Smith Maneuver Pros and Cons
The Smith Manoeuvre is one of the most powerful, yet often misunderstood, financial strategies available to Canadian homeowners.
While it can seem complex at first glance, you’ll discover that whether the Smith Maneuver is good or bad depends only on whether it’s right for you.
To determine whether the Smith Maneuver is right for you, we’ll review the pros and cons of the Smith Maneuver.
But first, we’ll briefly review how the Smith Maneuver works.
You will leave this quick 5-minute article with a solid understanding of the Smith Maneuver, and if it’s right for you.
How the Smith Maneuver Works in 4 Phases:
1: Set up a re-advanceable mortgage
As the mortgage principal is repaid on each payment, the Home Equity Line of Credit (HELOC) limit available grows.
For example, if $1000 of the mortgage principal is paid down = $1000 more borrowing limit is available on the HELOC.
HELOC limit keeps growing until the mortgage is paid off.
2: Invest from the HELOC
As the HELOC limit increases each month, borrow from the HELOC to invest.
The investment needs to be an income producing asset, or an asset capable of producing an income. A stock, or ETF of stocks may qualify, but not a commodity such as gold or Bitcoin.
So as the mortgage is paid down, and the HELOC limit grows, so does your investment pool.
Because you’re borrowing from the HELOC to invest, the interest on the HELOC is tax deductible.
3: Income Tax Deduction
The main mortgage you’re paying down is NOT tax deductible, but the HELOC interest you’re using to invest with IS tax deductible (if set up properly).
So each year, we take this interest expense from our HELOC investing activities, and use it as a tax write off or tax deduction from your main income.
This can result in an income tax refund.
4: Use the income tax refund as a mortgage pre payment, to pay down the main mortgage faster
Remember from ‘phase 1’, when we pay down the mortgage, the limit of the HELOC increases.
So in addition to your regular mortgage payments, the pre payment from the tax deduction speeds up the repayment of the mortgage.
This is how the mortgage is paid down faster.
As the investment in the HELOC grows each year, the income tax deduction grows, and so does the mortgage pre payment from the income tax refund.
It is a perpetual growth strategy.
What are the Pros and Cons of the Smith Maneuver?
Pros:
– It pays down the main mortgage faster.
– Results in tax savings at marginal tax rate: For those in a high tax bracket, the tax savings can be huge. For those on salary or who receive T4 income, there are very few ways to reduce their income tax. This is one.
– If investment gains are higher than the HELOC interest rate, you gain.
– Investments are made consistently, in up and down markets, over months and years, through ‘dollar cost averaging’, which mitigates market risk.
– With the right financial partner, it can be a very simple, easy to manage strategy – simple bookkeeping and tax preparation – far easier than a rental property.
– Under normal circumstances, no additional mortgage payments are required. You just make your regular payment for this to work.
Cons:
– Your debt level doesn’t go down, it’s just converted from non tax deductible (regular mortgage) to tax deductible (HELOC).
– You’re borrowing to invest and even though tax deductible, it’s still a debt and a cost which magnifies risk.
– If the investments are not invested properly, there’s higher risk that returns do not match interest costs. It takes increased risk to beat the HELOC interest rates over time.
– If there’s a market crash, you may need to wait years for the market to return to gains. This is not a short term strategy, it needs to be committed for the long term.
– If interest rates increase significantly, the interest costs could result in no investing or higher mortgage and HELOC payments.
Do the cons outweigh the pros?
For some people, definitely. But the Smith Maneuver can work well for others.
Who is it for?
There is no one size fits all approach for determining who the strategy is right for. But the points below can help to provide an indication:
– Has a long time horizon of at least 15 – 20 years.
– Who is comfortable with more volatile market based investments that fluctuate. Someone who does not worry too much about their investments, even in market downturns.
– Who is more entrepreneurial in nature and understands the risk of leveraged investing for gains. This does not mean you need to be a business owner, but that you may be more comfortable with the risk involved in starting a business that includes debt. The Smith Maneuver can be thought of as a very simplified version of this.
Careful use of the Smith Manoeuvre can significantly accelerate wealth creation.
If you have any questions, feel free to book a no obligation appointment today!