This post will be the first interview for the Frugal North! I’m very excited about this one as I think it’s an important topic to discuss for the Canadian FI community.
I had the great pleasure to ask Robinson Smith a few questions about the Smith Manoeuvre (a topic I touched on here) which is a method to create tax deductibility on your mortgage and pay off that loan sooner. For those who don’t know, Rob is the son of Fraser Smith who invented the Smith Manoeuvre. Rob is now the President over at Smith Consulting Ltd and spreading the good word on this more advanced topic for the Canadian community.
Below are a series of questions I asked Rob who graciously responded with some great content. Check it out below:
What is the Smith Manoeuvre and why would home owners use it?
The Smith Manoeuvre is a financial strategy available to Canadian homeowners to help build themselves out of the heavy financial hole in which their mortgage has placed them. It is a way for them to make their mortgage work to their financial advantage to help ensure that they enjoy the comfortable, relaxed retirement they deserve, spending time with the grandkids or on the golf course rather than face the prospect of working at a big box store or fast food restaurant in their golden years due to insufficient income.
It is a creative, legal strategy which causes the Canada Revenue Agency to send you tax refunds each year which enables the homeowner to eliminate their expensive mortgage well in advance of when they would be able to if they were to simply go on paying it off as per conventional practice.
Simultaneously, they will begin investing meaningful amounts for their retirement on a monthly basis whereas otherwise there would simply not be any (or as much) funds to do so.
As for why they would implement The Smith Manoeuvre, we don’t have to look much further than the origin of the word ‘mortgage’ to get a hint of the answer: the word ‘mortgage’ originates from Latin (‘mortuus’, meaning ‘death’) and French (‘gage’, meaning ‘pledge’). So ‘Mortgage’ translates to ‘Death Pledge’. And it certainly can feel this way: as an example, if we look at someone at a 40% tax rate who has a $400,000 mortgage at 3.99% for 25 years and calculate how much that homeowner has to earn to pay it off, we get some scary figures. Firstly, they have to obviously pay the $400,000 back. But they also have to pay interest -in this case just over $192,000. So we’re up to a total of just over $592,000. But before the homeowner can make the mortgage payment each month, he or she first must pay tax – a total of about $395,000 over the course of the mortgage, actually. So one must earn just under $987,000 in order to repay that $400,000 mortgage loan. That’s a lot of hours at the office.
And it is conventional practice in Canada to focus on first paying out the mortgage and only once we have no more mortgage payment, we can start to invest for our retirement. But if it takes 25 years to get rid of the mortgage before we are able to start saving, then we have missed out on 25 years of compound growth – and at 8% growth, if we were able to invest $1,000 per month, we would end up with almost $916,000 in an investment portfolio right at the time we would normally be lear title with $0 in savings. So it is a very expensive prospect to forego investing for retirement because you are focussing on paying out the mortgage. That being said, most Canadians don’t have any option but to approach their finances this way considering life’s expenses – if we are paying more in taxes than food, clothing and shelter combined, we don’t have any option but to focus on the mortgage first and forego investment. But The Smith Manoeuvre allows the homeowner to focus on both goals – the mortgage and retirement – simultaneously, starting now. And there are a number of very effective accelerators which can move the process along even quicker.
Canadian homeowners are paying more in taxes than they need to, they are taking longer to rid themselves of expensive mortgage debt than they need to, and they are unable to invest as much for their retirement security as they need to. The Smith Manoeuvre attacks all of these issues immediately.
What types of products / investment vehicles would home owners need to execute the SM? A HELOC? What about a readvanceable mortgage?
A readvanceable mortgage is different than just putting a straight HELOC in second position behind the principal-plus-interest amortizing mortgage loan you may already have. And this type of mortgage is essential because we want the line of credit limit to increase dollar for dollar as the principal balance of the mortgage decreases due to the regular mortgage payment and any accelerators. A HELOC itself is not sufficient because a HELOC gets approved for a total limit and that limit doesn’t increase without re-applying, which is expensive and clunky. Many banks offer readvanceables but not all are created equal – some are high-maintenance and restrictive. Some are certainly better than others when talking about functionality. We can help firstname.lastname@example.org.
As for the monthly investment component, we want to invest only in a non-registered account in order to generate tax deductions which will help us get rid of the mortgage quickly. This is because interest on money borrowed to invest into registered accounts or TFSA’s is not tax deductible and therefore there would be no refunds or debt conversion process taking place.
Also, it’s important that the bank accounts linked to the mortgage for payment (and prepayments) and withdrawals are set up correctly for clear tracing of the use of line of credit funds and ensuring no pollution of the two types of debt – non-deductible and deductible.
The minimum amount of equity that a homeowner requires in order to implement The Smith Manoeuvre is 20% because while some more conventional mortgages will allow a higher total loan, readvanceable mortgages will only be offered with a minimum of 20% equity.
A number of years back the government changed the rules as regards secured interest-only lines of credit and this applies to readvanceable mortgages as well. The total limit for a secured line decreased from 80% to 65% of the appraised value of the home. So while an amortizing loan of a readvanceable mortgage can go up to 80%, the interest-only line of credit can only go up to 65%. And again, the type of readvanceable mortgage you procure is very important because a readvanceable from one lender may restrict you from implementing The Smith Manoeuvre until you have 35% equity rather than just 20% equity, but a readvanceable from another lender may enable you to structure the debt such that you can begin the conversion process immediately and therefore not have to delay the creation of wealth. There are a few strategies for dealing with this 65% LOC-limit rule, but we know them all.
As regards to how much equity would be safe or appropriate fo the homeowner to use, we always recommend this be determined with the help of a professional advisor (mortgage broker or investment advisor) considering everybody’s situation is unique.
One thing we have had a bit of discussion about is whether The Smith Manoeuvre does actually involve leverage at all. It’s a minor discussion in the grand scheme of things but we contend that there is no leverage. The ‘leverage’ occurred as soon as the homeowner went out and got their mortgage when they bought their house. That’s when the leverage/borrowing occurred. And a homeowner implementing The Smith Manoeuvre is not increasing their debt, they are simply converting it from non-deductible to deductible. If I can access $1,000 of funds on the line of credit which I will invest only after the non-deductible mortgage debt has been reduced by $1,000, there is no additional borrowing, therefore no leverage occurs.
As for the investment strategy, that is entirely up to the homeowner, preferably in consultation with their investment advisor. As far as what they can invest in – stocks, bonds, mutual funds, ETF’s, investment real estate, their business, somebody else’s business – there is a wide variety of qualified investments that the government will recognize as eligible for interest deductions on any money that was borrowed to invest in the asset. That being said, the rule is that you must invest with the expectation of generating income. So gold bullion and raw land, which are pure capital gains plays, for instance, would not qualify. We always recommend the homeowner discuss their goals and determine their risk tolerance and objectives with a professional advisor.
As regards to the ‘benchmark’ rate a homeowner needs to beat, there is much confusion out there. The myth is that if their rate on the line of credit is 5% then the investments must return at least 5% to break even. This is not the case considering the tax deductions and the nature of taxation on the assets. The fact is that if someone is at a 40% tax rate, and if their line of credit rate is 5%, then the real rate they are paying for that money is only 3% because they get some of that money back at tax time.
Further, due to the increasing efficiency of the regular mortgage payment, no new money is required from the homeowner in order to service the monthly interest on the line of credit (this is explained further in the last FAQ on our website). And so if the increasing efficiency of the mortgage payment is taking care of all the monthly line of credit interest expense, then you don’t need to – either from personal cash flow or from income from your investments. So when the markets dip and you are earning less than the aforementioned 3% real rate of interest, you can ride it out because you are in no way reliant on investment income to continue to operate the strategy.
Talbot Stevens put out a great booklet a number of years ago, “Dispelling the Myths of Borrowing to Invest”. I suggest your readers pick up a copy. It’s an easy and informative read and concisely explains other reasons why your benchmark return is much less than your nominal rate of interest.
The Smith Manoeuvre functions to the advantage of the homeowner even when rates can be historically on the high side. The Smithman Calculator available from our website (CD only at this time – web-based coming soon) allows the homeowner to input any variables they wish as regards mortgage balance and rates, LOC rates, investment growth rate, etc. Playing around with the variables will show you that for someone at the 40% tax rate with a $400,000 mortgage amortized over 25 years is ahead even if the mortgage and line of credit rates are both 9% with an investment growth rate of only 5% (not accounting for taxation).
Different rates for both the loan and line of credit portion of the readvanceable mortgage and different growth rates will affect the results one way or another but you can run scenarios all day long on the calculator and find out if what makes sense for you as regards various rates. My father, Fraser, developed The Smith Manoeuvre strategy and started putting clients into it in the mid-80’s when lending rates were in the double digits and the program was still profitable for clients.
We discussed interest rates above – we know they will go up for certain. But they will also go down for certain. Same with the markets – up and down they go, and it has been ever thus. The beauty of The Smith Manoeuvre is that it is such a long-term investment program, typically till death, that the rate risk and market risk curves flatten out considerably indeed. A good financial advisor will help you navigate and mitigate these risks.
There is also regulatory risk which is the fact that the government could change the rules at any time; for example, they could disallow tax deductions on money borrowed to invest (however unlikely that may be). But if we look at typical results from the Smithman Calculator, we see that about one-third of the benefit from implementing The Smith Manoeuvre comes from interest deductibility and about two-thirds of the benefit comes from simply owning your investments sooner. So even if we couldn’t deduct interest, we would still choose to continue with the strategy.
A big risk is emotional risk – that whereby the investor starts to get in his own way, buying high and selling low. Again, while it is human nature to act in direct opposition to your long-term financial goals (people tend to buy high when there’s lots of positive market hype and sell low when there’s lots of negative market hype), a good financial advisor will help you through. Plot an investment course and stick with it.
Perhaps the biggest risk, however, is complacency – not doing anything at all. We know that if we don’t invest when it’s possible to do so we are voluntarily missing out on the magic of compound growth. And in fact we are losing to inflation – if my money is earning zero percent and inflation is running 2.5%, I am losing 2.5% per year. And that gets terribly expensive. And having all that equity in your house – and more of it each and every month – earning you zero percent is doing nothing for you. We may feel ‘safe’ if we do nothing at all, and indeed we are ‘safe’ – safely losing money.
Firstly, do your homework and read the book. It will show you how implementing The Smith Manoeuvre can add hundreds of thousands to your net worth over time – for example, a typical $350,000 mortgage at current rates and reasonable investment growth projections can improve a family’s net worth by between $350,000 and $400,000; and with use of the accelerators, this can be greatly improved.
I would invite your readers to visit www.smithman.net. There you can buy the book and learn some more. Or if you don’t want to buy the book, go check it out from your local library or maybe your friend or colleague owns a copy. We can always be reached at email@example.com if you would like to be put on the list for our quarterly newsletter or if you are looking for a mortgage professional familiar with The Smith Manoeuvre to look into a readvanceable mortgage. We have contacts with hundreds of brokers across Canada (no cost to the homeowner) and it is imperative that you are set up by someone who is knowledgeable with the particulars of The Smith Manoeuvre as, if it’s done improperly, you could wind up with some complications you don’t want, but if done right, it will pretty much run itself.