By Michael J. Wiener
Special to the Financial Independence Hub
Many people have heard of the Smith Manoeuvre, which is a way to borrow against the equity in your home to invest and take a tax deduction for the interest on the borrowed money.
It was originally popularized by the late Fraser Smith, who passed away in September 2011. Now his son, Robinson Smith, has written the book Master Your Mortgage for Financial Freedom, which covers the Smith Manoeuvre in detail for more modern times. Smith Jr. explains the Manoeuvre and its subtleties well, but his characterization of its benefits is misleading in places.
The Smith Manoeuvre
In Canada, you can only deduct interest payments on your taxes if you invest the borrowed money in a way that has a reasonable expectation of earning income. Buying a house does not have the expectation of earning income, so you can’t deduct the interest portion of your mortgage payments.
However, if you have enough equity in your home that a lender is willing to let you borrow more money, you could invest this borrowed money in a non-registered account and deduct the interest on this new loan on your income taxes (as long as you follow CRA’s rules carefully). A common mistake would be to spend some of the invested money or spend some of the borrowed money. If you do this, then some of the money you borrowed is no longer borrowed for the purpose of investing to earn income. So, you would lose some of your tax deduction.
With each mortgage payment, you pay down some of the principal of your mortgage, and assuming the lender was happy with your original mortgage size, you can re-borrow the equity you just paid down for the purpose of investing and deducting any interest on this new loan. Some lenders offer mortgage products with two parts: the first is a standard mortgage, and the second is a line of credit (LOC) whose limit automatically adjusts so that the amount you still owe on your standard mortgage plus the LOC limit stays constant. So, after each standard mortgage payment, your LOC limit goes up by the amount of mortgage principal you just paid, and you can re-borrow this amount to invest and deduct LOC interest on your taxes. This is the Smith Manoeuvre.
Smith describes a number of ways of paying off your mortgage principal faster (that he calls “accelerators”) so that you can borrow against the new principal sooner and boost your tax deductions.
Compared to a Standard Mortgage Plan
Ordinarily, mortgagors pay off their mortgages slowly over many years. Their risk of losing their home because of financial problems is highest initially when they owe the most. This risk declines as the mortgage balance declines, and inflation reduces the effective debt size even further.
With the Smith Manoeuvre, the total amount you owe remains constant (declining mortgage balance plus LOC balance) or may even increase as your house value increases and your lender is willing to lend you more money against your house. So, your risk level as a function of how much you owe doesn’t decline in the same way as it does with the standard mortgage plan. You could argue that your financial risk does decline somewhat because you’ve got your invested savings to fall back on in hard times, but your risk certainly doesn’t decline as fast as it does with the standard plan.
Smith likes to say that the Smith Manoeuvre isn’t a leveraged investment plan. He justifies this assertion by saying that you’ve already borrowed to buy your home, and you’re now slowly converting this mortgage that isn’t tax deductible to an LOC debt that is tax deductible.
In fact, the Smith Manoeuvre is a leveraged investing plan. Under a standard mortgage plan, you would have slowly decreased your leverage and risk over time. With the Smith Manoeuvre, you maintain your leverage.
Smith Manoeuvre Benefit
To illustrate how you can benefit from the Smith Manoeuvre, Smith assumes that your invested savings will earn 8% per year, after income taxes. Assuming a 1% annual cost in income taxes on dividends and capital gains, the pretax assumed return is 9% per year.
In one example with a $400,000 mortgage, the Smith Manoeuvre has you coming out ahead roughly $440,000 after 25 years. But this is misleading because we’re talking about future dollars. If we assume that we shouldn’t count on more than a 5% real return, then our 9% portfolio return corresponds to 4% inflation. Discounting the $440,000 to present-day dollars gives about $165,000.
So, the question you must ask yourself is do you want to implement the Smith Manoeuvre to possibly get $165,000 extra dollars if the stock market cooperates and nothing happens in your life for 25 years to mess up this plan? This type of question always comes up when considering using leverage. A stock market crash, a housing decline, or losing your job are all potential risks, particularly if they happen in combination. The Smith Manoeuvre’s risk/reward combination wouldn’t have appealed to me when I was young and buying my first house, but others may differ.
The first couple of chapters offer little information about the Smith Manoeuvre. They are designed to give you the feeling that you’re missing out on tricks that rich people know about, that you’ll retire in poverty, and that you should be outraged by high taxes. These chapters also contained lots of marketing for Smith’s online calculator ($70 plus $4/month as of this writing), a homeowner course ($300 as of this writing), and training programs for financial professionals to get “certified” on the Smith Manoeuvre and get “territorial exclusivity.”
I almost gave up at this point, but the book took a sharp turn and began giving clear, detailed information about the mechanics of employing the Smith Manoeuvre, its various subtleties, and warnings about mistakes that could jeopardize your tax deductions.
I am of two minds about the calculator, courses, and training. Avoiding mistakes with the Smith Manoeuvre really is complicated enough that people could use some training (or at least some mandatory reading), but I have no idea whether the courses and training offer enough value to justify their cost, and it was annoying to see the constant marketing references throughout the book.
Another Misleading Comparison
Smith introduces two couples to show the power of the Smith Manoeuvre. The Marshalls have an annual income of $100,000 and decide to use the Smith Manoeuvre. The Joneses earn a whopping $300,000 per year, but go the conventional route. In addition to the extra income, the Joneses save $700/month compared to the Marshals’ $500/month, and the Joneses start with $150,000 invested compared to only $50,000 for the Marshalls.
Amazingly, the Marshalls come out ahead in net worth 25 years later despite making $200,000 per year less. Unmentioned is that the Joneses did almost nothing with their $300,000/year income to help themselves other than saving $200/month more than the Marshalls did. The presumption is that the Joneses just spent almost all of their large income. So, this difference in income was hardly factored into the comparison at all. The Joneses could have made only $90,000 and scrimped more.
In one case study, “even if the Petersens only earned 2% on their investment portfolio, they’d still be better off with The Smith Manoeuvre by over $912,000.” I can’t see how this is true when the interest rate on their mortgage is 4.5%. I understand that loan interest is 100% tax deductible, and dividends and capital gains aren’t 100% taxed, but it seems like a stretch to get a meagre 2% investment return to overcome 4.5% loan interest.
Smith advocates getting rid of emergency funds and collapsing RRSPs and TFSAs. He says to use the money to pay down the mortgage to generate more principal to borrow against for investing. I’m not a fan of going all in on risk and just hoping you never lose your job.
Table 4.5 compares the progress of Darren (who didn’t use the Smith Manoeuvre) and Mark (who did). Darren ended up having to take out a lump-sum reverse mortgage, but the table of net worth progress fails to account for the remaining amount from the lump sum.
A chart of the 2019 top marginal tax rates in each province has the wrong figure for Ontario. It lists 46.16%, but the actual figure was 53.53%.
If you’ve already decided you want to implement the Smith Manoeuvre, this book is a valuable resource for understanding the subtleties of implementation. However, if you’re trying to decide whether to proceed, you need a more objective source of information, or at least additional sources to see all sides.
Michael J. Wiener runs the web site Michael James on Money, where he looks for the right answers to personal finance and investing questions. He’s retired from work as a “math guy in high tech” and has been running his website since 2007. He’s a former mutual fund investor, former stock picker, now index investor. This blog originally appeared on his site on Jan. 18, 2021 and is republished on the Hub with his permission.
One thought on “Master your Mortgage for Financial Freedom”
Hello Michael. Thank you for your balanced review on my book, Master Your Mortgage for Financial Freedom. I have had one other reviewer mention it was a bit ‘salesy’ and I shall bear this in mind for any future revisions. My goal is to ensure that Canadian homeowners know there are resources out there to help them make a more informed decision about whether the strategy is for them or not but maybe it could be toned down a hair… But until such revisions, my hope is that readers can get past that and find value in the subsequent chapters.
As regards the discussion on whether The Smith Manoeuvre is a ‘leveraged’ strategy or not, I know that this is a discussion that will continue into the future – and that I may fail to change minds more often than not – but my premise that it should be considered a ‘conversion’ strategy can be explained by the following example: Let’s look at the fact that some people have an interest-only line of credit as their ‘mortgage’ as opposed to an amortizing loan with principal plus interest payments as most do. Assume a homeowner makes monthly interest-only payments against their $300,000 line of credit mortgage so that their total debt does not change going forward. Beginning of the first month, end of the first month, beginning of the next month, etc., their debt load is always $300,000. The homeowner has started to think about retirement so they talk to their friend who is a mortgage broker and he informs them that based on the $300,000 balance and current rates, if they were actually making principal plus interest payments, on top of the $1,000 interest-only payment they already make, they would be paying another $1,000 for the principal component for a total monthly payment of $2,000. So, the homeowner decides to start saving for their future by directly investing $1,000 from personal cash flow each month. With an interest payment on the line of credit of $1,000 and an investment of $1,000 they are out of pocket $2,000 – the exact same amount they would be if they were making a regular P&I mortgage payment like most Canadians with mortgages. After two months they have $300,000 of total debt and $2,000 invested. After three months they have $300,000 of total debt and $3,000 invested. After four months they have $300,000 of total debt and $4,000 invested. And if this person were implementing The Smith Manoeuvre, these numbers would be the same. Each month they would be coming up with $2,000 for the P&I mortgage payment and each month they would have the same total mortgage balance as if they were following the interest-only process; they would have the same amount of dollars invested as well. No matter what month we looked at for the first twelve months, the total debt in either scenario would be the same and the amount of dollars they had contributed to their investment program would be the same.
The differences, however, are that if they continued to make interest-only payments, they will have $300,000 of non-deductible debt forever. With The Smith Manoeuvre, they will also have $300,000 of debt forever, but it will eventually all be 100% tax-deductible, meaning they will have received thousands of dollars in the form of tax refunds over the years and they would have a much bigger retirement portfolio because of these deductions. But the values are the same only for the first twelve months because as soon as they receive their annual tax refund and run it through the mortgage and invest it, they now have more total funds invested than if they were following the interest-only scenario.
The Smith Manoeuvre didn’t increase their total debt, and it still did not require any additional funds from out of pocket. So in the interest-only scenario there was absolutely no ‘borrowing to invest’ and in The Smith Manoeuvre scenario there is in one isolated moment of the whole process but the net result is the exact same amount of debt each year into the future; however, they have been putting their equity to work and therefore enjoying compound growth. Again, this is a contention I expect will continue, and maybe rightfully so, but I hope I have conveyed my perspective clearly.
Concerning the reduction of risk as one pays down their mortgage conventionally versus The Smith Manoeuvre, the comparison, I feel, is that with the conventional method, risk is reducing because your debt is reducing; with The Smith Manoeuvre, your risk is reducing because your assets are increasing. Can the homeowner get comfortable with the risk associated with getting the equity invested or are they more comfortable leaving the equity in the home where it is unproductive? The trick is to make sure your returns outweigh the cost of borrowing but wealthy Canadians and businesses invest with borrowed money on a daily basis so we know this works; but yes, it takes diligence and a prudent approach to choosing the investments.
Concerning the Marshall/Jones comparison, I see your point – the actual dollars made by families are not relevant, moreso simply the marginal tax rates. However, my goal is to show the comparison as regards their current financial position and monthly investment amount without change going forward, so the suggestion that the Joneses could have only made $90,000 and scrimped and saved more would invalidate the comparison. Were that to be assumed, we could also suggest the Marshall’s could have scrimped and saved more. And yes, the presumption is that the Joneses spent the almost all of their large income – many people tend to spend more when they make more…indeed I have been guilty of that myself!
As for the Petersen’s, as total debt is staying constant but assets are growing due to the monthly contributions, the returns do not have to be too great for net worth to improve considering no additional cash is required from the homeowners pocket – and also we need to consider the additional dollars the homeowner receives in the form of annual tax refunds. It would be a different story if the interest expense were indeed additional funds coming out of the homeowner’s pockets as that would have to be factored in, but the increasing efficiency of the mortgage payment covers the increasing interest expense. So we may have underperforming assets but when looking at the balance sheet at the end of the original amortization, we can still be ahead in terms of dollars.
I never meant to imply that I advocate collapsing registered investments to implement any of the accelerators. Surely it could be looked at by a professional to determine from a forecast perspective if one could expect to come out ahead, but I agree that if one wanted to hold a variety of types of investments rather than go all in, they should. It would be a personal decision – same as regards the emergency fund. The individual’s comfort level would determine the course of action. And speaking of going all in, on page 122, I do discuss how someone can start slow and indeed reduce their total debt over time while still taking advantage of tax deductions, getting invested now rather than later and still eliminate the non-deductible debt quicker than otherwise.
Lastly, thank you for noting the correct marginal tax rate for Ontario.
Well, I appreciate you taking the time to get to the end of this reply, Michael, and thanks for the taking the time to review the book. Take good care.