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.

Leveraged Investing

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. Continue Reading…