Smith Manoeuvre

[pitz]

is it safe to assume that the SM should ONLY be undertaken once all other debt, especially revolving-credit debt, is completely wiped out? Step #1 of any financial planning is to get rid of credit card debt, no?

Yes, it goes without saying that other debt should be consolidated into the non-deductible mortgage debt whenever possible.

If you need to restructure your financing, you may be able to do the SM, and roll the CC/car loan debt all into one new loan.

The SM is not for the financially irresponsible though. If you were coming to see me for professional advice on the matter, I would inquire as to why you racked up other debts in the first place.

[inntents]

Yes, it goes without saying that other debt should be consolidated into the non-deductible mortgage debt whenever possible.

If you need to restructure your financing, you may be able to do the SM, and roll the CC/car loan debt all into one new loan.

The SM is not for the financially irresponsible though. If you were coming to see me for professional advice on the matter, I would inquire as to why you racked up other debts in the first place.

Points taken - thank you!

[regrus]

Some of you are reporting that you are using a HELOC for the Smith Manoeuvre. My main problem with a HELOC is that banks report HELOC's to credit reporting agencies as revolving debt wherein a readvanceable mortgage is not reported at all.

In my case I don't owe anything except for a $150,000.00 HELOC against a $400,000.00 home. It pisses me off when I check my credit report and it always says "my outstanding balance is too high in proportion to my available credit." This hurts my Score.

The way I look at it is I have a $150,000.00 credit against $400,000.00 property which is under 40% debt ratio. The credit agency looks at as I am using $150,000.00 of $150,000.00 available credit. Not good in their eyes.

[cannon_fodder]

No, the carrying costs of the entire LOC remain level throughout the entire scheme.

I challenge you to offer proof of that, because if you are successful then I will have greatly increased my understanding.
And I don't mean offsetting the costs with increased income from investments, or siphoning off a portion of principal redraws to pay the interest charges, but the actual total liability each payment period must increase.

My argument is based on these premises:

1. The mortgage payment continues unchanged until the mortgage is fully paid off. (Of course, the principal payment increases as the interest payment decreases, but each period payment is the same.)
2. The SM increases the deductible interest charges because the LOC liability also increases. In fact, near the end, you have to pay interest on the entire LOC AND a full mortgage payment.

While you MAY see an equivalent (or greater) offset due to tax refunds and investment income, that does not change the fact that the cost to service the SM increases.

However, the tax refunds are supposed to be used to pay down the mortgage faster, not service the deductible interest on the LOC, correct?

Perhaps you are suggesting that the investments should be chosen more for their income producing capability (like an income trust) rather than their solid, dependability (e.g. blue chip stocks with 5 year + history of increasing dividends). If so, then that is where we are coming at it from two different angles and your thinking might have merit that I have not been able to discern.

I'll try and develop a spreadsheet that attempts to mimic the SM and see what they tell me.

[pitz]

And I don't mean offsetting the costs with increased income from investments, or siphoning off a portion of principal redraws to pay the interest charges, but the actual total liability each payment period must increase.

If you borrow additional funds, sure, the liability increases.

With a conventional mortgage arrangement, your liabilities are the greatest at the beginning of the mortgage, and then they subsequently decline as you pay down the principal of the mortgage through an amortized blend of principal and interest payment.

With the Smith Manouevre, your liabilities remain level until you have completely swapped the entirety of your non-deductible debt for deductible debt.

1. The mortgage payment continues unchanged until the mortgage is fully paid off. (Of course, the principal increases as the interest decreases, but each period payment is the same.)

2. The SM increases the deductible interest charges because the LOC liability also increases. In fact, near the end, you have to pay interest on the entire LOC AND a full mortgage payment.

Sure, but the mortgage payment, at/near the end, is nearly 100% principal, and 0% interest. The payment on the LOC, at/near the end, is always 100% interest.

Don't confuse the payment of interest with the payment of principal. Principal contributes to capital/equity accumulation. Interest is the expense associated with renting investment capital.

While you MAY see an equivalent (or greater) offset due to tax refunds and investment income, that does not change the fact that the cost to service the SM increases.

Sure, the SM does produce a greater interest bill. But at the end of the manouevre, you have twice as many assets.

However, the tax refunds are supposed to be used to pay down the mortgage faster, not service the deductible interest on the LOC, correct?

Yes.

Perhaps you are suggesting that the investments should be chosen more for their income producing capability (like an income trust) rather than their solid, dependability (e.g. blue chip stocks with 5 year + history of increasing dividends). If so, then that is where we are coming at it from two different angles and your thinking might have merit that I have not been able to discern.

If you can find quality income trusts, then they are ideal for the purpose. Unfortunately, there are very few examples of quality income trusts in Canada, and certainly not enough to build anything resembling a properly diversified portfolio. Canadian Oilsands is the only trust i'd consider as part of a 'blue-chip' portfolio, and I think you can agree that it would be very highly risky to go 100% into COS.UN.

I'll try and develop a spreadsheet that attempts to mimic the SM and see what they tell me.

Sure, try and understand the math.

[pitz]

Some of you are reporting that you are using a HELOC for the Smith Manoeuvre. My main problem with a HELOC is that banks report HELOC's to credit reporting agencies as revolving debt wherein a readvanceable mortgage is not reported at all.

So replace some of the tax-deductible mortgage debt with tax-deductible margin debt. In other words, borrow from your broker, not from your mortgage lender.

Problem solved.

[cannon_fodder]

To pitz:

I think my understanding of the math is far better than you've given me credit for. Some of the statements you made could be misinterpreted, or were simply incorrect.

I, too, made some statements that did not accurately reflect what I was trying to say. For example, I said "1. The mortgage payment continues unchanged until the mortgage is fully paid off. (Of course, the principal increases as the interest decreases, but each period payment is the same.)" What I meant to say was that "... the principal payment increases as the interest payment decreases..."

I believe I have constructed an Excel spreadsheet which reflects the SM. It does not have a glossy front end, but it is probably a little bit more flexible in that I could put in any prepayments at any time (e.g. for winfalls, other components of my tax refund, etc.)

If you perform the Plain Jane SM at the end you should have a total payment that is equal to your mortgage payment + the interest portion of your first mortgage payment. This is because you have converted the mortgage to be a tax-deductible LOC. Since you are having to pay down the mortgage (both P+I) but you only have to pay the I on the LOC, then this makes sense.And my Excel spreadsheet confirmed that.

What I was driving at is that this is a real, and significant, increase in cash outlay. What I infer from your statements is that the income generated from your investments will be planned to substantially contribute, and perhaps completely offset, the increased cost to service the declining mortgage and the increasing cost to service the growing LOC liability.

That is an interesting perspective, but my initial reaction is that I'm now declaring additional, taxable income. Would you argue that all income you receive from the investments:

- should be used to pay down the mortgage even faster and then redraw the amount to invest,or
- should be split into two parts: only enough to cover the additional carrying costs; and use the rest to paydown the mortgage, redraw & invest, or
- something completely different?

I'll plug in some numbers to see how this affects everything if I receive income which:

- is returned at a level less than the interest costs of the LOC
- is returned at a level more than the interest costs of the LOC

I'm going to read the SM book again, but I don't think he adequately addresses the increase in cost to service the mortgage and LOC. Sure, he drills into you that the total liability does not change. BUT, he does not provide any information, yet alone numbers IIRC, that show that or how much your periodic payments increase.

[cannon_fodder]

Just saw that www.smithman.net has announced the formation of "Smith Manouevre Financial Corporation". They also talk about the "Freeboard Equity" program where you implement a readvanceable mortgage by tapping into the increased equity in your home since you took out your mortgage.

http://www.smfc.com/services/for_home_owners/

The approach suggested is one that others have implied - invest in income producing mutual funds with monthly cash distributions and pay down the mortgage first, redraw and invest.

[pitz]

What I was driving at is that this is a real, and significant, increase in cash outlay. What I infer from your statements is that the income generated from your investments will be planned to substantially contribute, and perhaps completely offset, the increased cost to service the declining mortgage and the increasing cost to service the growing LOC liability.

Is it really a 'cost' if its being used to accumulate equity? While analyzing for cash flows is important in the context of the Smith Manouevre, I think you should be taking the approach of analyzing for overall net worth. Think of the Smith Manouevre as giving you a discount on your mortgage interest rate at your highest marginal rate. If you were previously paying 6% on your mortgage in a 40% tax bracket, once you have the entirety of the debt swapped over, you will be paying an effective rate of 3.6%.

The technicalities of the Smith Manouevre (and the Income Tax Act) dictate that you must have the investment portfolio in order to receive the deduction, however, so you can't merely just accelerate your mortgage payoff as though you could if you truly were paying 3.6% on a cash basis.

That is an interesting perspective, but my initial reaction is that I'm now declaring additional, taxable income. Would you argue that all income you receive from the investments:

- should be used to pay down the mortgage even faster and then redraw the amount to invest,or
- should be split into two parts: only enough to cover the additional carrying costs; and use the rest to paydown the mortgage, redraw & invest, or
- something completely different?

I would argue that if you have non-deductible debt of any kind, it should be first repaid. Whether you choose to re-draw to invest is ultimately your decision. If you feel the stock markets are over-valued, then maybe just paying off the mortgage is the better idea.

I don't encourage market timing, but when Nortel was 45% of the TSX index, probably wasn't a very good time to consider investing in it. Generally speaking, you always want to invest in 'stuff' that produces after-tax GAAP earnings greater than your cost of capital.

Yes, over time, there is an increasing effect on your overall taxable income. However, hopefully you had the foresight to invest in instruments that provide income in the form of either capital gains or tax-advantaged Canadian dividends. This is a very valid point and should be included in your modelling.

I'll plug in some numbers to see how this affects everything if I receive income which:

- is returned at a level less than the interest costs of the LOC
- is returned at a level more than the interest costs of the LOC

I'm going to read the SM book again, but I don't think he adequately addresses the increase in cost to service the mortgage and LOC. Sure, he drills into you that the total liability does not change. BUT, he does not provide any information, yet alone numbers IIRC, that show that or how much your periodic payments increase.

The cashflows associated ultimately depend on the type of financing used.

Its possible to get a LOC, for the purposes of the Smith Manouevre, that does not have any 'payments' associated with it. Or you can use a margin account which doesn't require any 'payments' for a portion of the borrowing. There are lots of ways of managing the cashflows.

[cgtor]

i'm not exactly sure how the timing works with respect to the investment loans under SM method

i was just approved for a mortgage of approximately 200,000 and i came across the book

after having read the book, i am curious to learn how often the loans should be taken

for example, suppose i put a lump sum payment of $1000 this month, and $1000 next month, does it not seem odd to be approaching the bank every month to ask for a loan of $1000 for investing? is it better to do it this way, or better to do it semi-annually, say every 6 months?

[grant]

So replace some of the tax-deductible mortgage debt with tax-deductible margin debt. In other words, borrow from your broker, not from your mortgage lender.

Problem solved.

My margin account is prime + 1.5 or 2%. A HELOC would be Prime + 0%. So it's not an ideal solution.

[fsmontenegro]

To pitz:
I'm going to read the SM book again, but I don't think he adequately addresses the increase in cost to service the mortgage and LOC. Sure, he drills into you that the total liability does not change. BUT, he does not provide any information, yet alone numbers IIRC, that show that or how much your periodic payments increase.

Yes, that is my impression as well. The two approaches that have been recommended (both in the book and in the website) are:
- Pay the interest on the LoC from the amount that is borrowed. Example:
mortgage payment = $800 ($400 P + $400 I)
borrow from LoC = $ 400
assuming LoC interest due = $10
amount to invest = $400-$10 = $390

- Do the "guerrila" method (or something like that) and arrange for capitalizing the interest owned. In the example above, take $400, invest $400 and add the $10 to the LoC balance. Apparently not too many places will allow you to do this (any references to lenders that actually allow this? please let me know...)

Hope this helps.

Cheers,
Fernando

[cannon_fodder]

Well, I finally have a really good approximation of the SM calculator at least in that I can plug in his numerical examples and get the same answers within plus or minus a couple of bucks. There are certain assumptions that he made that I wasn't aware of but it seems to work.

I can see that, unlike the FP who talked to me about this method, the SM calculator DOES pay for the additional, and increasing, interest costs for the LOC through capitalizing interest and from siphoning off money that you withdraw. It does NOT require that you use any of the income that the investments generate to pay for it.

As an example, if we take the one quoted in his book:

$200,000 mortgage amortized over 25 years, 5 year term at 7% interest compounding semi-annually
Investment LOC at 5% interest supporting capitalization of interest(one of the many items that bother me in his book - if I have just put together this readvanceable mortgage why would my mortgage be at 2% higher than my investment LOC? No explanation as to why this strange difference.)
Investment growth at 10%
Tax rate 40%
Monthly payment at $1,400.83
Reinvest tax refunds
Assume mortgage begins January 1, 2007 for this example

On February 28, 2029, you make a mortgage payment of $1,400.83 as usual, you only have $563.30 to invest because about $15.23 goes to the mortgage interest and $822.30 goes to the investment LOC for interest.

I believe this is what pitz has been trying to get through to me that there is no additional strain put on your finances through this application of the SM. The FP who had sat down with me suggested a different, what he considered 'much better' approach, whereby the investment LOC interest was paid with external cash (e.g your salary). This, of course, would allow the full amount of any payment to the principal of the mortgage to be actively invested. I think I could say that both pitz and I were right, but we were coming at it from quite different angles. Sorry, pitz, for my stubborness!

Here are some key points I discovered in creating my spreadsheet:

The SM calculator assumes the tax refund will come in 6 months after the end of the year (e.g. start your mortgage on January 1, 2007 and your first refund will be used to pay down your mortgage June 30, 2008.)
The end calculations of tax refunds and investment portfolio amount are indeed at the end of the amortization period. I had mistakenly thought that this was what you would have as soon as the mortgage was discharged. I think this is a bit misleading, or at least, it should be made very clear. I would bet that I'm not the only person who didn't realise that you had to let this SM go on for the full 25 years to reach those numbers.

To be fair, it is probably the best way to compare apples to apples
- don't do the SM and this is where you are
- no mortgage and no investments, no tax refunds OR
- do the SM and this is where you are
- no mortgage, $510k in investments and a nice $4k in tax refunds each year and all it will cost you is $10k in interest charges which is less than the almost $17k you used to make in mortgage payments.

In the example he uses in the book, the mortgage is paid off 2.75 years earlier. At that point, the portfolio is about $361,079 and the tax refunds total about $32,400. But, for the next 2.75 years you keep paying the $1,400.83 into this SM (subtracting the $833.33 for the investment LOC carrying costs leaving $567.50 for investing) and keep applying the tax refunds and you will wind up with the figures he quotes.

Now I'm going to work on adding the "Freeboard Equity" wrinkle to my spreadsheet.

[pitz]

My margin account is prime + 1.5 or 2%. A HELOC would be Prime + 0%. So it's not an ideal solution.

My margin account is roughly Prime - 0.6%, or currently, approximately 5.3% (in Canadian dollars).

It certainly pays to shop around .

[FrugalTrader]

i'm not exactly sure how the timing works with respect to the investment loans under SM method

i was just approved for a mortgage of approximately 200,000 and i came across the book

after having read the book, i am curious to learn how often the loans should be taken

for example, suppose i put a lump sum payment of $1000 this month, and $1000 next month, does it not seem odd to be approaching the bank every month to ask for a loan of $1000 for investing? is it better to do it this way, or better to do it semi-annually, say every 6 months?

That's why if you want to do the SM, you need to obtain a re-advancable mortgage. These mortgages will AUTOMATICALLY increase your HELOC credit limit as you pay down your non-ded principle. Some examples of these mortgages are:
First Line: The Matrix Mortgage
RBC: The Homeline Mortgage
Manulife: Manulife ONE

FrugalTrader
http://www.MillionDollarJourney.com