Master Your Mortgage for Financial Freedom

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 Fraser Smith, who passed away in Spetember 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.

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.

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.

Marketing

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.

Other Observations

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%.

Conclusion

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.