Smith Manoeuvre – When Should You Consider It

home valueThe 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. Not so long ago, 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 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 how to proceed as you debt will increase while your investment also increase but you will have debt.

Related: How to assess if the Smith Manoeuvre is for you 

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 result benefit.

Debt Servicing

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. 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 an tax deductible loan for investments. The interest on the investment loan is serviced by the line of credit (also referred to as an 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 it. Your debt level doesn’t really decreases; in fact, it grows when you consider the interest on your HELOC.

Tax Deductible Interest

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 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 Debt Comfort

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. While learning about GDS (Gross Debt Service) ratio and TDS (Total Debt Service) ratio, I decided to come up with a value I would be comfortable to execute the Smith Maneouvre. Just like the banks look at your GDS and TDS to lend you money, you can look at this to decide on when you can start executing the Smith Manoeuvre if you are interested in the concept.

I have a Google Template (Debt Servicing Calculator) ready for you to try your numbers. The example below assumes a Family Gross Income of $100,000.

  • GDS: Mortgage only ratio against your income. The guideline expects a borrower to be under 30%.
Gross Debt Service Ratio
Gross Debt Service Ratio
  • TDS: Overall debt ratio against your income. The guideline expects a borrower to be under 40%.
Total Debt Service Ratio
Total Debt Service Ratio
  • MSR: Mortgage Safety Ratio – I came up with this one and I am still refining it, go easy on me :). The goal is for you to assess your comfort of debt in order to move on and decide on focusing on other investments. A MSR under 3.5 is showing a confortable debt ratio, anything above starts to show some risks and there is little room for safety unless you have a large emergency fund.
Mortgage Safety Ratio
Mortgage Safety Ratio

 

Smith Manoeuvre – Mortgage Safety Ratio

Dividend Snapshot
The MSR is based on the GDS and TDS since it’s all about evaluating when you can really focus on investments or the Smith Manoeuvre for example. It’s not meant to be a hard line but a guideline to show you where you stand in terms of debt. The formula is simple, I look at your remaining mortgage amount compared with your family income and add the ratio with the GDS and TDS ratios against a safe value. The closer your GDS and TDS is to the safe value, the better your ratio is.

I have provided my template for my readers to look at the GDS, TDS and my new MSR. That way you can get an idea of your relative debt compared with financial institution expectations and also evaluate what you are comfortable with.

Success with the Smith Manoeuvre

I am interested in executing the method but I am still looking for a success story when using the Smith Manoeuvre and I am curious how long it actually takes to see the success. I understand the theory and the math behind but since it takes years to see the results from investments, I would love to hear from home owners that have done it and share their feedback. Would you do it again?

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 unemployement 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. 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 accounts you are going to use. 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.

Readers: Share your opinion on the Smith Manoeuvre or your experience if you have done it.

Image courtesy of renjith krishnan – FreeDigitalPhotos.net