The Smith Maneuver - Should I Use It?
Lately I’ve been seeing a lot of posts, particularly from the world of mortgages, advocating for the use of the Smith Maneuver. This is a complex strategy and while it can provide some advantages, also brings along risk and uncertainty. In this article I’m going to go through what the Smith Maneuver is, pros and cons and how I generally view using it with clients.
What is the Smith Maneuver?
The main idea of the Smith Maneuver is to turn non-deductible interest payments into a deductible payment for tax purposes, thus lowering your tax owing each year. First, it is important to mention that interest on a mortgage for your home is not tax deductible in Canada. However, interest on debt used for investment purposes where there is a reasonable expectation for gains is deductible in Canada.
This is where Fraser Smith had the idea in the 1980’s for what is known as the Smith Maneuver. In order for the strategy to work you cannot use a regular mortgage but must have what is known as a re-advanceable mortgage. This type of mortgage is made up of both a traditional mortgage and a line of credit (secured against the home)how all bundled as one. The process for the Smith Maneuver is then as follows:
Each month make your required payment, for example let’s say it is $3500 with $1500 allocated to principal repayment and $2000 to interest
Take the $1500 allocated toward the principal out from the line of credit and invest it in a non-registered portfolio with the holdings of your choice.
There is now interest owing on the line of credit which you would pay each month and since the funds were used for investment purposes that interest is deductible (unlike the $2500 on the mortgage payment)
Finally the idea is to use the tax refund to pay down the principle of the mortgage further (creating more borrowing capacity) and re-invest it to the portfolio.
The appeal to many people is a) creating tax deductible interest from non tax deductible interest and b) using no additional funds to create an investment portfolio while still paying down the mortgage.
At this point a lot of people are thinking “save on taxes and build an investment portfolio, I’m sold!” However it is important to first consider the pros, cons risk factors and other planning options available.
Pros and Cons
Let’s first take a look at some of the pros and cons of the Smith Maneuver before I get into the financial planning discussion.
Pros
Turns non tax deductible interest payments into tax deductible payments
Can build an investment account/take advantage of early compounding with no additional cash flow required
Potential to pay off your mortgage faster by using tax credit toward additional principal repayment
Cons
Strategy is complex which may increase fees from professionals or if implemented incorrectly incur penalties
The strategy is risky. If you cannot follow it as it is designed and ride out periods of volatility or interest changes, you could go backwards
Your net debt does not go down. You are simply shifting it from a mortgage to a line of credit
Interest rate risk. If rates were to rise the strategy may become harder to execute since a higher return on investments is needed
Market risk. If the value of the house fell drastically the value of the loan may become higher than the value of the house
Risk Factors and Planning Considerations
The pros of the Smith Maneuver have been well covered – turn non deductible interest into deductible interest, create investments to utilize longer term compounding and potentially pay your mortgage down faster and increase your net worth quicker as well. It is of course just as important to consider the other side of the coin which are the risks.
As mentioned above the risks to using this strategy include changing interest rates, a significant drop in home value, fees or penalties resulting from incorrect structure, and volatility. One of the biggest risks in my opinion, is on the behavioural side. The strategy really only pencils out well when the person is conscious of their spending and cognizant of the fact that the taxes saved should be reinvested and put towards the mortgage principal. If someone takes that tax refund and spends it on something else, the strategy is going to be much less effective and perhaps a net negative in the long run.
I often see people advertising this strategy to “get the house you want while saving and building a portfolio for the long term.” As a financial planner I gravitate toward the strategic and responsible purchase of a house that is within a person’s means. I don’t mean the highest mortgage payment you get approved for.
I’m thinking about all the expenses of homeownership, daily living and other needs that the mortgage payment should not inhibit you from paying for. If someone tells me their mortgage payment and other bills are so large they can not afford to put some money aside for an emergency fund and long-term investments I generally see that they bought too much house.
Let’s go through a comparison.
Smith Maneuver vs. Lower Mortgage and RRSP
Greg is in the final stages of buying a house and he has narrowed his search to two options. The only differences between house 1 and house 2 is that house 1 would have a mortgage of $600,000, has an additional garage bay and is slightly larger with an additional 250 square feet. However, house 2 would result in a mortgage of $564,000. Although the additional space and garage bay would be nice Greg and his family wouldn’t need them to be happy and comfortable. To justify the higher price he is considering using the Smith Maneuver to try and justify the higher price and stay on track with his financial plan. Here is what he found.
Greg’s mortgage rate is quoted at 4.50%, his LOC (Line of Credit) interest rate is 5.00% and his projected investment return after fees and taxes is 6.00%. He always takes his tax refund and adds it to his mortgage principal. He is firmly in the 33% tax bracket the whole time. To cover the interest on his LOC he would need to withdraw some of the funds in his investment account.
Option 1: Greg chooses the higher priced home and uses the Smith Maneuver.
Summary from my large Excel spreadsheet:
His mortgage is paid off early by approximately 3 years (although will be dependant on renewal rates) but he still has a LOC debt of $600,000
He was refunded $90,019 in income tax total
He grew his investment portfolio to $679,728
He can then work to pay down the LOC or liquidate some of his investment account leaving him with $79,728
In year 25 the $79,728 will have grown to $94,957
Option 2: Greg chooses the lower priced home and takes the $2500 per year saved from the lower mortgage payment to invest in an RRSP. He also reinvests his tax savings to his RRSP each year once received.
Summary from Excel:
His mortgage is paid off in 25 years at which time Greg is totally debt free
He saved $ 20,625 in income tax total
His investment account grew to $189,829
In this hypothetical scenario with these specific numbers, I would recommend Greg avoid the Smith maneuver as it is likely to not yield a significant result for him but expose him to all of the potential downsides and risks. With that said, when investment returns are much higher than the LOC interest rate it becomes a more enticing option from a numbers standpoint. I still would generally always gravitate toward maximizing tax preferred accounts like the RRSP and TFSA before moving to a strategy like this. And even then, I prefer something called the debt swap accelerator. I’ll cover that another time.
Final Opinion
When it comes to the Smith Maneuver I, like many others, enjoy the idea of creating deductible interest from non-deductible interest. I do see how there could be certain situations out there where the strategy would be a wise move.
However, in my opinion I would gravitate towards less complex strategies where the variables can be controlled easier. For most people I would have a hard time recommending a Smith Maneuver, especially if they have RRSP and TFSA room available. The strategy takes commitment, patience and attention to detail. There are also things out of a person’s control that can derail the strategy which is partially why I would use other planning tools. I think something that should not be lost in this topic is the importance of not buying too much house and becoming “house poor.”
Simply working within a reasonable budget or saving more for a larger down payment is an important planning topic to remember and analyze. If someone needs to use the Smith Maneuver to have enough cash flow to invest, their situation and likely the way they handle money, is probably not suitable for the Smith Maneuver strategy.
My final word is to simply be cautious and ensure you seek advice from a professional or do your own research if someone recommends the Smith Maneuver to you.
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Please note the information provided herein is not tailored to any one individual and is general in nature. For specific recommendation consult with me directly. Although this article was written with the utmost care and based on sources deemed reliable, there is no guarantee of it’s accuracy.