Reader’s Question #8

Yesterday I got a question from our long time commenter Will, on a topic I have yet to really touch on.

Q: I was wondering if you’ve heard of the Smith Manoeuvre and, if so, what your thoughts on it were.

A: Yes I’ve heard of the Smith Manoeuvre. For those who are not so familiar let me do a short review of the basics involved. The Smith Manoeuver is a Canadian thing on changing out your non tax deductible mortgage interest debt into a debt that is tax deductible. For US readers: in Canada we can’t deduct our mortgage interest on our taxes (in exchange we have no capital gains on our primary residence when we sell), but we are allowed to deduct interest on loans used for investments.

So the idea is as follows. You take your mortgage and make sure you get a line of credit that is linked to it. Depending on your bank they will call it something else, for example Scotiabank calls it a STEP plan. Then you pay down your mortgage as fast as possible, after you reach the point where you can pull out equity from the line of credit (typically this is at least 10% of your home value or more depending on what terms you get when applying). Then you take the money out and invest it in a taxable account and write off the interest on your taxes (Note: you can NOT invest the money in a RRSP as that loan interest would not be tax deductible). You keep doing this until you end up with a large line of credit balance that used to be your mortgage which you can write off the interest on. You also end up with a sizable investment account. The theory is with making your loan tax deductible and having a investment account you will be further ahead that a standard mortgage.

In theory this is a good idea. The issue of course is your are really leveraging yourself out hugely which means your really going to magnify your returns or your losses in the market. This also only really works well if your going to do it for an extended period of time (10 years +).  For me personally, I would think that could be a bit too much risk. Why? I don’t have the correct personality to take on $100,000+ of leveraged investments. I know I would worry about them going down and potentially do something stupid.

Instead, in my case, I would be willing to do a small Smith Manoeuvre of around $10,000 to give it a try. I would suggest doing your homework on this to make sure you completely understand what you are doing and ensure the CRA (Canada Revenue Agency aka: our version of the IRS) does not come back at you with questions. I’m personally very close to be able to do this myself since I almost have 25% of my original house value paid off which was the agreement I made with my line of credit on my mortgage. Yet you should be aware that the government changed the rules on mortgages and you can now easily do this at the 20% level as well since that is now the limit to avoid CMHC fees.  I would likely buy several dividend paying blue chip stocks to provide some low taxation income to pay off the interest on the investment loan.

That’s my thoughts on it all. Has anyone given this a try?  If so what are your thoughts on it?

17 thoughts on “Reader’s Question #8”

  1. I haven’t done it yet (I don’t own a principal residence), but I intend to once I do. Like Mike said, you don’t HAVE to borrow out to the maximum if you’re worried about being too leveraged, and if you already have investments, if you sold them, paid down your mortgage, then bought back something similar, you aren’t anymore leveraged (you just changed the situation from having an all-non-deductible mortage to partially deductible mortgage, probably at a higher interest rate).

  2. Just an fyi…Americans do not pay capital gains on their primary residence when they sell either – I believe up to $250k for a single owner or $500k for a couple.

  3. I think my biggest concern with this manoeuvre would be interest rates. If interest rates continue up, can this still be a viable method to increase walth? I can’t see how one could cover borrowing costs at say 9%.

  4. I have my doubts about whether SM is all that it is made out to be. Keep in mind that SM is simply a leveraging strategy and leveraging has been around for a long time and given a lot of grief to a lot of people. Leverage is a bit like fire. You can cook your dinner but also burn down your house; so it’s best to be very careful with it.

  5. CC: like a lot of things, it’s all in the assumptions. As long as the markets do well and interest rates stay level, then the SM is great, but if we go into an extended bear market then it will be a huge mistake (along with any other kind of leveraged investment).

    Telly – according to my analysis, the two main factors for the success of a leveraged portfolio of dividend stocks are 1 – the rate of increase of the dividends and 2 – interest rates. Simply put the higher the interest rates, the less profitable the plan will be. That’s one of the risks.


  6. SM is not leveraged investing, from the definition that I am familiar with. You maintain the same amount of debt pre and post SM.

    Numbers used to make the math easy, not be realistic. 😀

    Mortgage debt: -$100k
    Non-registered investment account: $100k
    Home LOC: $0

    Mortgage debt: 0
    Non-registered investment account: $100k
    Home LOC: -$100k

    The problem is that most people don’t have a large non-registered account they can use to pay off their mortgage with. In this case, it is done slowly, but you *never* increase your debt level beyond your original mortgage.

    There is no additional risk.

  7. I’ve been doing the SM since Jan07. A couple of points:
    – it is “leverage” to the extent that a mortgage is leverage as well.
    – “with great power comes great responsibility”. There’s a lot more freedom with a LoC than a mortgage, so be careful to NOT use the LoC for anything that is not investment related (no home theaters, no fancy vacations, etc…). Not only it is a bad idea financially, but any interest for that cannot be deducted at tax time.

    There’s a TON of information on it on the web and I recommend people to look at Millionaire Journey’s research as well as long thread on RedFlagDeals. You do NOT want to get into this unprepared, trust me…

  8. Alex, I don’t think your view is all that accurate.

    With a normal mortgage, your debt amount goes down over time and your interest rate risk goes down with it. With a SM, the debt level stays the same over time so clearly with the SM you will eventually have more debt than with a normal mortgage. It’s only the first month where the amount of debt is the same.

    This is one of the fallacies that financial advisors will tell you.

    Another thing is that I’ve seen some advisors recommend getting your house re-appraised occasionally in order to increase the amount that can be borrowed which obviously increases the debt from the original mortgage amount.

    I will say however that the interest rate risk is lower with the leveraged debt (and yes, it is leveraged) since you can write off a portion of it. But this investment debt is still obviously riskier than no investment debt so to say there is no extra risk is simply not true.


  9. Wow.. great discussion. Thanks for the post CD! I had browsed through the thread on RFD and been directed to SM information over the past 6-12 months. It’s a concept that appeals to me, though I know I need to do a lot more research to make sure it applies to me. At this stage, my wife and I are in the process of buying and selling primary residences. Whether we will continue after completion of our next house (~Feb. ’08) is yet to be determined. Given the HELOC involvement, I certainly want to be in a “long-term” residence prior to moving forward with the SM (assuming I attempt it).

    The approach I like the best is to elect a government that wil make our mortagge interest tax deductible! Anyone willing to place any bets? 😉

    Thanks for the discussion and please continue. It provides much more insight than I could glean from individual research.

  10. Will said, “The approach I like the best is to elect a government that wil make our mortagge interest tax deductible! Anyone willing to place any bets? ”

    Actually, I hope we no one ever does! To me this just encourages never paying off your mortgage and holding on to too much debt (see your neighbours down south).

    Fernando said, “You do NOT want to get into this unprepared, trust me…”

    Could you elaborate? It sounds like you might have an interesting viewpoint on this.

  11. Mike P & Mike,

    Thanks for the links. I was trying to recall who had those posts when I sat down to write this.


    Thanks for the US numbers. I knew there was an amount they can avoid tax on, but I could not recall where I found that information.


    I love the comparison to fire. Thanks.


    Great to hear feedback from someone who has actually done it! I was trying to get that point across in the post. You don’t want to get into an SM without knowing a lot of information about it.


    Thanks for the topic. It looks like you got some great feedback on it all. I think the government is just as likely to give us tax deductions on our mortgage interest as income splitting. It’s a dream and nothing more.


  12. Telly..

    We’re already there.. with the CHMC insuring 40 year ammortizations and mortgages like the Scotiabank “zero-down” vehicle, people WILL never pay off their mortgage. While tax deductible interest could be a temptation to some, it would also help those of us trying to pay things down a little quicker as well.

  13. Like always…an excellent post!

    I’m currently reading the SM book and continue to be impressed with the concept.

    I have made several posts so far on my thoughts about the SM and expect to write more on the subject.

    I agree that the debt remains larger but it is not as risky as having a larger debt on one’s principle residence.

    To a degree, inflation will actually make the original debt decrease over time relative to wage rates and the cost of other goods. $100,000 today is not the same as $100,000 15 years from now.

    My SM post of Sept 2, 2007 ends with a few ideas for a SM emergency plan to implement when things get tough.

    I also agree that for many people, the SM might be a bad idea. Worse case scenario…leverage bigtime into the stocks like Nortel, just before the Nasdaq crash in 2000!

    Now all I need is a way to get money out of an RRSP and avoid paying those pesky taxes!

    Still learning.

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