What Is The Smith Manoeuvre?
Unlike homeowners in the U.S., interest you pay on your mortgage in Canada is not tax deductible. Since you can end up paying almost the entire price of your home in interest over the years, this means you’re effectively losing tens of thousands of dollars by not being able to deduct that interest.
If only there was a clever way that this interest could be deducted.
Turns out, a cleverer man than you or I figured this out, and now you can reap the benefits. Fraser Smith came up with what is now called the Smith Manoeuvre, and it’s absolutely brilliant.
To start, you have to understand the basics:
- Interest paid on your home mortgage is NOT tax deductible
- Interest paid on money borrowed for the purposes of investing IS tax deductible
The trick then, is to somehow convert the money you’re borrowing for your home into money you’re borrowing to invest, and voila, you can claim a tax deduction for the interest charges.
To get started most effectively, you’ll need the largest down payment possible on your home, so if you have other investments like stocks or TFSAs, consider cashing them out. You’ll see why in a moment.
Get A Readvanceable Mortgage
A readvanceable mortgage is a mortgage with two parts. The first is a traditional mortgage, and the second is a built in home equity line of credit (HELOC). Readvanceable means that every payment you make against your home automatically increases the amount available to you in the HELOC portion.
A HELOC works by allowing you to borrow a percentage of the equity in your home as a line of credit. As you ‘buy’ equity in your home by making payments, the amount you can borrow goes up.
Now, if you use that HELOC money to invest, you’re now doing #2 from above – using borrowed money to invest, and you can therefore write off the interest paid.
You might invest in dividend stocks, mutual funds, or other investments. In a way you’re investing against your home, so the riskier the investment, the riskier your overall situation. Dividend stocks are a pretty safe bet.
The next step is when tax time comes. You’ll calculate how much you paid in interest on the HELOC portion of your loan. As an example, say you paid $10,000 in interest and you’re in a 35% tax bracket. You’ll get $3,500 back on your tax refund.
Now take that $3,500 and make a lump-sum payment on your mortgage. This will free up additional HELOC room, which you use to keep investing.
As the HELOC portion invested increases, so will the interest you’re paying (but you’ll also be paying less on the mortgage portion).
That means that every year your refund will be bigger, accelerating the pay-down of your mortgage.
What Happens Next?
Continuing this process, you will eventually end up in a situation where the mortgage portion of your home is completely paid off, but you’ll still owe the full HELOC portion. BUT, you’ll also have your entire investment, which will now be worth much more than the amount you owe on the HELOC.
At this point you can simply cash out, pay off your HELOC, and be debt free – owning your home outright and having a nice investment on the side.
What Are The Risks?
The obvious risk is one of leverage. If you choose an investment that tanks, this could all be for nothing. You won’t have enough at the end to pay off the HELOC, and you’ll have been spinning your wheels for years.
You also have to consider what happens if you have to move or if you house price goes down (this can affect how much you can borrow, but typically doesn’t).
No matter how you look at it, this is a complicated strategy. But if it means saving tens of thousands of dollars, it’s probably worth thinking about before diving into a mortgage.