The Smith Manoeuvre is a strategy that allows Canadian home owners to convert their mortgage into a tax deductible investment. It’s often referred to as the Canadian Tax Deductible Mortgage. South of the border, our American friends benefit from having the interest on their mortgage as tax deductible where as in Canada, none of those benefits exist.
The interest paid on our mortgage is paid with after-tax income. The Smith Manoeuvre found a way to convert the biggest debt individual would take over a lifetime into a tax-deductible investment. The first time I read that, I was ready to jump with both feet but once I understood the process, I was a little reluctant due to the cash flow requirements.
I realized that while it’s a good thing to get tax credit wherever possible, the cash flow needs to be really thought through. As a result, I started thinking about when it would make sense to start it.
- Is it for everyone? I don’t think so. You need a strong debt servicing ability which means a strong dependable income.
- Should you start right away when you buy your home? I don’t believe you should. Manage your initial mortgage term and plan your cash flow first. There will be many changes in your cash flow in the first few years that you should focus on.
Mortgage vs The Smith Manoeuvre
The common point between a mortgage and the Smith Manoeuvre is the debt factor. They both allow you to manage your debt. They differ in the debt servicing model and the end benefits.
With a mortgage, you make your payments and over time, the ratio between the principal and interest changes. You pay a lot of the interest up front, unfortunately that’s jut the way it is, lenders pay themselves first. The only way to reduce the interest is by either getting a better rate or increasing your payments.
With the Smith Manoeuvre, you make your payments and borrow from the principal paid to create a tax deductible loan for investments. The interest on the investment loan is serviced by the line of credit (also referred to as a Home Equity Line of Credit or HELOC).
Your HELOC ends up growing on its own while the payments on the mortgage are fixed since you still have to pay for the interest on the HELOC. Your debt level doesn’t really decrease as you are simply moving money from one asset (your home) to another (investment portfolio). The idea is that the growth and dividend earned offset the interest you pay on the HELOC after the tax deduction.
What you end up with is the following:
- A home fully paid (blue columns below).
- A loan of equal value to your initial mortgage that must now be paid (green columns below).
- An investment portfolio that should be worth at least 3 times your initial mortgage amount if properly invested. Have a look at my TFSA investment performance to get an idea.
Below are the numbers for a Smith Manoeuvre with a $400,000 mortgage @ 1.97% for 25 years.wpDataTable with provided ID not found!
On paper, you should have significantly increased your net worth but in practice, you still have a large loan that must be paid and since it’s a HELOC, your home is still a collateral. While you may be mortgage free, you still have shackles from the financial institution as long as you owe money on the HELOC.
In the end, your success with the Smith Manoeuvre will depends on your investing capabilties as you essentially borrow to invest. So ask yourself the question, are you comfortable borrowing money to invest? Do you trust your investing skills with provide you with a return higher than the cost of the loan?
There are 2 components to the Smith Manoeuvre where the first part converts a loan into a tax-deductible loan and the second you invest the money from that tax-deductible loan. With interest rates at near 0%, you have no choice but to invest to generate a return.
The interest on a mortgage is not tax deductible but once you convert the equity from your principal payments into an investment loan, the interest on the investment loan becomes tax deductible as long as the investments meet the requirements (income producing investments). Make sure you run the math, the higher your taxes, the more you save in this case. It requires diligence to see the benefits through.
The Smith Manoeuvre Is All About Your Investment Skills
Your ability to handle the Smith Manoeuvre is going to be about your ability to handle debt since it’s all about leverage. What the Smith Manoeuvre ends up doing is leveraging your home equity to invest.
Personally, I wasn’t ready to start the Smith Manoeuvre when I took the mortgage on the house. I was not comfortable with the debt level I would have needed to carry. My plan was to reduce my mortgage in order to assess the ability to execute the Smith Manoeuvre at a later time.
Smith Manoeuvre – Mortgage Safety Ratio
The safety ratio is simply the ratio where you feel comfortable with your debt level. If you worry about losing your job and making payments, you should not start the Smith Manoeuvre.
If you have a stable job, a bit of money saved, a paid vehicle and no other debt then your mortgage, than you are in a good position to consider the Smith Manoeuvre investment strategy.
Success with the Smith Manoeuvre
The Smith Manoeuvre doesn’t reduce debt initially and ads risk in my view. Be sure to be in the best financial position to execute the strategy. Just like an emergency fund, paying your mortgage first provides a type of safety in the event that your income will change.
An emergency fund will help during unemployment but you might still have to adjust. Rather than be faced with downsizing, if you had made extra payments, you can extend the amortization because you were ahead.
Not all HELOC can work either if you try to do it on your own as you need a re-advancable HELOC to avoid paying the interest from your income from your cashflow. A re-advancable HELOC allows you to accumulate the interest within the HELOC.
Another important consideration is the money flow. You need to be able to show and prove the money flow so be diligent about the investment accounts you are going to use in case of auditing. You don’t want to mix the accounts with your normal accounts. I would go so far as to recommend a new discount broker such as Questrade for your investments.
My strategy so far has been to accelerate my mortgage and also invest in my TFSA, RRSP and RESP.