rate which you are presumably borrowing at on from your readvanceble HELOC.
I am doing this now I borrowed to invest as the markets look like they may have bottomed out and stock prices are rising. Derek Foster tells us dividends matter and so you can invest for dividend income, in stocks that have a PROVEN TRACK RECORD of dividend increases over many years (S&P now has a Canadian Dividend Aristocrats list but I don’t trust it completely).
My only question is I am not completely sure of how to make sure my investments and my investment loan qualifies for the Canadian Tax deduction for loans on investments?
16 Traciatim // Jan 25, 2008 at 9:22 am
Hey Tomw, the way to be sure is that your investment has to have a reasonable expectation of income. You could to a small venture capital loan to a business or startup, you could invest for dividends or get bonds or other interest bearing instruments.
Plus, you don’t have to beat your interest rate to break even either. For instance lets say you have a 10000 loan at 6% so it cost you 600 to carry this year. That will come off of your income If your income was 80000 your marginal rate in Ontario you will get back 43% of that on your taxes so you get
258 back leaving with a needed profit of 342 to succeed.
Keep in mind this will be after tax, so if you are investing the 10000 in eligible dividends in order to get 342 after tax in the same income bracket you will need to earn about a 4.3% yield on the 10G. I’d also like to point out that currently CIBCs yield is 4.8%, that is, if they can stop walking in to sharp objects. BMO also is yielding around there right now too.
In the right situations it works out, what happens in the fall when they jack interest rates by 1.5% to [stick it to the average person] slow the booming economy as our dollar falls and inflation spikes?
17 Freedom Seeker // Feb 25, 2008 at 6:03 pm
Traciatim, correct me if I’m wrong:
The 4.3% yield on 10G would give you an after-tax profit of $245.10 which is less than the $342 of after-tax interest payment on the loan. Break-even is at 6% yield. My understanding is that had you invested in Index fund over the last 10-year period, you’d have earned a return of 7-9%.
Thanks.
18 Traciatim // Feb 26, 2008 at 8:09 am
Hmmm, maybe I’m miscalculating, but a 4.3% yield on 10G would have 430 dollars for the year. The marginal rate on eligible dividends is around 20% or so (depending on province) which would make 86 bucks go to tax, leaving you with 344 left over. The 600 bucks you pay to interest comes off of our income, so someone with a high income (80K) would get around 250 back on the 600 bucks, leaving them with 350 paid in interest.
I think I may have miscalculated slightly, but my example of just CIBC and BMO both at 4.8% at the time would be more than enough to keep you afloat. I’m not sure what their yields are now, I need to get ready for work, but I’m sure you can find it quick enough on google/yahoo/globeinvestor.
Also keep in mind that in year 2 your interest costs go down and your yield (if a dividend increase happens) goes up . . . so eventually you pay off your loan and still have the income (in a perfect world).
I’m not too sure if I like the leveraged strategy like this, but to each his own. I think I like the safer route of just putting in money over time to the same securities. Also, I’m not sure if you can deduct interest paid on loans that are for capital gains, the rule is very specific to investing for income, which would mean interest and dividends. I wouldn’t want the CRA to come knocking and having a lecture and audit on what’s considered income so I’d just stay on the safe side.
19 Canadian Capitalist // Feb 26, 2008 at 12:22 pm
Good discussion. The SM works by arbitraging the difference between the tax treatment of interest expenses (fully deductible against income) against the favourable way in which dividends and capital gains are taxed. I haven’t checked but I believe Traciatim is right. You probably need less in dividend income than interest charges to break even (without taking taxes into account).
20 Kiasmine // Mar 4, 2008 at 2:46 pm
My Husband and I bought our first home 4 months ago (we are 30 years old no children we have approx. $20,000 worth of personal debt/student loans). Our mortgage is 290,000 we used a no down payment mortgage 100% financing. We have been offered a 50,000 LOC to attach to the mortgage to perform the smith manouver. This 50K is also 100% financed – higher interest – invested in mutual funds.
We view this as we have nothing to loose if we go with it. We put “0″ into our house other than our regular accelerated biweekly mortgage payments which could be considered as rent because he did not put a 5%-20% down payment on the home.
We were told that we will not be required to pay anything extra (considering the additional $50K) other than our original accelerated mortgage payment and we still benefit by gettin the net distribution.
Do you think it is in our best interest to start the smith manouver
21 David // Mar 4, 2008 at 10:04 pm
Kiasmine,
What you have described does not sound like the Smith Manoeuvre, but some other form of leveraged investing. You might wish to look at Million Dollar Journey’s Blog for more information on this process.
DAvid
22 Kiasmine // Mar 5, 2008 at 10:10 am
Thanks David for your reply……. curious if it would be the SM if we took the net accumilated and applied it to the mortgage instead of a mutual fund then used the $ against taxes?
Perhaps I am not understanding the SM.
Thanks in advance
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