Canadian Capitalist

164 responses so far ↓

• 1 0xcc // Jan 28, 2007 at 9:13 pm

  You didn’t account for the fact that the $275/month interest on the investment loan is tax deductible. Part of the ‘hook’ for the Smith Maneuver is that you can turn your mortgage interest into a tax deduction. So for some one in around the 40% tax bracket that $275/month would mean around a $1320 tax refund which over 5 years still wouldn’t account for the $11,000 difference noted in your example.

  As I have mentioned before, I don’t think that the SM is for everyone and I don’t think the majority of people that learn about the SM really understand what risk they are exposing themselves to if the market doesn’t give positive returns. I think that for the majority of people it makes much more sense to do what you have suggested here; just pay off your mortgage and then make the payments you were making to your mortgage to your investments.

• 2 0xcc // Jan 28, 2007 at 9:23 pm

  I should have started my last comment with “It doesn’t look like you accounted for the tax advantages of an investment loan.” I can’t really tell from the example if you did account for it…

• 3 Ryan // Jan 29, 2007 at 12:46 am

  Well, personally I always prefer to keep things simple. Paying down the mortgage versus SM not only sounds simpler, but it also means waaay less stress and in my books that will always win out.

• 4 Phil // Jan 29, 2007 at 1:50 am

  the SM sounds similar to the UK Endowment mortgage debacle. Basically, you pay just the interest on the mortgage and also buy life insurance and investments. At the end of the term, supposedly you will have sufficient equity to repay the mortgage *and* also be left with a lump sum to enjoy. That was the plan. Sadly 80% of people in the UK (source: BBC) with endowment mortgages are now facing a shortfall and unable to repay the mortgage at the term end.

  Further reading:-
  http://news.bbc.co.uk/1/hi/business/1887292.stm

  http://www.moneymadeclear.fsa.gov.uk/news/how_mortgage_endowments_work.html

  Caveat Emptor

• 5 Canadian Capitalist // Jan 29, 2007 at 8:33 am

  0xcc: The numbers given to me did account for the tax refund. The tax refund is used to pay down the mortgage and a loan taken out and added to the investment portfolio.

• 6 0xcc // Jan 29, 2007 at 9:09 am

  Ok, thanks for the clarification. I was sort of wondering how the investment was growing if this was a ‘worst case’ analysis where the investments were returning 0%.

• 7 Sandor // Jan 29, 2007 at 4:45 pm

  I must congratulate Mr. CC for the thorough analisis presented above and thanks for taking the trouble.
  My conviction however, is not the least shaken.
  It is virtually impossible that a portfolio should return 0% over 20 years. The analysis also neglected to account for the difference in the compounding of interests; mortgage vs. loan.
  Also, the assumed $275 added to the mortgage payments reduces Joe’s cash flow, while the same amount deployed to the debt service will attract a tax refund.
  And now let’s see item by item CC’s contentions!

  CC: “What about after 10 years? With mortgage pre-payments, Joe’s net worth would be (Home:$350K - Mortgage:$149K) $201K.”

  Sandor: He will indeed have that net worth, but it is dead equity in his house, doing nothing for him.

  CC: “Even after 15 years, Joe would be better off with a mortgage pre-payment (net worth of $280K) than the SM (net worth of $270K).”

  Sandor: Surely, if he stopped here the $4,949 yearly tax refund would soon make up for the difference of $10,000 in his net worth. But if he continues the program, the tax refunds will increase about $400 progressively every year, reaching $7,000 in year 21. If he sticks with it, chances are that he never pays taxes again as long as he lives.

  CC: “The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K.”

  Sandor: So, Joe made a modest profit, $25,000, just for doing the “right” thing. The main difference therefore, is, that the accelerated mortgage payments would bring him to the same place, at the same time, but without the portfolio, without the profit, and without the perpetual tax refunds.

  Then here is an other comment from CC that is worth a bit of an answer.

  CC: “Also, while segregated funds may give you peace of mind, it also comes with a higher price tag. If you are earning 8% in the markets and giving up 3% in expenses, you would probably just break even with the SM.”

  Sandor: This is slightly mistaken. Segregated funds usually charge 0.1-0.5% above the MER of the underlying fund. This small difference is well worth the guaranties. However, the gains announced are net of the MER, therefore the above mentioned 8% is net 8%, after the management expenses are already accounted for.
  Finally, if you have a quote to show how : “dangerous” the SM is, let me quoute in return from IE: Money, June/July 2003:

  “Smith tells the tale of how the tax official came around years ago after he first opened shop. Rather than make a case against Smith, the investigator asked if the maneouvre would work for him. “I new I was onto something at that point,” he says.”

  But of course I could quote many other fragments from my lovely collection of related articles. The fact however is that this strategy is devised for everyday circumstances, (as opposed to 0% return for 20 years,) for everyday people. Under those circumstannces it works and it works beautifully.

  Sandor

• 8 Canadian Capitalist // Jan 29, 2007 at 5:42 pm

  Sandor: We are talking in circles here. You’ve already counted on the tax refund to reduce the mortgage principal. You can’t count it again.

  And the 8% market returns that many experts think is reasonable is before fees, taxes and other expenses. Seg funds, on average, have a MER that is 0.66% higher than regular mutual funds, which themselves have a MER of 2.5%.

  “… but without the portfolio, without the profit, and without the perpetual tax refunds”
  And my key point: without the risk.

  Since we have now established that the SM doesn’t work for 0% returns, tell us how much returns we need to generate just to break even. My guess is it is somewhere around 5% with today’s prime rate.

• 9 MillionDollarJourney.com // Jan 29, 2007 at 6:15 pm

  I think that if you invest properly for the long term, the Smith Manoeuvre will win every time. However, the question is whether the risk is worth the reward. Betting the ranch so to speak..

  FT
  My Smith Manoeuvre Article - Part 1

• 10 Canadian Capitalist // Jan 29, 2007 at 6:29 pm

  FT: I read your posts on SM. Very balanced and you correctly point out the risks.

  I think the key words in your comments are “invest properly” and “long-term”. I am not sure about the “win every time” part. It depends a lot on how the money is invested, whether attention is paid to minimizing costs, taxes and commissions etc. and how long a time period we are talking about.

• 11 Aleks // Jan 29, 2007 at 7:24 pm

  I think the main question here is who is this “manoeuvre” targeting? It will work for people with the investment savvy and stomach to stick with it through three+ years of low or negative returns. But how many people like that are really out there? I know plenty of people who, despite having an investment timeframe of 10+ years, panicked and sold when the market tanked in 2000. I’ve talked to people whose reaction to a stock going up 25% in one year is to buy.

  I realize segregated funds are designed to limit losses, but does that take the MER into account? Wouldn’t a 0% gain actually equate to a loss of the MER for that year? My investment advisor has always said segregated funds are a waste of time. If you want to manage your risk, keep a percentage of your portfolio in bonds.

  A scheme like this requires a lot more discipline than most people have. As far as get-rich-slow schemes go, this one comes with a lot more risk than the Wealthy Barber approach of investing 10% of your income off the top, or giving up the daily latté.

• 12 MillionDollarJourney.com // Jan 29, 2007 at 8:49 pm

  CC,

  If you’re in for the long term, aka, rest of your life, how can you lose? You’re investing in equities while paying down your mortgage, not paying down your mortgage THEN investing. You have the extra time and compounding on your side. If you invest in strong dividend paying companies who have historically increased their dividends annually, how can you not come out ahead? Wouldn’t investing in these strong companies also reduce the risk involved? Even when markets have tanked in the past, how many banks reduced or eliminated their dividend?

  FT
  http://www.milliondollarjourney.com

• 13 Canadian Capitalist // Jan 29, 2007 at 9:42 pm

  FT: It is easy to have conviction in the market when returns are okay or even great. Not so much when there is a bear market.

  It is very hard to see your own capital being lost in the market. How would it be if you lost money that you had borrowed to invest? Would you still have the discipline to keep investing?

  I speak from experience on this issue. You fill out forms and silly questionnaires to figure out your risk tolerance, you can convince yourself all you want that you are in for the really long haul, but guess what? You find out what your risk tolerance is when a bear market hits.

  Luckily for me, I kept investing through the bear market and was amply rewarded for it. But I know plenty of people who stopped investing in equities altogether. They were in it for the long term too.

• 14 David // Jan 29, 2007 at 10:16 pm

  Sandor: “It is virtually impossible that a portfolio should return 0% over 20 years.”

  True, however according to my quick calculations, one would have to average about
  3.75% in dividends to meet this goal. Other instruments would require a higher return, as they are not so favourably tax advantaged. (I assumed capitalization of interest in my calculation.)

  Sandor: “The analysis also neglected to account for the difference in the compounding of interests; mortgage vs. loan.”

  That may be, however, usually mortgages are available for prime -0.75%, while LOC are at bank prime. In the early years of the mortgage this would make a considerable difference in monthly payments. Also, the semi-annual compounding of a mortgage saves interest costs over holding the same amount at the same interest rate in a loan.

  Sandor: “Also, the assumed $275 added to the mortgage payments reduces Joe’s cash flow, while the same amount deployed to the debt service will attract a tax refund.”

  Actually, the $275 per month added to the mortgage also has tax advantages, especially if applied in the early years of the mortgage. Since this amount is applied to reducing the principal, the savings on the future interest (every year) that is never paid is equal to the interest rate / ABS(1-marginal tax rate). Thus the $3300 per annum at 6% ($198) actually has a value closer to a 10% return, as “Joe” does not have to earn some $331 and pay the tax on it to pay his interest.

  Sandor: “Surely, if he stopped here the $4,949 yearly tax refund would soon make up for the difference of $10,000 in his net worth. But if he continues the program, the tax refunds will increase about $400 progressively every year, reaching $7,000 in year 21. If he sticks with it, chances are that he never pays taxes again as long as he lives.”

  Of course to obtain this $7000 refund, Joe must have earned and paid some $17,370 in interest costs to the bank.

  CC: “The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K.”

  Sandor: “So, Joe made a modest profit, $25,000, just for doing the “right” thing. The main difference therefore, is, that the accelerated mortgage payments would bring him to the same place, at the same time, but without the portfolio, without the profit, and without the perpetual tax refunds.”

  Joe’s $25,000 profit should be eroded by the $11,498 (net) annual interest costs he pays the bank on his $321,000 loan, or have I missed a step? It strikes me that if I do not need to service the loan, I do not need to generate the income to pay that interest, and earning $17,000 less per year would also lower my taxes.

  David

• 15 MillionDollarJourney.com // Jan 29, 2007 at 11:07 pm

  CC,

  Ah, i see your point. My point is that bear market or not, it doesn’t matter if the dividends keep coming in (and increasing). I agree that people have to analyze their risk profile very carefully before considering ANY sort of leveraging.

  FT

• 16 Sandor // Jan 30, 2007 at 2:39 am

  My ardor is flagging, but I valiantly march on, addressing this time David’s arguments.

  David: That may be, however, usually mortgages are available for prime -0.75%, while LOC are at bank prime. In the early years of the mortgage this would make a considerable difference in monthly payments. Also, the semi-annual compounding of a mortgage saves interest costs over holding the same amount at the same interest rate in a loan.

  Sandor: a $100,000 conventional mortgage at 5.25% interest will have a cost of the borrowing $79,774, that in a case of 30% tax rate will require $233,706 pre-tax income.
  The same amount of investment loan will cost $150,000 in interest, but will bring about $50,000 in tax saving. However, this tax saving invested for the same 25 years, at 8% average return, will grow to $330,755.99. Now we deduct from this the difference of the two different interest costs; 100000-79774=20226. (The extra cost in order to get the tax refund.) This we deduct from the total investments: 330756-20226=$310,530 This is the benefit of the investment loan over the mortgage under the given circumstances.
  But even if we take the more realistic scenario of investing only the tax refunds, (6000×30%=1800), then the result in 25 years at 8% will be $137,275. He is still better off.

  David: Thus the $3300 per annum at 6% ($198) actually has a value closer to a 10% return, as “Joe” does not have to earn some $331 and pay the tax on it to pay his interest.

  Sandor: Surely, my dear David, you would agree that he will still have to earn the same $331 in order to make the extra $275 payment on the mortgage. The two are a wash.

  David: Of course to obtain this $7000 refund, Joe must have earned and paid some $17,370 in interest costs to the bank.

  Sandor: Herein lyes the rub! No, he doesnt, no matter what his interest costs are, he can carry forward the accumulated tax write-offs indefinitely. So, even if he has long paid the loan back, as long as he has taxes to pay he can always write off the a portion of the accumulated interest payments incurred perhaps several years before.

  Sandor

• 17 Canadian Capitalist // Jan 30, 2007 at 9:50 am

  Sandor: We’ll agree to disagree. My point from my first review is that SM will work under most circumstances. I just question whether most people have the discipline to make it work.

• 18 Sandor // Jan 30, 2007 at 12:05 pm

  Dear CC:

  Since you compressed your opinion in such egreeable manner I no longer feel I disagree with you. In fact I do agree completely.
  The only thing is to add that I, the financial advisor, am supposed to help to practice the discipline necessary.

  I enjoyed our exchange and we shall talk again, I hope.
  See you

  Sandor

• 19 Duncan // Jan 30, 2007 at 7:14 pm

  This is why I’m scared to implement this when I move into my new home in a couple months. Not even people in the financial industry can agree on it and it just gets too confusing for us simpletons…

• 20 Sandor // Jan 30, 2007 at 11:33 pm

  Duncan:

  It is too early for you to worry about it.
  This strategy is for people who have free equity in their home. As a newly minted home owner (congratulations, by the way) you probably don’t have it yet.
  You could start it in a small way though, or put every available dollar you have towards reducing your mortgage principal. If you manage to do that for 2-3 years you will acquire the free equity and will be a suitable candidate for the Smith Maneouvre.
  Good luck, and as CC would say, good discipline!

  Sandor

• 21 David // Jan 31, 2007 at 12:47 am

  Thanks for your reply(and patience), Sandor.

  David

• 22 Silverm // Jan 31, 2007 at 3:42 am

  Please help clarifying this for me. Isn’t SM a tax strategy, not an investment strategy?

  Whether someone has the tolerance for the stock market/businesses is a question that needs to be answered *before* SM even comes into the picture.

  To test SM, you need 2 person which both have a mortgage and investments. Not between a person with mortgage and another with mortgage & investments.

• 23 Duncan // Feb 1, 2007 at 5:14 pm

  Sander:

  I will have about 200,000 equity in a 500,000 home. So I shouldn’t try the Smith Manouvre then?

• 24 Sandor // Feb 1, 2007 at 9:33 pm

  Duncan:

  No, I am sorry, I assumed mistakenly, that you are at an early stage (as a firs home buyer normally is,) and it didn’t occur to me that you may be in a better position.
  As you describe your situation, I think you should examine your prospects with a view to the SM, because as it appears, you are an exemplary candidate to do it. So much so, that if other characteristics of your finances permit, (such as your income for example,) you may be able to pay off your house in 4-6 years.
  This however, needs more work.
  Good luck and congrats to the new house.

  Sandor

• 25 CK // Feb 3, 2007 at 10:50 pm

  Our condo is closing on Feb 20 (Yeah! First home!), and I have been looking at SM for the past two weeks, and after some thoughts and number crunching, my husband and I decided against it.

  The decision was mostly emotional — yes, number crunching tells us SM works out better, but not significantly enough to justify the risk and the hassle.

  Mostly the hassle. We don’t have a financial planner and have no plans for one. Implementing SM at our stage pretty much requires a good financial planner and getting a HELOC. Both requires additional research, especially the former.

  Pardon me for being skeptical, but I just finished reading “The Naked Investor”. It doesn’t exactly increase my confidence in financial planners.

  (Side note: Engineers and software people always believe they can do better without the middleman, and we are no different. As I was just telling my accountant friend, “Unless the ROI of using a financial advisor - the fees beats that of investing on our own, I prefer to do it myself.”)

  Our current situation is simple. We have good income, insignificant investment outside RRSP, and no debt. We bought a small place, put 35% down (a portion is through HBP), with about $30k liquid assets left in high interest savings (PC Interest Plus). With our current income, we can pay it off in 5 years if we really really want to, without touching the money going into our maxed out RRSP. (No, we don’t really really want to.)

• 26 Ed Rempel // Feb 4, 2007 at 1:59 am

  Hi, CC,

  Very interesting blog, CC. There seems to be a misunderstanding here, however. Your initial example is not really an example of the Smith Manoeuvre - it is an ordinary leverage strategy. The SM requires no cash outlay, so there is no scenario where your mortgage is paid down more quickly without doing the SM.

  The SM is essentially “leverage by dollar cost averaging” - you reborrow the principal from each mortgage payment to invest. If you start by using your freeboard equity or an investment loan ($55,000 in your example), the interest payment is reborrowed from your credit line, not paid from your cash flow.

  Without knowing your interest rate and amortization in your example, with the SM, you would only make your regular mortgage payment, have the investment loan paid from your readvancing credit line, and you should also get about $350/month additional to invest (and increasing each year). Alternatively, if you did the “Rempel Maximum” (maximum leverage that can be financed completely from the SM), you could finance an investment of about $110-125,000 completely from the SM.

  Therefore, the comparison to see the benefit of the SM would be whether a leverage investment of $55,000 plus $350/month (and increasing each year), plus using the tax refunds to pay down the mortgage more quickly would be better than not doing it. Alternatively, would a $110,000 leverage investment (financed completely from the SM), plus using the tax refunds to pay down the mortgage more quickly be better than not doing it.

  Therefore, any comparison of the SM to paying down your mortgage are irrelevant, since the SM uses no cash flow (as you mentioned Silverm). So, the comments by David Trahair in the Star article are not relevant to the SM.

  In answer to your question, CC, the breakeven on leverage strategies based on studies generally is that you need to make 2/3 of the interest rate after 5 years and 1/2 the interest rate after 15 years. If we reborrow at prime (6%), we need to average 4%/year on our investments for 5 years to breakeven and only 3%/year after 15 years to break even. This is because of the different tax treatments and because the investment growth is compounded, while the loan interest is simple interest.

  This assumes there is no tax on the investments. Therefore, if the investments pay out distributions or dividends, the breakeven point will be a bit higher.

  Your “worst case scenario” of 0% for 20 years is unrealistic. The longest period of time the major markets have had a negative return in the last 70 years is 7 years (when you include reinvested dividends). I concur with you again, CC, about not using seg funds because of the higher MER. For the average person, the higher MER is for nothing, since no diversified equity fund would be down over a 10-year period. And even if it did, who would continue to hold it for the entire 10 years?

  Your concern about whether people will be able to stomach a bear market is very valid. The risks of the SM are only related to the investments - and the main risk of investments is the behaviour of the investor. If you sell out or become more conservative as soon as your investments go down, your return will not be there and probably the SM is not for you - unless you are working with a trusted advisor that can keep you invested. In fact, studies show the average investor only makes 1/3 of the return of the investments they own, due to bad investor behaviour and continuously “buying high” and “selling low”. (Dalbar study)

  So you’re right - the SM is only for long term investors.

  This is one of the advantages of the SM (done properly), however, since the regular bi-weekly investments with the dollar cost averaging tend to reduce market concerns - both psychologically and technically (because of the benefits of dollar cost averaging). Just like you mentioned, CC, you keep on investing right through the bear market and you will be okay.

  Also, since the SM is “leverage by dollar cost averaging”, all you actually need to start is 10% equity in your home - although 25% is better because you avoid CMHC fees and because of the better readvanceable mortgage products available.

  Good luck and good discipline (I like that)…

  Ed

• 27 ezboy // Feb 4, 2007 at 10:31 pm

  David: “That may be, however, usually mortgages are available for prime -0.75%, while LOC are at bank prime. ”

  According to Bank of Canada’s figures, prime rate is usually lower than 5-year mortgage rate. This is the average interest rate I get from Bank of Canada’s website (http://www.bankofcanada.ca/en/rates/sel_hist.html):

  1992-2006: Prime was averaging 4.63%, 5-year mortgage was averaging 6.46%
  1997-2006: Prime was averaging 5.81%, 5-year mortgage was averaging 6.96%
  1987-2006: Prime was averaging 7.34%, 5-year mortgage was averaging 8.69%
  1977-2006: Prime was averaging 9.06%, 5-year mortgage was averaging 10.27%

  I believe what you say might be right for those who shops around and have very good credit rating, they can usually get mortgage rate way better than what Bank of Canada tallied.

  EZ

• 28 Canadian Capitalist // Feb 4, 2007 at 11:34 pm

  Ed: Thank you for your comment. I should point out the SM example isn’t mine but was provided by a financial planner.

  I’ll concur with you that a 0% return over 10 years with regular investments is unlikely and the SM might make sense for a disciplined investor.

  ezboy: David is not comparing prime with 5-year mortgages. He is pointing out that you can borrow below prime for a mortgage but investment loans are at prime.

• 29 Ed Rempel // Feb 5, 2007 at 12:51 am

  CC,

  Thanks for you comment. I thought it was your example. The SM has a few implementation details to do successfully and requires getting the right mortgage. The benefits on it are huge over the long run, though, so I think it is worth the effort (plus we’ve done hundreds, so we have it down to a fine art).

  There are a relatively small number of SM advisors (many on Fraser’s site will try to talk you out of it if you call them) and we all know each other. So, I have seen a few shortcuts being marketed, such as simple leverage - and calling it SM, even though there is no regular readvancing from the mortgage payments.

  I’ve also seen several versions involving leveraging into an income fund that pays a high regular distribution. One even has a 12% payout that is almost completely return of capital(that I highly doubt is sustainable, since it is really only an average balanced fund). The problem with taking the distribution, is that if it is return of capital and you don’t pay it down on the investment loan, then the investment loan becomes non-deductible. For example, with the fund with the 12% distribution, the investment loan becomes completely non-deductible after 8 years.

  I guess a straight leverage strategy or leverage financed by a distribution are just much easier to sell and set up. However, the SM is clearly worth the extra effort to set up vs. simple leverage, because the automatic regular investment provides a huge benefit over time.

  Ed

• 30 ezboy // Feb 5, 2007 at 1:46 pm

  CC: “David is not comparing prime with 5-year mortgages. He is pointing out that you can borrow below prime for a mortgage but investment loans are at prime.”

  David: “That may be, however, usually mortgages are available for prime -0.75%, while LOC are at bank prime. In the early years of the mortgage this would make a considerable difference in monthly payments. Also, the semi-annual compounding of a mortgage saves interest costs over holding the same amount at the same interest rate in a loan.”

  CC,

  Am I missing something? David stated that the interest rate for a mortgage is usually lower than LOC which is at prime. As a result, the cost of borrowing through a mortgage is lower than the investment loan. Isn’t that conclusion base on a comparison between mortgage rate and prime rate?

  As I pointed out with the historical figures tallied by the Bank Of Canada, the average mortgage rate is usually higher than the prime rate. So, the cost of borrowing from mortgage is quite likely to be higher than LOC even before tax consideration for a lot of people.

  Again, I am not totally discounting David’s statement because a good number of people can get a below prime mortgage if he/she has good credit rating and take the time to shop around.

• 31 Canadian Capitalist // Feb 5, 2007 at 7:00 pm

  ez: The figures you quote show compare 5-year fixed rate mortgages with prime. So, yes if you take a fixed rate mortgage and an investment loan at prime, you are right.

  But, if you take a variable rate mortgage, the interest rate will be better than the investment loan before taking into account tax benefits. That is what David is comparing.

• 32 David // Feb 5, 2007 at 10:17 pm

  Thanks for filling in during my absence CC! My comments echo yours. ezboy, I believe that anyone who would consider (or be considered for) the SM would have a good credit rating, and would be financially savvy enough to have determined that a short-term, or variable-rate, or virtual-bank mortgage would net them the most cost efficient mortgage. I would also expect that they would have shortened their amortization period from 25 to 21 years simply by adopting an “accelerated bi-weekly” payment option, and would be considering further reductions of their principal through additional privilige payments.

  David

• 33 David // Feb 5, 2007 at 10:50 pm

  If I interpret Ed Rempel’s comments correctly, you have to be sure that you choose the right Investment Advisor, or you won’t see benefit from applying the strategies espoused by Fraser Smith. He further states that even some of the Advisors listed on the Smith Manoeuvre website will either discourage potential applicants, or provide poor investment options.

  Since Fraser Smith repeatedly states in his book words to the effect of “if you don’t understand the manoeuvre, just see your financial advisor, and he’ll (or she’ll)make it work”, I can understand many folks trepidation.

  I want to know where my money is going, and need to understand the mechanics of any investment. I’ve been cautious about such things ever since we bought a “no down-payment, no interest for 12 months” freezer that had a financing fee greater than the interest payment for 12 months would have been. BTW, that transaction is still reflected in my Credit Bureau report some 16 years later.

  I admit to having a poor understanding of all the ramifications of tax law, but when someone smiles and says “trust me”, common sense tells me to run, not walk in the other direction.

  David

• 34 Sandor // Feb 7, 2007 at 12:54 am

  I welcome Ed Rempel to this discussion with regard to the fact that I gethered some of my selfconfidence with the help of his articles about the Smith Maneouvre.

  Sandor

• 35 ezboy // Feb 7, 2007 at 8:26 pm

  CC: “But, if you take a variable rate mortgage, the interest rate will be better than the investment loan before taking into account tax benefits. That is what David is comparing.”

  CC,

  Thanks for the clarification. Now I understand he was comparing an Adjustable Rate Mortgage with the investment loan, not mortgage rate in general.

• 36 ezboy // Feb 7, 2007 at 10:51 pm

  David: “I would also expect that they would have shortened their amortization period from 25 to 21 years simply by adopting an “accelerated bi-weekly” payment option,…”

  David,

  Yes, bi-weekly payment plan definitely shortens the amortization period. The plan speed up the mortgage payoff significantly because it increases the total yearly payment by about 8.7%, not so much by changing the time interval between payment. This is one of the biggest illusion in the mortgage industry. Many mortgage brokers never mention the fact the the home owner has to make more yearly payment to shorten mortization period. Anyhow, this illusion helps the mortgage payer.

  Like the bi-weekly payment, the Smith Manoeuvre is somewhat another illusion. In contrary to Fraser Smith’s presentation, the manoeuvre does not reduce the interest cost of the mortgage. But, it definitely helps the payer to get a very cost efficient investment loan which is often overlooked by many home owners.

  David, you are right, for the investment part, you need a good investment advisor to make the investment successful. Since the Smith Manoeuvre makes the investment fund available periodically, this makes it a perfect fit for one of the best investment strategy — the dollar cost averaging strategy.

  This strategy eliminates the trouble and risk of market timing. As long as the investment appreciate in value faster than the cost of the investment fund (in this case, the long term after tax interest rate of your HELOC) in the long run, you will definitely win. The up and down of the market price of the investment won’t hurt your investment.

  As you pointed out, one has to understand the mechanics of his/her investment before jumping in. This is particularly important in market slump. Most investors lose money only because they sell low in a crashing market, not because they buy high in a booming market.

  If an investor truely understand how well dollar cost averaging works with his/her investment vehicle, the Smith Manoeuvre will give them the mechanism to get the investment fund available. Thanks to Fraser Smith.

  EZ

• 37 David // Feb 9, 2007 at 1:47 am

  ezboy said: “The plan speed up the mortgage payoff significantly because it increases the total yearly payment by about 8.7%, not so much by changing the time interval between payment. This is one of the biggest illusion in the mortgage industry. Many mortgage brokers never mention the fact the the home owner has to make more yearly payment to shorten mortization period. Anyhow, this illusion helps the mortgage payer.”

  Yes, and while some mortgage retailers don’t explain the mechanics of the process, for most mortgagees, it is a painless means to an end.

  Now if I could wrap my head around the SM as easily….

  David

• 38 Sandor // Feb 11, 2007 at 1:07 am

  David, send me your email address and I shall send you a sample case. That will immediately help you to understand the SM.

  Sandor

• 39 Ed Rempel // Feb 12, 2007 at 1:32 am

  David,

  The SM is really not that comlicated. You just reborrow the principal from each mortgage payment in a credit line linked to the mortgage to invest. Then you have the credit line pay its own interest. Those are the basics. What part do you find hard to understand?

  I realize that implementation is not that simple. It requires getting the right mortgage product, following the tax rules, investing effectively, and figuring out which variations or enhancements are appropriate for you. The main thing is to be comfortable with the concept of borrowing to invest in general and investing so that you are confident in the investments.

  You’re right about the bi-weekly payments. Banks and mortgage brokers tend to tell you that you are paying it off faster, but that is almost entirely because you effectively make 13 monthly payments, instead of 12.

  In actual fact, the most efficient mortgage payment is also the simplest - match it up to your paycheques. If you are paid monthly, then monthly mortgage payments will save you money over bi-weekly. This is because you get paid, then leave money sitting in your chequing account until the mortgage payments are made.

  Banks and mortgage brokers will tell you paying more often is more efficient, but they are only looking at the mortgage, not at the money sitting in your chequing account doing nothing until the mortgage payment. When you take that into account, matching your mortgage payment to your paycheques will always be the most effective - and the simplest.

  Ed

• 40 Ed Rempel // Feb 12, 2007 at 1:35 am

  EZ,

  Your comments on the investment strategy are right on. Great comments, EZ.

  Ed

• 41 Don // Feb 17, 2007 at 7:23 am

  We just paid off our mortgage and have maximized our RRSP contributions. The issue we face now is that we have virtually no savings outside our RRSP. The SM isn’t 100% applicable to us, any suggestions on strategies to set up an investment loan once the mortgage has been paid off?

• 42 Sandor // Feb 17, 2007 at 11:19 pm

  Don,

  I would cautiously mention the possibility of reborrowing some of the paid-down mortgage.
  Without some important details it wouldn’t be responsible to suggest any amount, or percentage however, if you leverage a minority of your equity and place it into a conservative, long term investment you will almost certainly gain.
  You probably know that the leveraging does magnify the effect of investment fluctuations. But there are loan products that contractually exclude the danger of margine calls, (that is, if your collateral looses value you don’t have to rebalance the loan with the collateral,) and the resulting tax advantage is also helpful to improve your prospects.
  The other thing you may consider is either redirect your RRSP contributions to a nonregistered investment based on the above, tax-efficient portfolio, or a so-called RRSP melt down.
  This latter strategy assumes that you establish a portfolio with borrowed money (the portfolio is the collateral,) and the cost of borrowing will be paid by your former RRSP contributions. (Redirected from the RRSP, of course.)
  This method however, is more suitable to people of higher income, who can afford to take the higher risk and at the same time can benefit from the tax reductions.
  There are suitable bank products for this purpose that also refrain from margine calls.

• 43 Ed Rempel // Feb 18, 2007 at 12:26 am

  Hi, Don,

  Congratulations!

  Having everything in RRSP is an issue when you come to retire, though. Some of our retired clients have that issue. Larger expenses become an issue. They would have to withdraw $50,000 to be able to buy a $30,000 car.

  One of the big benefits of the SM is that you build up a large non-RRSP portfolio. If you have both a large RRSP and non-RRSP portfolio when you retire, then you can easily plan your tax effectively.

  In your situation, you can basically jump to the finish line of the SM. Just borrow 75% of the value of your home to invest. Or leverage enough so that the interest payment is the same as your mortgage was.

  Now that your mortgage payments are done, you can use that same cash flow for leverage payments. This is just simple leverage, but if you invest effectively, you’ll find that leverage grows your net worth much faster than RRSP’s or paying down your mortgage.

  Ed

• 44 Ed Rempel // Feb 18, 2007 at 11:40 pm

  Hi, David,

  Your story of the Whites is interesting, but essentially shows the “Sacred Cow” – the way Canadians normally do it. A fair comparison is not the Blacks to the Whites, but the Whites to the Whites with the SM. I put your numbers into the SM Calculator and the benefit over the first 7 years until the mortgage is paid off is $43,428. The investments are up to $193,428 from $150,000 borrowed over 7 years.

  From that point, the $193,428 would grow to $977,676 over the next 17 years at 10%. The interest cost over the 17 years would be $102,000 (your example assumes prime is 4%) and the tax refunds would be $31,620. The net benefit of adding the SM to the Whites plan over 26years would be $757,296. Of course, the expected benefit will be far higher when you include the benefit during 25 years of retirement.

  You may be right that they might have enough for retirement without the SM. You did not mention their retirement goal, but if it would be the equivalent of 75% of their present income, then they would need $1.5 million at age 65 (assuming they both get maximum OAS and CPP and that they continue to be fully indexed). Since they would only have $1,150,000, they would be somewhat short.

  So, but why not get an extra $757,296 from doing the SM, since it requires no extra cash flow?

  Ed

• 45 David // Feb 19, 2007 at 9:11 pm

  Ed’s comments above refer to my comments in the Book Review post: http://www.canadiancapitalist.com/2006/04/03/book-review-the-smith-manoeuvre

  I believe that if the Whites treat their portfolio in the same fashion as a RRIF (i.e. consume it to zero in their lifetimes) they would only need $725,000 in the portfolio to maintian their income at 75% of their current income until age 100.

  I came into the world without a dollar in my pocket. I’d like to leave having paid the undertaker with my last dollar.

  David

• 46 Ed Rempel // Feb 19, 2007 at 11:06 pm

  Hi, David,

  I did assume the last dollar is used. Inflation is what makes the big difference. If the Whites would want to retire on $75,000 in today’s dollars, they would need $139,522 in 21 years (3% inflation). This number keeps climbing to over $450,000/year at age 100 (same as $75,000 today).

  I assumed an extremely generous $53,000 from CPP & OAS. They still need almost $1.5 million to maintain their lifestyle to age 100.

  Inflation of only 3% means the cost of living is more than 6 times higher during their life.

  A lot of people do a quick calculation of what they would need to retire comfortably, but forget about 60 years of inflation.

  Ed

• 47 Bill // Feb 21, 2007 at 9:35 pm

  hi guys,
  just finished reading all posts and still confused
  Here is my story.
  We still have about $300,000 mortgage on our house and
  about $300,000 mortgage on rental property that is worth now about $ 600,000 and bringing us rental income of $2,800/mo.
  Should I sell my rental property, pay off mortgage on my house and borrow another $600,000 to by another rental property or to invest?
  Or should I use SM?
  Will appreciate any suggestions.
  Thank you.
  Bill

• 48 Tim // Feb 22, 2007 at 1:04 am

  Hello,

  I have read all of the preceeding comments as per the SM. There appears to be a great wealth of knowledge within this forum and I was hoping to seek any advice w.r.t my situation.
  We are planning to build a house (closing October) value $450000. Our current residence has an equity of $80000, and our rental property has $110000 equity. We wish to sell both homes so we can put at least $150000 down(after paying off all other debts) leaving us with a $300000 mortgage. It appears that the SM may be an option to us? Any thoughts, or advice would be greatly apprecaited.

  Thank-you,
  Tim

• 49 Ed Rempel // Feb 23, 2007 at 1:41 am

  Bill,

  Selling and re-buying a rental property will be quite costly. In your situation, you can do 2 things.

  First, you can do 2 SM’s and top them up to 75%. This will double the SM benefit and give you larger tax deductions now to pay down on your home mortgage. While your rental mortgage is deductible against rent, you still create dead equity unused in the rental property that the SM can use.

  We have a client with 5 rental properties that finally realized they would need at least 20 rental properties to be able to support their desired retirement lifestyle. Now they are doing 7 SM’s - home, 5 rentals and a cottage. The results of 7 SM’s can be amazing!

  Second, you can use the “Cash Dam” to make your home mortgage tax deductible more quickly. It is in the SM book. You probably have $20-25,000/year of rental expenses. With the Cash Dam, you can convert $20-25,000 of your home mortgage to tax deductible, in addition to the SM.

  You can pay your gross rent directly onto your home mortgage, and then pay all your rental expenses from a separate credit line. You need a readvanceable mortgage with muliple credit lines for your home mortgage, since the interest for the Cash Dam and SM are claimed on different lines on your tax return.

  Ed

• 50 Ed Rempel // Feb 23, 2007 at 1:56 am

  Hi, Tim,

  Your idea is sound, but what are you really asking? Of course the SM is a good option for you, whether or not you build and whether or not you sell the rental.

  Selling both will give you at least 25% down, which will allow you to both avoid CMHC and give you access to the best SM mortgages.

  Your other option is to keep the rental and put less down on your home. This will of course cost you CMHC fees and limit your SM mortgage options, but would allow you to do 2 SM’s and the Cash Dam.

  The other disadvantage of keeping the rental is that you can limit your borrowing potential for higher leverage in various SM enhancement strategies, which can give you much higher growth than the rental can (without the PITA factor).

  Your idea is probably the best strategy, but I’d have to know all the details of your situation to say for sure.

  Is this what you are really asking, Tim? Or are you doubting the benefits of the SM?

  Ed

• 51 Ed MacDonald // Feb 23, 2007 at 8:54 pm

  I am 2 years into a 5 year mortgage, so a special “SM friendly” mortgage is not in the cards. But my take on this so far (please correct me where I’m wrong) is that the SM-ness seems to be just a layer of discipline around a continuous re-leveraging strategy. If so, I should be able to reap most of the benefits of a SM by taking the money I had earmarked for an RRSP contribution this year and instead paying down the mortgage and establishing a HELOC for investment purposes. The readvanceble mortgage appears to be merely a convenient way to continuously extend my credit as the equity in my home grows. Could I not accomplish the same thing by nagging my bank every month and asking them to extend my HELOC manually? And even given that I would never go to that troublet, it seems the readvancing bit is similar to the bi-weekly mortgage payment in that its effect is simply because you are leveraging more. Looking at it another way, given the same investment vehicle and the same cost of borrowing, the readvancing bit can never make the difference between making money and losing money - it will just be more of either.

  Looking forward to being straightened out on this stuff.

  Ed

• 52 David // Feb 24, 2007 at 12:26 pm

  Ed Macdonald,
  Some banks will allow you to switch to a suitable product with minimal charges and NO penalties. If I understand correctly, the readvancable mortgage forces you to participate in dollar cost averaging, helping to level the ups & downs in the market.

  You might wish to discuss this further on the Red Flag Deals site, which seems to be more of a Q&A space. Ed Rempel mentioned it in the CC Smith Manoeuvre Book review entry on this blog.

  http://www.redflagdeals.com/forums/showthread.php?t=150279&highlight=smith+manoeuvre

  David

• 53 KEH // Feb 27, 2007 at 10:02 pm

  Hi all,

  I am currently considering TSM on my current mortage (in which I have 50% equity) and so this blog has been extremely useful. However, I would like more information on how effective TSM is if you use the mortgage principal re-advancement to invest in rental property rather than a portfolio. I am considering purchasing a rental property and wonder if it would be better to use TSM on my existing home mortgage to put the 50% equity towards the purchase of the rental property (and thus tax deductible interest) or carry out TSM in the normal way to get tax deductible financing for an investment portfolio and then just take out a separate mortgage for the rental property (which will have tax deductible interest anyway). Also, is the interest on a rental mortgage immediately tax deductible from the date of purchasing the property or only from the date you start renting out the property?

  The cost of the current and rental properties are around $300k each.

  Many thanks,

  KEH

• 54 Sandor // Mar 4, 2007 at 12:59 am

  Hi KEH!

  It would not be really any use to say anything about your options unless there are some numbers to support the suggestion. Nobody can responsibly say which would be better whithout the numbers. In fact, you should not even consider anything that is not based on sound calculations. So, why don’t you just calculate the whole thing and make your decision based on that?
  If you have doubts, I will be happy to help.
  Send me a private email and we can discuss it.

  Sandor
  falconaire@sympatico.ca

• 55 Colin // Mar 6, 2007 at 11:33 pm

  Hi all,

  I just read the book over the weekend and the SM with a Cash Dam seems like it could be a real good fit for me. My wife and I are looking at buying our first home later this year and we were thinking about getting a house with a basement appartment to help with the mortgage payments.
  Can you apply the Cash Dam to a basement rental?
  Does having a basement rental mean you will need to pay capital gains when you sell the house later?

  For example, we would be looking at a mortgage of around $2500/ month and could probably get $1100/ month for the basement.

  Thanks for the comments.

• 56 Ed Rempel // Mar 7, 2007 at 1:51 am

  Hi, Colin,

  No reason that Cash Dam won’t work on your basement rental (although it will take some record-keeping, since your expenses are mainly a portion of personal expenses).

  Also, you won’t have to pay capital gains later as long as the portion being rented is a smaller portion of the total and as long as your never claim any depreciation (on the building or improvements).

  Ed

• 57 Paul // Mar 7, 2007 at 3:50 am

  Hi Ed.

  I will refinance 75% of our house under my wife’s name only and she has no income. Will she get the tax refund using SM?

  Can I add my name to the mortgage later after I clear my debt?

  Paul

• 58 Canadian Capitalist » Toronto Star Mention // Mar 7, 2007 at 10:51 am

  [...] The Smith Manoeuvre Debate [...]

• 59 telly // Mar 7, 2007 at 4:07 pm

  I’ve read a little about the Cash Dam method but it seems a bit shady for me. I’d like to know if anyone has been doing this and how they go about preparing their tax forms using this method. It seems to me the CRA would have a problem with this ‘manoeuvre’. I’d like to know if anyone has been questioned on this.

• 60 red997 // Mar 7, 2007 at 10:18 pm

  Hi Colin,I try to explain you.
  You have in your monthly payment principal roughly $700 which you send to Mutual Fund.That will give You (if you’ll add tax refund every year) about $890,000.00 through Smith manouvre calculator.If You add your $1100 every month You’ll have about $2,750,000.00 in your investment portofolio in 25 years.
  Best regards,try.
  red997

• 61 Ed Rempel // Mar 9, 2007 at 2:16 am

  Hi, Paul,

  Even though the house and therefore the mortgage are only in your wife’s name, you can still borrow to invest and claim the interest deduction. Legal ownership and tax ownership can be different. If you borrow and invest from a credit line in your wife’s name, the interest deduction (and any tax on investment gains) is yours.

  Ed

• 62 Ed Rempel // Mar 9, 2007 at 2:34 am

  Hi, Telly,

  The Cash Dam is specifically allowed by CRA in an IT Bulletin, but is often misunderstood. It is NOT an investment strategy. Therefore, the benefits are only tax savings, which means the projected benefits are a lot less than with the Smith Manoeuvre.

  Here is how the Cash Dam works. You have a non-incorporated business or rental property. You use a separate credit line against your home to borrow all the money to pay all the expenses for your business or rental property. Meanwhile, you take the gross income or rent and pay it all down on your mortgage. By doing this, you pay enough principal down on your mortgage so that you can readvance enough in the credit line to pay all the expenses.

  For example, say you are collecting $1,000/month rent on a property and paying $1,000/month in rental expenses. Usually, you use the rent to pay the expenses, but you don’t have to. You can borrow to pay the expenses and that interest will be tax deductible.

  So, you take the $1,000/month rent and pay it down on your mortgage. You then gain $1,000 credit in a credit line that you use to pay the expenses. In doing this, you have converted $1,000 of your mortgage to tax deductible each month. Note this is deductible against the rent, so if you sell the rental property (or close down your business) some day, then that loan is no longer deductible.

  So you see, no investments are involved. It is a simple debt conversion.

  You should use a 2nd credit line for this if you are also doing the Smith Manoeuvre, since the SM interest and the Cash Dam interest are claimed on different lines on your tax return. The Cash Dam does take a bit of work to do properly.

  Remember that the benefits of the Smith Manoeuvre are much greater than the Cash Dam, since they include investment growth and leverage benefits, not just tax benefits. So, if it ever becomes an either/or, go with the SM.

  The really cool thing when you have a rental property is to do 2 Smith Manoeuvres (home and rental) plus the Cash Dam. It’s amazing how quickly your mortgage becomes tax deductible. And 2 SM’s can grow your investments quickly. Our record here is 7 Smith Manoeuvres and 5 Cash Dams with one client! The setup and maintenance of this is quite a bit of work, though.

  Ed

• 63 Wayne // Mar 16, 2007 at 12:14 am

  So in the case where “Joe” has a portfolio of $346K and an investment loan (HELOC) of $321K and Joe decides to sell is portfolio to pay off his HELOC what is Joe’s tax situtation then?

  Also, how does Capital Gains figure into the equation versus regular income tax?

  W.

• 64 Alex // Mar 16, 2007 at 5:00 pm

  After investigating this method, I came to this conclusion (I know that the complete calculations are more intrincated than this, but I think this is a very good starting point):

  This is a nice system for you, if:

  The interest paid for your loan minus your tax income % should be less than your ROI.

  For example if the HELOC interest rate is 6% and you are being taxed at 30%, then:

  The break-even is 4.2%

  Based on that example if you are confident that you can achieve 4.2% in the long run (assuming your HELOC rate will remain the same) then this method would be beneficial for you. Am I missing anything?

  Personally, I think that the potencial earnings do not compensate at all the risk incurred.

• 65 Canadian Capitalist // Mar 16, 2007 at 5:42 pm

  Wayne: In this example, there is no capital gains tax because there are no gains to tax. We’ve assumed 0% gains.

  Alex: The break-even calculation is a bit more complicated because you have to pay tax on any capital gains and dividends generated by your portfolio.

• 66 D.K. // Mar 17, 2007 at 2:55 pm

  Hi Ed
  Thanks for your informative views on
  the Smith Manoeuvre,and leveraging.
  We have a small mortage on our home
  which will be payed off in a couple
  years,would the SM still be useful
  for us.
  We were also shown a strategy in which
  we would borrow up to 75 percent of
  our home equity example 100,000 from
  BANK A and then BANK B would double
  this amount so now we could invest
  300,000 in a income fund which was
  paying 12 percent return of capital.
  We would take those return of capital
  payments an reinvest those back in the
  fund,the bank would now lend you
  double those amounts again,also
  because this is borrowed money to
  invest,we can use the interest amount
  as a tax deduction,he also called this
  The Smith Manoeuvre,is this true an do
  you think this stategy would be wise.
  Thanks D.K.

• 67 Canadian Capitalist // Mar 18, 2007 at 10:02 am

  DK: In my opinion, you should avoid the financial planner who showed this strategy to you like the plague. Think for a moment what he is suggesting: you leverage your equity three to one and invest in some rinky-dink income trust. If the trust falls 33%, your equity would be wiped out. That’s not even the worst case scenario! What is the fund falls 50% or 75%? Are you willing to bet your house on it? I hope not.

• 68 D.K. // Mar 18, 2007 at 9:14 pm

  Thanks CC
  For your advice.We have since spoken
  to our regular financial advisor
  an he has also advised us to walk
  away from this so called tax stategy.
  He told us if we wanted to use some
  of our equity we could borrow from
  our bank at prime,use the fund that
  we invest this money in as our security
  which pays out on a tax preferred
  basis percentage of 5%,so for example
  on 150,000 the return of capitial
  would be 7500.00 the cost of the loan
  would be 12,819 of which 8,556 would
  be interest payed at 6%prime,which is
  tax deductible.So take the return of
  capital of 7500.00 plus the tax refund
  of 3250.00 an pay these on the loan,
  thus leaving us with a after tax
  payment per month of 172.00 leave it
  invested in the fund for the long term.
  CC or Ed does this sound like a good
  investment stategy.D.K.

• 69 Alex // Mar 19, 2007 at 12:58 pm

  CC, you were right, I failed to calculate the tax on capital gains and dividends.
  So as a result, wouldn’t the break even be equal to the loan interest rate?
  If this is true, then your investment rate would have to outperform your loan interest rate throughout the years…wow…

• 70 Ed Rempel // Mar 19, 2007 at 8:22 pm

  Hi D.K.

  Interesting questions. First a couple of questions:

  1. Do you have a readvanceable mortgage?
  2. Is your day to day cash flow okay (sounds like it is)?
  3. What do you plan to do with the amounts you are paying for your mortgage payments once your mortgage is paid off?

  Why not do the Smith Manoeuvre, instead of just leveraging into a ROC fund in either of these options mentioned to you? Your mortgage is small, so you are likely paying down a lot of principal with each payment. If you use this principal payment and readvance them in a readvanceable credit line, you should be able to cover the interest cost on quite a large leverage. Likely, you can cover borrow up to 75% of your home value in the secured credit line with a readvanceable mortgage, plus more from an investment loan and make all the payments by readvancing your principal payment.

  The maximum you can get from this is what we call the “Rempel Maximum”, in which you would leverage the maximum amount that can be paid entirely by readvancing your mortgage principal payment.

  The main problem with these strategies (mainly the first one you mentioned), is that the focus is on the distribution of the fund, instead of the return and risk of the fund. I’ve seen quite a lot of advisors selling this version, which includes a fund from Stone or IA Clarington that I think are crappy funds being sold only because they pay a stupidly high distribution that they can’t possibly maintain.

  The funny thing is that the distribution is often presented as if it is the return of the fund. Note in the fist example you gave, the fund pays a 12% distribution that is reinvested in the fund (this does absolutely nothing) and then then the amount of the distribution is used as collateral to borrow more. At 12% of $300,000, you take $36,000 out of the fund and then put it right back in. If the fund didn’t go up, then your investment is still only worth $300,000. The only thing that matters is the growth of the fund - the distribution is irrelevant. I get a real kick out of these presentations.

  Remember, we need to make a decent return on the investments over time, so you should reject any strategy where the main reason for choosing the investment is because it pays out a high distribution.

  There is a tax risk with ROC funds, since the amount of the investment loan that is deductible is reduced by every dollar of distribution received that is considered ROC - unless all of the distribution is paid on the loan.

  There are some details involved in setting up the Smith Manoeuvre, and I find most advisors don’t want to go to the effort of figuring it out, so they take this shortcut and just do a loan into a fund with a distribution that pays the loan.

  We have set up more than 200 Smith Manoeuvres and we find there are only 2 scenarios where you may want to consider a ROC fund:

  1. You are retired and living off the income from the investment now.
  2. You want to leverage more highly than the SM can do, even with the Rempel Maximum.

  For example, if your mortgage payment pays down $500/month of principal, you can use this to pay the interest on $100,000 (which would be the Rempel Maximum). If for some reason you want to leverage more highly, then you may want to consider a ROC fund.

  If your situation is anything other than these 2 options (which it sounds like it is), then you are better off with the Smith Manoeuvre and choosing investments that are both exceptional based on risk/return and tax-efficient.

  In your situation, D.K., without knowing the numbers, the Smith Manoeuvre or Rempel Maximum should work very well, since you are probably paying a lot of prinicipal with each payment. Once your mortgage is gone in a few years, you can use the same cash flow to pay the investment loan interest, which will be less than your current mortgage and fully deductible. If you invest effectively, tax-efficiently and for the long term, this will build serious wealth for you.

  Ed

• 71 Ed Rempel // Mar 19, 2007 at 8:35 pm

  Hi Alex,

  There are 2 other factors you are missing in your break even analysis:

  1. The different tax treatments - the interest deduction is fully tax deductible each year, while the capital gains are only taxed at 50% and this can be deferred by decades if you have a very tax-efficient investment.

  2. Compounding - If you graph the interest, it is a flat line, since it is the same amount every year. However, the investment growth is compounding.

  When you take all the factors into account, based on a study by Talbot Stevens, the breakeven point after tax is at 2/3 of the loan interest rate after 5 years and 1/2 the interest rate after 15 years. For example, if you borrow at 6%, you need to average 4%/year to break even after 5 years or 3% after 15 years to break even.

  This assumes you have a 100% tax-efficient investment, of which there are quite a few good choices. If you pay any tax on distributions or transactions over the years, you would need a somewhat higher return to cover the extra tax.

  Ed

• 72 joy // Mar 28, 2007 at 1:53 pm

  can anyone explain how the investment return or dividend completely pays the interest on loan,also how much interest the borrower has to pay,is it below prime or prime,I heard that they are giving prime minus o.8% with out any margin call.If anyone knows the good mutual funds which pay good dividend with out the return of capital,please suggest.Many thanks for the people contributed immensely and the wealth of their knowledge,
  Joy

• 73 D.K. // Mar 28, 2007 at 7:55 pm

  Thanks Ed for all your insight into
  all my questions on leveraging,Ed is
  there a list of advisors in different
  provinces who can set-up the S.M.
  Thanks D.K.

• 74 David // Mar 29, 2007 at 10:52 pm

  D.K. asks: “Ed is there a list of advisors in different provinces who can set-up the S.M.”

  Have a look at http://www.smithman.net. There is a list there, and a link to another list at http://www.smfc.com as well. As always, choose well referenced advisors.

  David

• 75 Ed Rempel // Apr 2, 2007 at 1:12 am

  Hi D.K.,

  There is a long list of “advisors” on the smithman site, but you need to be careful. Fraser does not screen the list in any way. Here are a few things to be careful of:

  1. Many are not advisors, but mortgage brokers or real estate agents looking for leads. A mortgage broker may be able to get the mortgage for you (although the best SM mortgages are not available to them), but you need a financial advisor to set up the implementation and the best investments.

  2. Quite a few of our clients told us they contacted someone else from the site that tried to talk them out of it or didn’t seem to know exactly how to implement it. Many of done little or no implementations.

  3. There are also a bunch of advisors recommending ordinary leverage with an investment loan and calling it the SM. The SM involves automatic bi-weekly investmenting from a line of credit linked to the mortgage.

  4. There are also a bunch recommending to have the mutual fund pay out distributions that are paid down on the mortgage. This is what I call the “Reverse Smith Manoeuvre” since it is a process of converting a tax deductible investment loan into a non-deductible loan. There is a tax issue, in that if you take a distribution from the fund and don’t pay 100% of it down on the loan, then part of the loan interest becomes non-deductible. Virtually none of these advisors will do your tax returns and put their name on it, but they still recommend this usually without advising their clients of the tax issue. Ask any advisor to do your tax returns for you. If an advisor is also an accountant, that is a big plus.

  5. Unfortunately for our industry, most of the “financial advisors” are really just mutual fund salespeople or insurance salespeople. We’ve found the SM is best implemented as part of a comprehensive financial plan. When you buy mutual funds from anywhere, you have already paid the full cost of comprehensive financial planning, whether or not you receive it. Insist on the full service and look for a CFP.

  Ed

• 76 2007graduate // Apr 19, 2007 at 5:16 pm

  Hi there — I have only recently came across the SM, and have been reading about it and the ensuing debate over the last few weeks. Unfortunately, I am running out of time for research, as just last night I put down an offer for my first house (which was counter-offered this morning, and now I’m waiting nervously…) And unfortunately the mortgage specialist at my bank has only been on the job for 3 months and is not aware of SM.

  I have been trying unsuccessfully to find a scenario which reflects my current situation, and would appreciate some advice on whether the complexity of implementing the SM is worthwhile in my case.

  I currently have maxed-out RRSPs at 40K, another 30K total in CDN and USD savings accounts and GICs, and no debt. I have been pre-approved for a mortgage of 101K (@5.04%) with 28K down on the 129K property. I am graduating this year with my undergraduate degree and will be continuing with graduate work for the next 2 years. My current savings have come from previous employment, but while at school my income is only ~36K (though I earned 60K while employed full-time), and while I am good at saving money, I am also a novice investor. I expect rental of some rooms of my house to other students will bring in $900 monthly.

  I have read that SM applies primarily to people with a higher income and established equity, so I am unsure if SM would benefit me at this time or if I should wait till I am again employed full-time. If the latter case, what is the best way to approach the mortgage to ensure I can convert to SM in the future.

  Any timely advice is appreciated.

• 77 David // Apr 22, 2007 at 11:12 am

  2007Graduate:
  At the moment, your mortgage is going to be insured (CMHC or other), and most lenders want you to have 75% equity in your home, before offering a secured HELOC. My suggestion is that you take a short term on your mortgage of a year, to build the equity. Within a year, the combination of decreasing principal and increasing home value should put you in position to apply the SM. In the interim, stick to your current plan of maximizing your mortgage payout, possibly by adding some or all of the income from room rentals to your payment. Just don’t forget to allow for lulls in the rental demand during summer, etc.

  The SM will best be applied once you are full-time in the labour force — you will have a number of deductions while you are a student, that will replace the SM. You can apply the SM at this later date without difficulty, as long as you have a suitable mortgage product at the time.

  While waiting, find a suitable banking product, read the book, and select a financial planner, so that you are ready to implement the SM when you are finished your degree.

  David

• 78 David // Apr 22, 2007 at 11:13 am

  2007Graduate:

  Also, have a look at http://www.milliondollarjourney.com for other discussion on this topic.

  David

• 79 joy // Apr 24, 2007 at 12:47 am

  If anyone contributing to this SM discussion ,wants to get the benefit of SM and if you can pay the interest for the borrowing amount,you can do it with a lumpsum amount.You can borrow from $10000 to $250000.The only problem is that the interest rate is prime plus1.25%.you can invest in segregated funds with an average return of 10%plus since 1998.The MER is between 2.5 to 3.75. The return of the growth is calulated after substracting the MER.75 % of the principal is guarenteed at maturity.You can also withdraw 10% without any penality in every year from the segregated funds.You can also do SM through Manuone.If you can put 10% with CMHC insurance,either borrow a lumpsum from the subaccount, if you have the equity,or can use dollar cost averaging.In this case you pay only prime rate for the mortgage aswell as for the subaccount just like a credit line.The beauty of the mauone is that you can pay of the mortgage at any time if you have the money.Any money goes into your account will reduce your principal amount,and you pay only the simple interest at prime for the remaining principal.With a good decipline and by putting the tax returnfrom the investment in to the principal will reduce the principal subsatntially.If you don’t have the decipline don’t even think of this idea.I am an insurance agent,recently I read this SM program while surfing the net,I made my own research and doing it for my clients.I believe now 20% downpayment can get a mortgage without cmhc insurance.Fora long term investment plan,Manuone with a combination of Segregated fund investment I believe is the best way to pay off the mortgage quickly and investment for the retirement.

• 80 Canadian Capitalist // Apr 24, 2007 at 6:36 pm

  joy: It’s hard to invest successfully while paying MER of 2.5% to 3.75%. Many experts think future equity returns will be in the 6%-8% range. Again, 75% principal protection after 10 years is a very poor deal for your money. If I were to do a SM, I would invest in a very low-cost equity fund.

• 81 Sandor // Apr 25, 2007 at 11:17 pm

  Hello CC and Joy!

  I spent the evening listening to Fraser Smith tonight, as he gave a seminar to advisors and their clients.
  I must say, the concept is still as good as ever.
  CC, you are an incorrigible skeptic and I shall not even attempt to persuade you. Joy however, is exactly correct and I can only congratulate you Joy for your summary.
  The problem with you CC is that you are so hung up on the investment side of the matter, that you can’t see the forest for the trees.
  I assure you, that the investment doesn’t matter at all, because you can invest the proceeds in anything you like, including your own business. But no matter how low MER you may have, the risk in equity is still there. The best port folio is a diversified port folio, MER be damned.
  As to what the experts think of future returns that is also immaterial, partly, because those experts had been wrong before and partly because we already calculate the SM at an 8% projected return and it still works beautifully.
  Just as your expert go out on any limb, so will I risk the prediction that in 5-6 years the SM will be just as ordinary method to finance a house as a conventional mortgage is today.
  See you

  Sandor, falconaire@sympatico.ca

• 82 Canadian Capitalist // Apr 26, 2007 at 10:17 am

  Sandor: It is easy for you to say “MER be damned”. Returns are uncertain but costs are. Every basis point that investors pay in fees comes out of their pocket. Here’s my prediction for your clients who are using seg funds to implement their SM. They will be lucky to make 5% overall. Hardly worth the risk in my opinion.

• 83 Shassy63 // Apr 27, 2007 at 7:30 am

  CC and Sandor,

  I think you’re both right. MERs do play a big role in the return that you can expect to get over the LONG run. The fund managers that can produce returns CONSISTENTLY better than the index average are few and far between. I think Sandor had mentioned in earlier posts that Seg funds only charge around 0.2% more in fees than other funds. I have yet to find one (not saying they’re not out there, though).

  I think Sandor is right, though, that the SM isn’t THAT risky of a proposition, as long as you invest half-intelligently. For me, that means a thoughtful approach to tax-efficient index funds and proper asset allocation. “The Intelligent Asset Allocator” by W. Berstein is a good read if you’re so inclined.

  No matter how you package it, the SM is still leveraged investing, albeit at a lower interest cost than most other plans.

• 84 Jeb // Apr 27, 2007 at 1:53 pm

  A most interesting discussion. Many valid points on both sides of the argument.

  I am convinced of the value of the strategy as a whole and especially when considering the mathematics. Investor behavior, the other part of the equation has been touched on briefly and is as important as the numbers. That said, I would encourage everyone who insists on implementing this strategy, to utilize a full service independent planner. I have no problems with the DIY investor, but when you start delving into true financial planning that relies on working knowledge of tax law, it is always best to get professional help. The value of using an advisor also extends to having a detached point of view when decisions are being contemplated out of emotion and not logic (human beings being often irrational and emotion-driven). Disclosure:
  I am a dual licensed CFP.

  I think any discussion of risk needs to include both long-term and short-term. Short-term has been addressed (voliatility) but what about long-term? I would argue, that unless people are really prepared to save 10% annually for retirement, then the greater risk of NOT using a strategy such as this is running out of money during your retirment.

  You can’t have it both ways. You must chose short term-risk or long-term risk (unless as mentioned you will save 10%, then even investments such gold old GICs will get you there).
  The problem is with peoples saving/spending habits, not investment strategies. I would recommend The Richest Man in Babylon (Clason) to all.

  Cheers

• 85 joy // Apr 27, 2007 at 10:08 pm

  Many thanks for the people contributing to SM discussion,some one mentioned that the return of seg fund is only less than 5%for segreagated funds,let me assure you I have invested 25K in segregated fund and the return of that fund since 1998 is above 13%,I invested my client’s RRSP money in segregated funds most of them have a return of above 1o% and the MER is 2.5% ,when I invest my clients money I made sure that it is my money,if any one is planing SM and if you invest in Seg fund ,it is almost 100% guarentied at the same time based on the past performance ,the reurn is above 10% since 1998,I cannot predict the future performance but the past performace is above 10%,if you are skeptical please email I will send the details ‘, my email ID is joyjos@gmail.com,this is not a business pitch just an expression and exchange of details based on my experience and research

• 86 GLEN // Apr 28, 2007 at 11:53 am

  Hi,
  I am new to this disscussion here . It is indeed a very interesting one on both sides. but one thing that i cannot seem to understand is where thet heck do ppl get a mortgage higher than prime?? ( what prime are we talking about ??? bank of canada prime or our local bank prime rates??) working in the industry i have disected this strategy but i cannot seem to figure out how some ppl can say this will work for sure.
  mortgage rates are derived of the bond market which is in turn tied to the short term interest rates set by the bank of canada.
  why would someone take a loan @ prime and pay the interest ??if they have the money to pay the interest just accelerate your mortgage payment. or accumulate funds for a downpayment. the money you put towards the principle will save you a ton for the term.
  also why is everyone in the conversation talking in terms of 25 years????? i dont know any bank offering a steady rate for 25 years with a term of 25years.
  i think ppl need to sit down and speak to their financial service representatives before they try risky stuff.
  what if one year your portfolio did not make any return but instead lost money ?????? if you have the capital and the capacity to borrow more..why not just put the money towards accelerating your payments?
  ppl with a house should not contribute to rrsp’s put that money on the house. the faster you are mortgage free the faster you can max out the accumulated rrsp contribution limit.

• 87 David // Apr 29, 2007 at 1:33 pm

  “I am new to this discusssion here . It is indeed a very interesting one on both sides. but one thing that i cannot seem to understand is where thet heck do ppl get a mortgage higher than prime?? ( what prime are we talking about ??? bank of canada prime or our local bank prime rates??)”

  Bank of Canada Prime is not available to consumers, so we must be speaking about Bank Prime (currently 6%). Lots of mortgages are higher than prime, and many people choose them because they feel more secure with the fixed rates over a term, or, on insured mortgages, the lender requires a fixed term.

  “working in the industry i have disected this strategy but i cannot seem to figure out how some ppl can say this will work for sure. mortgage rates are derived of the bond market which is in turn tied to the short term interest rates set by the bank of canada.why would someone take a loan @ prime and pay the interest ??if they have the money to pay the interest just accelerate your mortgage payment. or accumulate funds for a downpayment. the money you put towards the principle will save you a ton for the term.”

  If you read the book, you will learn how the strategy is proposed to work. The purpose is not to accelerate the mortgage payment, it is to convert the debt of the mortgage to deductible debt. The shortened amortization is a secondary benefit.

  “also why is everyone in the conversation talking in terms of 25 years????? ”

  Because that is the surmise that Smith makes in his postulate. About 30% of Canadians use prepayments. Many ride their 25 year mortgage to it’s end, or even get new 25 year mortgages as they increase their house size.

  “i dont know any bank offering a steady rate for 25 years with a term of 25years.

  http://www.rbcroyalbank.com/RBC:RjTPwI71JsUAAKqgARs/products/mortgages/view_rates.html

  “i think ppl need to sit down and speak to their financial service representatives before they try risky stuff.”

  That is implicit in the discussions, and has not been dissuaded here.

  “what if one year your portfolio did not make any return but instead lost money ?????? if you have the capital and the capacity to borrow more..why not just put the money towards accelerating your payments?”

  Your portfolio is for future, not current expenditures. Since you are in it for the long term, you just buy more investments while the market is low.

  “ppl with a house should not contribute to rrsp’s put that money on the house. the faster you are mortgage free the faster you can max out the accumulated rrsp contribution limit.”

  This topic is not discussing RRSP contributions. It is about a different investment plan. The point is that the earlier you begin investing, the longer your pool of capital has to increase.

  Have a look at the book.

• 88 The Importance of Mutual Fund MERs // Apr 29, 2007 at 10:30 pm

  [...] response to a long-running debate on the merits of the Smith Manoeuvre, a financial planner made the following comment: The best portfolio is a diversified portfolio, MER [...]

• 89 Mike // Apr 29, 2007 at 11:08 pm

  I can’t believe this discussion is still going.

  Sandor - with all due respect if my FA said “MERs be damned” I would fire him for incompetence. How could the costs applied to the fund returns not matter?

  It really appears to me (and I’m not an expert) that the “SM” is a play on leveraged investing with the main goal being that a FA that can sell someone on the concept will get compensation from both the lending side as well as the investment side.

  I really like the idea of leveraged investing using a HELOC but as far as I’m concerned it has nothing to do with my mortgage. If I were to borrow $x from my heloc and make $1000/yr in dividends for example - I can put that $1000 into my mortgage, my rrsp, reinvest in the taxable account, buy a tv etc. Whatever I choose for those dividends is entirely independent of the mortgage.

  The other thing is that in my mind you should be able to manage the risk of your leveraged investments by choosing conservative stocks or funds but most of all by limiting how much you borrow. One of the biggest risks of leveraged investing is the interest rate risk so it’s up to the investor as to how much risk they can handle.

  Maybe I’m wrong but it seems that the SM demands that you leverage up to the amount the bank will approve you for. This seems designed so that over the life of the SM, the investor is either fully borrowed up to the HELOC limit they are approved for or fully leveraged on investments up to that limit (once the mortgage is paid off) or more likely somewhere in between with the mortgage amount owing + leveraged investment loan = HELOC limit which will maximize the compensation for the FA.

  My advice to anyone doing the “SM” is to skip the advisor portion and just do it yourself. Before you borrow anything to buy investments, do some analysis of different interest rate scenarios (including ALL your debt) and make sure that you can handle higher interest rates. If you can’t handle it then don’t borrow so much. Long term equity returns (in the US) were just under 10% in the last century - this was not counting fees so if you are being ripped off by your FA and have 3-4% mer seg funds then you can do the math to figure out your potential return.

• 90 David // Apr 30, 2007 at 10:42 am

  While surfing this weekend, I found yet another commentator on the Smith Manoeuvre: http://www.thefinancialblogger.com/?cat=11

  “The FinancialBlogger.com is a webpage that was created by M35, a company owned by Mikael Heroux and Pierre Cantin. Both have graduated in finance and are now working in two separate fields. While Pierre is working in the investment field, Mikael has more specialised in the debt sector as well as the area of personal finances.”

• 91 Keith // May 9, 2007 at 9:58 pm

  If I am to impliment the SM, How would a rental unit in my basement factor in? Seeing as how a portion of my mortgage interest is already deductable but this only applies to the rental income, I cant classify this as a loss to my personal income (even though it is after depreciation). I use the rental income to max. RRSP and pay down mortgage principle. Will SM benefit me further or be a waste of time… and how? Thanks

• 92 David // May 13, 2007 at 6:40 pm

  It strikes me that you would handle the two seperately. The deduction of expenses against income for the rental is one process, and the additional steps you take with the Smith Manoeuvre are in addition. If you look at your rental as a business, and the SM as a personal finance option, you may be better able to separate the two ideas.

• 93 falconaire@sympatico.ca: Sandor // May 24, 2007 at 10:14 pm

  Hello and let me direct my answer to Mike, the author of #89.

  “Sandor - with all due respect if my FA said “MERs be damned” I would fire him for incompetence. How could the costs applied to the fund returns not matter?”

  You see, the MER has little to do with returns. There are funds with high MERs and low returns as well as funds with high returns and low MERs. Since the results of the funds are net of the MER, you may do very well while paying high MER.
  Would I pay high MER by choice? Of course not. As long as two funds are bringing the same results, I would choose the lower MER however, wouldn’t hesitate to pay the higher for a spectacular performance. So, don’t fire me just yet, my funds are around 20%, my MER is 2.45, that is not bad. Is it?

  —————-

  ” If I were to borrow $x from my heloc and make $1000/yr in dividends for example - I can put that $1000 into my mortgage, my rrsp, reinvest in the taxable account, buy a tv etc. Whatever I choose for those dividends is entirely independent of the mortgage.”

  Well, this is what that would do to you:
  If you put it into RRSP you will pay tax on it later, and pay the interest now as well.
  If you invest it in a taxable investment then you again pay both interest and tax on the gains.
  If you buy a TV you pay tax, you will pay interest and get no return, except the lousy Tv programs.
  Although all those would be indeed independent of the mortgage. Big deal.
  If however you put it into the SM while you will pay interest, your mortgage will diminish rapidly, so you will save interest cost. Your investments will grow as rapidly as your mortgage will decrease. You will also be able to deduct from your taxes the interest and the resulting tax refund can also go into your investments, further boosting the results.
  By the time your house is paid off you will also make a profit.

  ——————–

  “My advice to anyone doing the “SM” is to skip the advisor portion and just do it yourself. Before you borrow anything to buy investments, do some analysis of different interest rate scenarios (including ALL your debt) and make sure that you can handle higher interest rates. If you can’t handle it then don’t borrow so much. Long term equity returns (in the US) were just under 10% in the last century - this was not counting fees so if you are being ripped off by your FA and have 3-4% mer seg funds then you can do the math to figure out your potential return.”

  This is really bad advise for those who, like you, don’t understand the concept and are too lazy to read the book. When an advisor is paid, in return he takes responsibility for the whole thing and doesn’t let you do silly things, like borrowing up to your limit.
  Those historical returns were net of MERs, therefore, your advisor cannot rip you off. Particularly not since the trailer fees are 0.5% of the portfolio yearly, which also comes out of the MER, so