My Articles > The Smith Manoeuvre - Using the Equity in Your Home to Invest for Your Future
One of the reasons our American neighbors enjoy a higher standard of life than us Canadians is because every year they receive a tax refund on their mortgage interest payments. We in Canada are not so fortunate. In fact, the only question posed to determine whether interest on loans in Canada is tax-deductible is "What were the funds used for"? If they were used to purchase an investment, the interest paid on such borrowings is tax-deductible.
The ability to claim mortgage interest as an expense makes a huge difference to one's net worth. If we look at an example where an individual has a mortgage for $200,000 at a rate of 7% amortized over 25 years, the total interest paid in the first year would be $13,703.09. If an American is in the 40% tax bracket, he would receive a tax-free cheque for $5,481.24. Not bad, right?
All that said, there is a way to re-organize our financial strategy to make interest on our mortgages tax-deductible. Fraser Smith is a Canadian financial planner that coined the term known as "The Smith Manoeuvre", which is the method of converting non-deductible interest on the mortgage to tax-deductible. In his Canadian best seller book
Is Your Mortgage Tax Deductible? he calls this process the conversion of bad debt to good debt. Here it is how it works
Every time you make a mortgage payment, a portion of it goes towards the interest and a portion towards the principal. In order to employ "The Smith Manoeuvre", you need to borrow back the portion that went towards the principal and invest it into some type of an investment. At this point you still have the same amount of the debt outstanding, except that the newly borrowed portion is now classified as the investment loan. You still have to pay the interest on it; however this interest is now tax-deductible. The process continues month after month. Every time your principal is reduced, your investment loan is increased by the same amount, and the interest that you pay on it is subject to tax refunds by the CRA. The money you receive from the tax department can be put against your mortgage principal, which will automatically provide you with additional funds to purchase more investments. Once you have completely converted your mortgage to the investment loan, you will have an investment loan equivalent to your original mortgage, on which you will continue receiving tax refunds, indefinitely.
"The Smith Manoeuvre" advocate argues that by the time a full conversion of the bad debt to a good debt has been completed, your investment portfolio should significantly outgrow your investment loan, provided you invest in some combination of stock, bond or mutual funds investments. At this point you could sell a portion of your investments to discharge your loan, but whether this should be done or not will depend on your individual financial circumstances, as you will continue receiving tax rebates for as long as the investment loan is outstanding.
The best seller book also underlines the importance of employing "The Smith Manoeuvre" now rather than later. This is probably the most important thing as waiting for 15 to 20 years to pay down your mortgage before you begin to invest loses you 15 to 20 years of compounding periods.
On another note, it is also assumed that the investments you purchase are providing a return that is higher than the after-tax-rebate cost of borrowing on the investment loan. Furthermore, it is also assumed that the investors who apply this method are actually risk-averse individuals willing to invest in higher-risk investments.
There is no significant cost to start using "The Smith Manoeuvre" method. All you have to do is set up a Home Equity Line of Credit that will allow you to immediately borrow back the principal you pay down on your mortgage and an access to a financial planner who specializes in "The Smith Manoeuvre" technique to provide you with an in-depth advice on how this method works.
For more information on this method, you can visit "The Smith Manoeuvre" official website:
www.smithman.net
