Modified Smith Manouvre - does it make sense?

[demrea]

Hope some of our resident analysts can provide their thoughts on this strategy. Risks and benefits?

I have an M1 mortgage, which means I am paying interest only. I dont want to do a full Smith Manouvre, because paying down my debt is important to me and my wife.

However, I also want to make sure I am putting some money away, because it feels right to me. Lets not get this statement take the thread too off topic.

Anyhow, under a traditional mortgage my payment would be about $1850. My M1 mortgage being interest only is around $1200. I was thinking that I would do a SM with the difference.

Frankly, I that 650 would have been budgeted for anyhow and it only represents less than 10% of our take home income.

Can someone help me breakdown the risk and benefit of doing this? What data points do I need to identify?

Its possible I am looking at this the wrong way?

[pitz]

A few points:

1) You could probably get a lower interest rate overall if you financed into a conventional mortgage with a line of credit. Manulife One isn't exactly a very cheap product, *and* the marketing pitch surrounding it assumes that you have, generally speaking, very bad financial habits in the first place.

A lower interest rate, in the grand scheme of things, would reduce your costs. The attached line of credit would facilitate the 're-borrowing' to invest as contemplated by the Smith Manouevre.

2) At some point in time, you need to pay off the house. You cannot rely upon appreciation to magically create equity, where equity formerly would not have existed. The past decade in real estate, from a long-term perspective, has been a complete abberation.

Paying down your mortgage is a form of savings that has a return that, on an after-tax basis, is just as good as the stock market in many circumstances.

3) Once you get even a partial SM going, the investments themselves should be yielding some cashflow which should help you accelerate the paydown of the debt. As long as you select the investments appropriately, the process should constantly be accelerating itself in a sort of feedback loop, until all of your debt is paid down.


Basically -- there is no requirement with the SM that you reborrow *all* that you can re-borrow. The SM pretty much requires that your portfolio be 100% stocks/stock funds -- and 100% stock is outside of the risk tolerance for many. The way to reduce risk is to reduce borrowing.

[pitz]

Might I add, depending on the shape of the rest of your portfolio (if you have assets other than the house), you may wish to just consider leveraging them instead.

For instance, you could leverage your RRSPs by using deep-in-the-money call options. You could borrow on margin against your non-registered investments (if any) to purchase more investments. You could also purchase options and/or futures outside the RRSP.

Since you have a fairly high take-home income, I'm suspecting that a good chunk of your income is in the 39% bracket in Alberta, which means, if you're servicing a 5.75% Manulife One mortgage -- you essentially have to earn $1.64 for every $1 of interest you end up paying. So you have a huge incentive to pay that off as quick as possible.

[demrea]

A few points:

1) You could probably get a lower interest rate overall if you financed into a conventional mortgage with a line of credit. Manulife One isn't exactly a very cheap product, *and* the marketing pitch surrounding it assumes that you have, generally speaking, very bad financial habits in the first place.

fair enough, i realize the rate is somewhat higher than a conventional variable mortgage, but i like the product (so far).





2) At some point in time, you need to pay off the house. You cannot rely upon appreciation to magically create equity, where equity formerly would not have existed. The past decade in real estate, from a long-term perspective, has been a complete abberation.

Paying down your mortgage is a form of savings that has a return that, on an after-tax basis, is just as good as the stock market in many circumstances.

I agree, I want to pay off the mortgage, which is why I am not borrowing against the full equity available. Simply was thinking to use the funds I would have spent on a standard mortgage.




3) Once you get even a partial SM going, the investments themselves should be yielding some cashflow which should help you accelerate the paydown of the debt. As long as you select the investments appropriately, the process should constantly be accelerating itself in a sort of feedback loop, until all of your debt is paid down.

Can you dumb this down a bit for me?

[demrea]

Might I add, depending on the shape of the rest of your portfolio (if you have assets other than the house), you may wish to just consider leveraging them instead.

For instance, you could leverage your RRSPs by using deep-in-the-money call options. You could borrow on margin against your non-registered investments (if any) to purchase more investments. You could also purchase options and/or futures outside the RRSP.

Since you have a fairly high take-home income, I'm suspecting that a good chunk of your income is in the 39% bracket in Alberta, which means, if you're servicing a 5.75% Manulife One mortgage -- you essentially have to earn $1.64 for every $1 of interest you end up paying. So you have a huge incentive to pay that off as quick as possible.

basically what you are saying is paying down the mortgage as fast as possible is probably going to give me the best return.

i dont understand at all what you mean by using deep in the money call options.

[pitz]

fair enough, i realize the rate is somewhat higher than a conventional variable mortgage, but i like the product (so far).


You could bank out of an unsecured line of credit, and place pre-payments against a far less expensive conventional mortgage, for savings that are similar to M1.

Yes you might pay a little bit more interest on the unsecured LOC, but it'll far outweight the extra cost of M1 and its service charges.




I agree, I want to pay off the mortgage, which is why I am not borrowing against the full equity available. Simply was thinking to use the funds I would have spent on a standard mortgage.


Sure, but then you're not paying off the mortgage. A standard amortizing mortgage forces you to pay principal. Your interest-only payment will *never* pay off the mortgage. And you cannot rely upon house price increases to create equity.

[pitz]

basically what you are saying is paying down the mortgage as fast as possible is probably going to give me the best return.

Well, do you want the 'best return', or do you want to pay down your debts? In your original post, you stated that you want to pay off debts, but if you aren't making repayments of principal, then you aren't paying off debt at all.

You are proposing, in essence, to do a standard, full-blown Smith Manouevre, with its full level of risk.

From my read of your original post, you stated you weren't comfortable with the risk of the full-blown SM, but you wanted a sort of "Smith Manouvre Light".

[demrea]

Sure, but then you're not paying off the mortgage. A standard amortizing mortgage forces you to pay principal. Your interest-only payment will *never* pay off the mortgage. And you cannot rely upon house price increases to create equity.

what about the thousands of dollars i am depositing and not using each month?

that is where the mortgage gets paid down.

[demrea]

Well, do you want the 'best return', or do you want to pay down your debts? In your original post, you stated that you want to pay off debts, but if you aren't making repayments of principal, then you aren't paying off debt at all.

You are proposing, in essence, to do a standard, full-blown Smith Manouevre, with its full level of risk.

From my read of your original post, you stated you weren't comfortable with the risk of the full-blown SM, but you wanted a sort of "Smith Manouvre Light".

we seem to be going in circles. the M1 mortgage is interest only, but i deposit all my income into the account, which is a few thousand dollars per month over and above my expenses and interest.

i am fairly certain by the history of your posts that you know this. whats the confusion?

wouldnt a full blown SM mean I would borrow the entire available equity? i am only suggesting investing the difference between what i would have paid in conventional mortgage.

anyhow, im not sold on it either. i like the thought of the guaranteed return of paying down the mortgage as fast as possible.

are we on the same page yet?

[pitz]

Okay, I think I understand what's going on here a little better.

Basically, if you calculated that you would need $650 of principal paydown per month to equal a conventional mortgage -- then this is money that you should subtract from the monthly loan principal paydown.

For instance, if your loan balance is going down $2000/month -- you could borrow and invest up to $2000 - $650 = $1350 into the SM each month, while still paying off your mortgage as though you were amortizing the payments on the basis that you calculated earlier.

The benefit -- you are borrowing money, essentially, at 3.5% (after-tax), and investing, after-tax, at rates that are probably much higher. If you buy a TSX index fund, I think a long-term after-tax return of at least 7% is fairly realistic. You profit from the spread between your borrowing costs, and the after-tax return of the fund.

Over time, this will also give you a substantial dividend income stream that can help make additional payments against your M1 account.

The downside -- its riskier than just paying off your mortgage.

The big risks, IMHO, are present in the asset allocation process. You'll probably read a lot of opinions out there, but I personally believe that, just like its a good idea to diversify your investments, its also a good idea to diversify your borrowing. And not many investment advisors, or institutions are really set up to facilitate proper diversification.

[Chigu]

SORRY TO THREADJACK, BUT I AM/MAY BE IN A SIMILAR POSITION AS THE OP.

1) I am a first time homebuyer, and I will be putting 20% downpayment. My wife works at the bank and we get HELOC at prime-0.5%. So we are not getting a 'mortgage'.

2) Would it be better to get a traditional mortgage with a HELOC attached? I am with TD Bank, do they have anything such as the 'RBC's Homeline' Mortgage etc. What is the advantage of doing this rather than just getting the HELOC with no mortgage (from my understanding the disadvantage of just the HELOC is due to the interest rate (of prime), but if I can get it at prime - 0.5%, should I even bother getting a mortgage.

I may want to do the SM

Thanks!!! It seems that the OP's issue and mine are similar, as I believe that MOne is just like a HELOC but with an interest rate of prime.

[pitz]

1) I am a first time homebuyer, and I will be putting 20% downpayment. My wife works at the bank and we get HELOC at prime-0.5%. So we are not getting a 'mortgage'.


That's okay, but not spectacular. You should be able to find a closed 5-year floating mortgage for slightly less than the cost of your HELOC. With just 20% down, against the backdrop of potentially falling house prices, I doubt you are going to have a lot of extra equity that you can deal with in the next 5 years.



2) Would it be better to get a traditional mortgage with a HELOC attached? I am with TD Bank, do they have anything such as the 'RBC's Homeline' Mortgage etc. What is the advantage of doing this rather than just getting the HELOC with no mortgage (from my understanding the disadvantage of just the HELOC is due to the interest rate (of prime), but if I can get it at prime - 0.5%, should I even bother getting a mortgage.


Personally I'd wait till you have more equity. 20% down is the bare minimum. On a 25-year amortization, it'll take you 5.5 years just to reach 30% equity, assuming house prices do not fall.

When Smith wrote his book, you needed 25% down to qualify for a mortgage -- and 30% equity would be reached at 3.5 years. Also, when Smith wrote his book, real estate wasn't so crazily overpriced.



I may want to do the SM


IMHO, you probably won't have any need, or ability to do the SM for the next 5 years. You need to build yourself at least a decent equity cushion before the SM is really viable.

[brunes]

I really don't want to take this OT, but it has to be said - if you are not using it to do the SM, it makes absolutely no financial sense to put money into another savings vehicle while you have an M1 mortgage. The whole point of a mortgage like the M1 is to put every single penny into that account to pay down the mortgage faster. That is the benefit you get for the SIGNIFICANTLY higher interest rate the M1 has.

If you are going to be doing other savings/investing along with paying down your mortgage you should not be with the M1 at all, switch to a traditional mortgage with a lower rate, you will save thousands of dollars.

[demrea]

I really don't want to take this OT, but it has to be said - if you are not using it to do the SM, it makes absolutely no financial sense to put money into another savings vehicle while you have an M1 mortgage. The whole point of a mortgage like the M1 is to put every single penny into that account to pay down the mortgage faster. That is the benefit you get for the SIGNIFICANTLY higher interest rate the M1 has.

If you are going to be doing other savings/investing along with paying down your mortgage you should not be with the M1 at all, switch to a traditional mortgage with a lower rate, you will save thousands of dollars.

i suppose you mean a traditional closed variable mortgage at around 5.15 (RBC has this).

yes, i have considered this, but I like the peace of mind the M1 gives my family. i know i could have pieced it together with a number of different products, but frankly the M1 works for us and once I am totally confortable with the system, i just might break it down to an a la carte program.

in the meantime, you are saying there is zero value in withdrawing funds to invest, even limited to the difference in what i would have paid out in traditional banking set up?

edit: i think your first sentance says if it is being used with SM, it makes sense, otherwise it doesnt?