The Smith Manoeuvre is a Canadian financial strategy that transforms your mortgage interest into a tax-deductible expense, helping you pay off your mortgage faster while building investment wealth. Developed by financial planner Fraser Smith in the 1980s and detailed in his 2002 book, “The Smith Manoeuvre,” this approach offers Canadians tax advantages similar to those available in the U.S.
Benefits of Implementing the Smith Manoeuvre
- Tax Deductibility: Converts mortgage interest into a tax-deductible expense, potentially reducing your taxable income.
- Accelerated Mortgage Repayment: By applying tax refunds and investment returns to your mortgage, you can pay it off faster.
- Wealth Accumulation: Builds an investment portfolio over time, enhancing your financial future.
Risks and Considerations of Implementing the Smith Manoeuvre
- Investment Risk: Investments can fluctuate in value, and there’s potential for loss.
- Interest Rate Fluctuations: Variable HELOC rates can affect interest costs.
- Discipline Required: Requires strict financial management and adherence to the strategy. This is the biggest risk from what I’ve personally seen. The Smith Maneouvre is an active mortgage and investing strategy. It only takes a small amount of time per month BUT you do need to be somewhat proactive with your mortgage and finances.
How the Smith Maneouvre Works
Fundamental Concepts
There are 2 fundamental concepts to know when it comes to the Smith Manoeuvre:
- Interest on investment loans and lines of credit are tax deductible
- A re-advanceable mortgage is a combined mortgage and Home Equity Line of Credit (HELOC) where the HELOC limit grows as you pay down your mortgage
Interest on investment loans and lines of credit are tax deductible
First, let’s pretend your marginal tax rate is 30%.
You open up a $20,000 line of credit with an interest rate of 5%.
You then use the funds from the line of credit to invest in a stock that pays dividends.
When you’re doing your taxes, the CRA charges taxes on your taxable income.
Because you’re using those funds to invest, you can reduce your taxable income by the interest cost.
In our case the interest is 5% of $20,000 = $1,000.
By reducing the taxable income by $1,000, you will get a tax reimbursement of $300. (Your marginal tax rate times the reduced taxable income: 30% of $1,000).
If we rearrange this we can come up with a simpler concept: net interest.
Net interest is the loans real interest (5%) minus the marginal portion of the loans interest (30% of 5% = 1.50%). In this scenario, the net interest is 3.50% (5% – 1.5% = 3.5%).
Side note: you want to find investments such that your net return (after taxes) is greater than this net interest number.
A re-advanceable mortgage is a combined mortgage and Home Equity Line of Credit (HELOC) where the HELOC limit grows as you pay down your mortgage
I will start with the basics to make sure we’re on the same page.
When you get a mortgage, you are getting something called an Amortized Loan. This essentially means any time you make a payment, you are putting some money towards paying down the mortgage (this is called your principal portion) and the remainder of the money goes to the lender (this is the interest portion). The amount that goes to your principal vs interest is determined by a math concept call your amortization.
When you get a Home Equity Line of Credit (HELOC) you are getting an interest only line of credit. Your payments are entirely interest. You can take money from the HELOC at anytime, and pay it back at anytime, without penalty.
When you get a re-advanceable mortgage, you are getting a product that has both of these types of loans (mortgage and HELOC). The re-advancing feature gives you the ability to automatically increase the HELOC limit every time you make a payment to the mortgage balance (aka principal payment).
For example, let’s say your mortgage payment is $2,000.
In this example, your mortgage payment is broken down based on your amortization as:
- Principal portion: $500
- Interest portion: $1,500
So you pay the bank $1,500 in interest while the $500 goes toward paying the mortgage down.
When the $500 is put toward the mortgage balance, the HELOC limit also increases. To keep it simple we will assume it goes up $1 for every $1 in principal payment. (side note, this changed slightly due to regulations in March 2022 but I won’t cover it here)
This allows you to have access to the $500 when ever you want it, even though it originally went towards paying down the mortgage.
How the Basic Tax Deductible Mortgage Strategy (Smith Manoeuvre) Work
When you get a re-advanceable mortgage on your personal residence, you can borrow from the HELOC to invest. (see Fundamental Concept 2: Re-advanceable Mortgage)
That investment will give you some sort of investment return.
You can take those returns and make extra payments to your mortgage. This will accelerate the paydown of your mortgage. You’ll be making your regularly scheduled payments, along with these extra investment income payments.
When you do this 2 things will happen:
- Since you’ve paid the mortgage down even more, you will end up paying less interest on that portion of the mortgage. This is because interest cost is calculated as the interest rate times the mortgage balance. Your mortgage balance is now lower, thus you will pay less interest.
- Because this is a re-advancing mortgage, every payment you make will increase the amount available on the HELOC.
With the increased limit on the HELOC, you can now access more funds to invest more.
This increased investment will give you more investment return.
Every year, at tax time, you will receive a tax reimbursement for the interest paid (see Fundamental Concept 1: Interest on investment loans and lines of credit are tax deductible)
As time progresses 3 things will happen:
- Your Non-deductible Mortgage will decrease
- Your Deductible HELOC will increase
- Your investment portfolio will increase
The standard strategy says that once the non-deductible mortgage is paid down to zero, you will have a large HELOC balance. You can then pay off the HELOC balance with the investments you’ve accumulated. Which in theory would have gone up over time.
This would leave you with a home with no mortgage on it and an investment portfolio in a fraction of the time you otherwise would have taken to pay the mortgage to zero.
An Example of the Basic Smith Manoeuvre
John has a home worth $1,000,000. He has a mortgage of $600,000 and a HELOC of $200,000. His mortgage rate is 5% and payments are $3,500. His HELOC rate is 5.45%.
When it comes to investments, he has access to investments that would give him 8% return on investment.
His current marginal tax rate is 30%.
Step 1: John borrows the $200,000 from the HELOC and invests it as 8%.
Step 2: John receives the investment income. It’s $1,333.33 / mo ($200,000 * 8% / 12 months)
Step 3: John adds this amount to his regular mortgage payment.
His regular mortgage payment would be broken down as:
- Interest Portion: $2,500
- Principal Portion: $1,000
When we add the investment income directly to the principal portion, John’s total mortgage pay down would be $2,333.33 for this month.
His mortgage would become $597,666.67. His HELOC limit would become $202,333.33.
Step 4: HELOC Interest gets capitalized
The HELOC balance would incur an interest payment of $908.33 ($200,000 * 5.45% / 12 months).
This interest can be paid in one of two ways:
- The interest could be “capitalized” to the balance – this means the balance would increase by the interest amount. By doing this, the personal take home cash flow wouldn’t change.
- The interest can be paid out of pocket. You wouldn’t incur interest on interest but you would have to add additional funds.
Important note: the CRA claims that interest on investment interest is still deductible.
The HELOC balance now becomes: $200,908.33 with a limit of $202,333.33.
Step 5: Borrow the remaining $1,425 available balance from the HELOC ($202,333.33 – $200,908.33) and invest it into the investment.
Step 6: Repeat these steps.
Annual Steps:
At the end of the year, there will be new additions to your taxable income.
First, your taxable income would increase based on the investment income. Second, your taxable income would decrease based on the interest paid on the investment loan.
The Results of the Smith Maneouvre
For this situation, in just 5 years, John’s Net Worth would be $29,964 larger than if he had stuck with a normal mortgage strategy.
His Non-deductible mortgage would have been fully converted into a deductible mortgage in 13 years while the normal strategy would have taken 25 years to fully pay off.
Key Components of the Smith Manoeuvre
- Readvanceable Mortgage: Allows simultaneous borrowing and repayment, enabling the strategy to function effectively.
- HELOC: Provides access to your home’s equity for investment.
- Income-Producing Investments: Essential for making the HELOC interest tax-deductible.
Eligibility and Requirements to Set Up this Tax Deductible Mortgage Strategy
- Homeownership with Sufficient Equity: Typically, at least 20% equity in your home.
- Qualification for a Readvanceable Mortgage: Not all lenders offer this product, so you’ll need to find one that does.
- Comfort with Leveraging Home Equity for Investment: This strategy isn’t for everyone; ensure you’re comfortable with the associated risks.