Real Estate

Is "smith manoeuvre" technique obselete?

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[OP]
Sr. Member
Nov 13, 2007
878 posts
124 upvotes
Toronto

Is "smith manoeuvre" technique obselete?

What is "smith manoeuvre"?
The technique to turn non-tax deductible mortgage into tax-deductible investment loan.

http://www.theglobeandmail.com/globe-in ... e12059456/

Currently, 5-year variable mortgage rate at banks is 2% (P-0.7%). And HLOC at p+0.50% = 3.20%. The difference between HLOC & a mortgage is 3.20-2=1.20. Therefore, HLOC interest rate is 60% more expensive than a mortgage. The highest tax bracket is 45%. So the tax saving is gone.

The only benefit is to allow some home owners to free up some equity stuck in their home. But bank only allow 65% of their property value for HLOC. Am I missing anything?
16 replies
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
I believe you're making a mistake in the tax savings calculation.
The 3.2% interest is all deductible, and at marginal 45% bracket, the effective HELOC rate will be (3.2% x 55%) = 1.76%

So there's still a bit of a difference to be saved over a conventional mortgage.
I won't comment on whether it's worth it, especially after all the fees for the transfer
Deal Addict
Mar 22, 2010
3266 posts
1083 upvotes
nev wrote: I believe you're making a mistake in the tax savings calculation.
The 3.2% interest is all deductible, and at marginal 45% bracket, the effective HELOC rate will be (3.2% x 55%) = 1.76%

So there's still a bit of a difference to be saved over a conventional mortgage.
I won't comment on whether it's worth it, especially after all the fees for the transfer
Plus you have to take account of return on your investment, which helps you pay off your principal faster.
Sr. Member
Feb 10, 2015
606 posts
228 upvotes
superping wrote: What is "smith manoeuvre"?
The technique to turn non-tax deductible mortgage into tax-deductible investment loan.

http://www.theglobeandmail.com/globe-in ... e12059456/

Currently, 5-year variable mortgage rate at banks is 2% (P-0.7%). And HLOC at p+0.50% = 3.20%. The difference between HLOC & a mortgage is 3.20-2=1.20. Therefore, HLOC interest rate is 60% more expensive than a mortgage. The highest tax bracket is 45%. So the tax saving is gone.

The only benefit is to allow some home owners to free up some equity stuck in their home. But bank only allow 65% of their property value for HLOC. Am I missing anything?
The point of the SM is convert your non-deductible debt to deductible debt. The whole thing is based on your ROI being (substantially) higher than your LOC rate, not the LOC rate being higher/lower than the mortgage rate.
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
DanTh3Man wrote: The point of the SM is convert your non-deductible debt to deductible debt. The whole thing is based on your ROI being (substantially) higher than your LOC rate, not the LOC rate being higher/lower than the mortgage rate.
Well, the HELOC vs mortgage rate is at the heart of the manoeuvre, because one is the rate that applies to the deductible debt and the other one to the non-deductible .

Example, you have $500K mortgage outstanding on your house at 2.0% interest (and let's say this is %50 of the FMV of the house), and you also have $500K investments.
This is your starting point, and we'll also assume that your after-tax ROI is higher than your non-deductible mortgage interest, otherwise, you might as well just pay it off, and just be done :)

After the manoeuvre, you'll have $500K in a HELOC at 3.2% interest, which will be deductible, and you'll also have the exact same $500K investments.
Because it's deductible, if you're assuming a 45% marginal rate, your effective after-tax interest rate will be 1.76%.

So in this case, there's a bit of a relative gain.
If the HELOC rate were to be 4% for example, you'd be worse off after the manoeuvre.

So the ROI vs the rate you're paying is obviously very important, though not necessarily for the manoeuvre, but rather for the basic decision of whether to pay down your debt, or keep it and continue investing.
Sr. Member
Feb 10, 2015
606 posts
228 upvotes
nev wrote: Well, the HELOC vs mortgage rate is at the heart of the manoeuvre, because one is the rate that applies to the deductible debt and the other one to the non-deductible .

Example, you have $500K mortgage outstanding on your house at 2.0% interest (and let's say this is %50 of the FMV of the house), and you also have $500K investments.
This is your starting point, and we'll also assume that your after-tax ROI is higher than your non-deductible mortgage interest, otherwise, you might as well just pay it off, and just be done :)

After the manoeuvre, you'll have $500K in a HELOC at 3.2% interest, which will be deductible, and you'll also have the exact same $500K investments.
Because it's deductible, if you're assuming a 45% marginal rate, your effective after-tax interest rate will be 1.76%.

So in this case, there's a bit of a relative gain.
If the HELOC rate were to be 4% for example, you'd be worse off after the manoeuvre.

So the ROI vs the rate you're paying is obviously very important, though not necessarily for the manoeuvre, but rather for the basic decision of whether to pay down your debt, or keep it and continue investing.
No, you would not be worse off.

Your ROI on the investments should be in the neighbourhood of 8% - 10%. If this is the case you are generating far more off of the $500k in investments than you are paying on the $500k loan and you come out much further ahead.

It is really your after tax ROI vs the mortgage rate and LOC rate that matter for the SM.
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
I really don't mean to get pulled into an argument, so I'll just correct the misconception one more time and then I'll stop.

In both cases, you have the exact same $500K investments, generating the same ROI, and you have the exact same debt, $500K.

In the first case with the mortgage, your effective interest rate on your debt is 2%.
In the second case with the HELOC, your effective interest rate on your debt is the (HELOC rate x 0.55). So if the HELOC were to be at 4%, it would give 2.2%.

So you would have been paying 0.2% more on your debt, nothing else changes.

Given that the current HELOC rates are 3.2%, the effective rate becomes 1.76%, so you would pay 0.24% less than the mortgage at 2%.

Still, hardly an amount to go through all that trouble IMO.
Deal Fanatic
User avatar
Apr 20, 2011
5310 posts
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Vancouver
by doing this stuff then the primary residence is no longer tax free when you sell it...
Jr. Member
Mar 14, 2015
180 posts
61 upvotes
Montreal, QC
popbottle wrote: by doing this stuff then the primary residence is no longer tax free when you sell it...
That's false. Eligibility for the credit is the fact that you stayed in it and set it as your primary residence, nothing else.
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
Thanks, that's actually very good information, but the tone is a little too alarming to make the article more interesting.
"As a result, if a Smith Manoeuvre loan is used to buy stocks mainly for the purpose of capital appreciation, the interest is not deductible."

Unless you're buying stock of an individual company that has never paid a dividend, and has no intention (or reasonable expectation) of doing so, you should be fine with most common stock, preferreds, and bonds.
(And obviously ETFs that pay dividends)

The following article has solid info on this:
http://www.taxtips.ca/personaltax/inves ... xpense.htm

Again though, especially with the spread being so thin right now even in the best of cases, it really does not seem like it's a move that's worthwhile.
Deal Addict
User avatar
Jan 2, 2012
4229 posts
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Toronto
nev wrote: Well, the HELOC vs mortgage rate is at the heart of the manoeuvre, because one is the rate that applies to the deductible debt and the other one to the non-deductible .

Example, you have $500K mortgage outstanding on your house at 2.0% interest (and let's say this is %50 of the FMV of the house), and you also have $500K investments.
This is your starting point, and we'll also assume that your after-tax ROI is higher than your non-deductible mortgage interest, otherwise, you might as well just pay it off, and just be done :)

After the manoeuvre, you'll have $500K in a HELOC at 3.2% interest, which will be deductible, and you'll also have the exact same $500K investments.
Because it's deductible, if you're assuming a 45% marginal rate, your effective after-tax interest rate will be 1.76%.

So in this case, there's a bit of a relative gain.
If the HELOC rate were to be 4% for example, you'd be worse off after the manoeuvre.

So the ROI vs the rate you're paying is obviously very important, though not necessarily for the manoeuvre, but rather for the basic decision of whether to pay down your debt, or keep it and continue investing.
I really don't understand your logic here. The mortgage rate is pretty much irrelevant. The only thing you can claim and deduct from your income is the interest paid on the HELOC portion of your home.

As long as you're making more from your investments (after tax) purchased with the HELOC, vs the effective interest rate you're paying on the HELOC, then the SM will be beneficial to you.
HELOC could be at a 10% interest rate, but if you're making 20% on the investments then you're net positive with the SM.
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
rob444 wrote: I really don't understand your logic here. The mortgage rate is pretty much irrelevant. The only thing you can claim and deduct from your income is the interest paid on the HELOC portion of your home.

As long as you're making more from your investments (after tax) purchased with the HELOC, vs the effective interest rate you're paying on the HELOC, then the SM will be beneficial to you.
HELOC could be at a 10% interest rate, but if you're making 20% on the investments then you're net positive with the SM.
Smith Manoeuvre is about replacing your non-deductible mortgage debt by a deductible loan debt. It's not about borrowing to invest generally.
So it's applicable when you already have a non-deductible mortgage that you're paying interest on, and at the same time you have investments that bring you income.
You essentially sell your investments to pay down the mortgage, then borrow back against the house equity on a HELOC (for a lower rate than a regular credit line), and re-purchase the same investments.
Now the interest paid on your debt is deductible.

So of course the mortgage rate you have is very relevant. The manoeuvre is about lowering your effective debt payments.
If you were paying 2% on your mortgage, and the HELOC was at 4%, you would never do this.

Given your example, if you're making 20% ROI, and the HELOC is at 10% and the mortgage at 2%, which would you choose to have your debt in?
Remember, you *will* have the same debt, either as a non-deductible mortgage, or a deductible HELOC.
Deal Addict
User avatar
Jan 2, 2012
4229 posts
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Toronto
nev wrote: Smith Manoeuvre is about replacing your non-deductible mortgage debt by a deductible loan debt. It's not about borrowing to invest generally.
So it's applicable when you already have a non-deductible mortgage that you're paying interest on, and at the same time you have investments that bring you income.
You essentially sell your investments to pay down the mortgage, then borrow back against the house equity on a HELOC (for a lower rate than a regular credit line), and re-purchase the same investments.
Now the interest paid on your debt is deductible.

So of course the mortgage rate you have is very relevant. The manoeuvre is about lowering your effective debt payments.
If you were paying 2% on your mortgage, and the HELOC was at 4%, you would never do this.

Given your example, if you're making 20% ROI, and the HELOC is at 10% and the mortgage at 2%, which would you choose to have your debt in?
Remember, you *will* have the same debt, either as a non-deductible mortgage, or a deductible HELOC.
You don't need to sell investments, pay down mortgage, and then re-borrow them. You can do the SM even from a position of having zero investments/cash to start.

With a mortgage/re-advanceable HELOC product, with each regular mortgage payment you make you are then increasing the amount of your HELOC. You then take that new HELOC amount and invest with it. There is no requirement to make extra payments against the mortgage above and beyond your regularly scheduled payments.
So in this case, really your mortgage rate is irrelevant and all that you care about is the return you're getting vs your effective HELOC rate.

The decision whether to take extra cash/investments you have elsewhere and apply them to your mortgage simply to withdraw them under the HELOC, is a whole separate decision but not essential to performing the basic SM in general.
Member
Feb 25, 2004
353 posts
273 upvotes
Montreal
rob444 wrote: You don't need to sell investments, pay down mortgage, and then re-borrow them. You can do the SM even from a position of having zero investments/cash to start.

With a mortgage/re-advanceable HELOC product, with each regular mortgage payment you make you are then increasing the amount of your HELOC. You then take that new HELOC amount and invest with it. There is no requirement to make extra payments against the mortgage above and beyond your regularly scheduled payments.
So in this case, really your mortgage rate is irrelevant and all that you care about is the return you're getting vs your effective HELOC rate.

The decision whether to take extra cash/investments you have elsewhere and apply them to your mortgage simply to withdraw them under the HELOC, is a whole separate decision but not essential to performing the basic SM in general.
Agreed, that's the slow, over time method. But if you don't make any additional payments, you're basically just paying down mortgage, and borrowing to invest, not much of a "manoeuvre". In fact, the borrowing doesn't even need to be against the house, a regular credit line would do the same thing, albeit with a slightly higher rate.
AFAIK, the method you mention takes investment income and the tax returns and pays down the principal further, so you can borrow even more to invest, and quickly convert the mortgage to HELOC.

So the same principle of the rate spread still applies. If your mortgage is cheaper than the effective HELOC, you wouldn't choose to pay it down to borrow; you would just directly re-invest the returns, and pay your cheaper mortgage.

Regardless of the way you go about it, without getting into the semantics, the SM is about "converting your non-deductible mortgage to deductible debt".
So if your deductible debt's effective rate after the conversion is higher than you non-deductible debt's, there'd be no point.
Deal Addict
Jun 8, 2004
1779 posts
724 upvotes
Oakville
I think the point of the OP is to take out a variable rate mortgage instead of a HELOC and use the funds for investments. Only the product is changed. This assumes the interest on variable rate mortgage is deductible since the proceeds are used to buy investments and not the house itself.

Then the effective rate would be 1.2%x0.55=0.66% which is better than the 3.2%x0.55=1.76% on HELOC.

Downside is that you need to make principle payments on variable mortgage while you can make just interest payments on HELOC which frees up cash flow.
Sr. Member
Feb 10, 2015
606 posts
228 upvotes
cba123 wrote: I think the point of the OP is to take out a variable rate mortgage instead of a HELOC and use the funds for investments. Only the product is changed. This assumes the interest on variable rate mortgage is deductible since the proceeds are used to buy investments and not the house itself.

Then the effective rate would be 1.2%x0.55=0.66% which is better than the 3.2%x0.55=1.76% on HELOC.

Downside is that you need to make principle payments on variable mortgage while you can make just interest payments on HELOC which frees up cash flow.
That isn't the SM. One of the points of the SM is not to impact cash flow (i.e. capitalize the interest on the HELOC).

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