Should you borrow to invest with the Smith Manoeuvre? – MoneySense

Advertisement
Ask a Planner
By   Jason Heath   on June 6, 2022
Estimated Reading Time: 6 minutes
By   Jason Heath  on June 6, 2022
Estimated Reading Time: 6 minutes
Warren is trying to crunch the numbers on borrowing to invest using a strategy often referred to as the Smith Manoeuvre.
Advertisement
Photo by Andrea Piacquadio from Pexels
Do you know of any Smith Manoeuvre calculators? The more variables I add, like inflation, ROI, different interest rates for principal, HELOC vs. variable-rate mortgage, the more my head spins.
–Warren
Advertisement
Advertisement
I am not familiar with any Smith Manoeuvre calculators, Warren, but I can try to simplify the math a bit. First, what is the Smith Manoeuvre? It was developed by Fraser Smith in the 1980s as a method to make mortgage interest tax-deductible while building investment assets.
Lenders will typically allow you to have a home equity line of credit (HELOC) for up to 80% of the value of your home minus your mortgage balance. (If you are refinancing, your HELOC may be limited to 65% of the home’s value.) 
As an example, say you have a $750,000 home and a $600,000 mortgage with an interest rate of 4%. Your HELOC would be $600,000 less your mortgage. As you pay down your mortgage, the equivalent amount of room is added to your HELOC limit. Assuming a 25-year amortization, the first monthly payment for your mortgage pays down $1,173 of principal. After 12 months, you will have repaid $14,330 of principal and added the equivalent amount of room to your HELOC.
The Smith Manoeuvre involves borrowing the new room available on your line of credit to invest each month. The interest is tax-deductible if the funds are invested in a taxable non-registered account, and you end up with more investment assets growing over time. If you use all the new room, your mortgage debt level stays the same, because you’re borrowing back every dollar of principal you repay—but more of your debt becomes tax-deductible. 
You mention a few variables that you are having trouble addressing in your calculations, Warren, including inflation. Inflation will have an indirect impact on the numbers.
If inflation is high, interest rates will also typically be high to fight inflation. According to the Bank of Canada, it aims “to keep inflation at the 2 per cent midpoint of an inflation-control target range of 1 to 3 per cent.” Right now, inflation is over 6%, so inflation is on everyone’s mind. But over time, inflation will return to the target, hopefully by 2023, based on the Bank’s assessment.
If high inflation were to persist, not only would interest rates stay high, but investment returns would also likely be higher. Interest rates would be higher for bonds and guaranteed investment certificates (GICs). Persistent high inflation as represented by increasing prices for goods and services would generally lead to higher corporate profits and stock returns as well. (More on interest rates below.)
Warren, I’m inclined to assume that your calculations are over a long enough period that inflation is back under control and not a factor in deciding whether to borrow to invest. I would not recommend borrowing to invest as a short-term strategy. Market timing is very difficult, and leverage increases investment risk. So, if an investor decides to borrow to invest, it should be over a long time horizon.
Advertisement
Advertisement
The return on investment (ROI) is relevant and is impacted by two primary factors: your risk tolerance and your investment fees. 
The Smith Manoeuvre probably works best with an all-equity or high-stock-exposure portfolio, so if you are not an aggressive investor, it probably does not make sense to consider borrowing to invest.
If you do borrow to invest, however, what ROI is realistic? Over the past 50 years, the Toronto Stock Exchange (TSX) returned 9.6% annualized and the S&P 500 returned 11.7%. That said, inflation was much higher over that period—3.9% annualized—compared to the current Bank of Canada target of 2%.
Over the past 20 years, during which time inflation was 2%, the TSX returned 8.1% and the S&P 500 returned 8.4%. All rates are as of December 31, 2021.
For any long-run ROI projections, I would be inclined to consider more conservative assumptions than the returns of the past 50 years. For example, a globally balanced portfolio with 20% emerging market equities and the balance split between Canadian and foreign developed-market equities might be assumed to return 6.6%. This is based on FP Canada’s 2022 guidelines for Certified Financial Planners, which estimate a 6.3% return on Canadian equities, 6.6% on foreign developed-market equities and 7.7% on emerging-market equities.
What about interest rates? The prime rate is currently 3.7% and is widely expected to rise another 0.5% in July, potentially followed by a couple more rate increases before the end of the year. So, the interest rate on a HELOC could be over 5% by 2023, and five-year fixed mortgage rates are already around 4.5% at the Big Five banks.
FP Canada’s current guidelines suggest assuming a borrowing rate of 4.3% over the long term. So, in a simple example, borrowing at 4.3% and investing at 6.6% should produce a profit. For every $100,000 of leverage (money borrowed to invest), the profit would be about $2,300 per year pre-tax (6.6% return minus 4.3% interest), and likely $1,500 or so after tax.
However, not everyone who borrows to invest will put 100% into stocks. And if you work with an investment advisor or use mutual funds, your returns could be 1% to 2% lower due to fees. That basically negates most of the potential profit based on the assumptions above.
Advertisement
Advertisement
So, the best candidate for borrowing to invest may be an aggressive investor paying low fees. The potential upside is there, but it may not be worthwhile unless you get lucky and invest at the bottom of the market. I am not a big fan of market timing, given that data shows how hard it is for investing professionals, let alone anyone else.
Another consideration is that most people would be better off maxing out their tax-free savings account (TFSA) and registered retirement savings plan (RRSP) before borrowing to invest in a non-registered account. Interest on money borrowed to fund these accounts is not tax-deductible, mind you, but the returns are tax-free (TFSA) or tax-deferred (RRSP).
In response to your question about whether to use a home equity line of credit or a variable-rate mortgage for borrowing to invest, Warren, the line of credit is more flexible for taking withdrawals and making repayments, whereas a mortgage is a one-time advance of funds. 
HELOC payments are typically interest only at prime plus 1% interest, or sometimes a lower premium. The interest on variable-rate mortgages is typically prime minus a discount, so this could result in a lower interest rate. However, mortgage payments include principal plus interest, so they would be higher each month. To bring down your interest costs, you can typically convert a HELOC balance into additional mortgage debt. 
In summary, Warren, there may be an opportunity to build wealth by borrowing to invest. This strategy works best for aggressive, low-cost investors with a long time horizon. It should probably be considered only after maxing out tax-preferred investment accounts. For investors with a moderate risk tolerance or high investment fees, the investment returns may not outpace the interest costs.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ont. He does not sell any financial products whatsoever.
Share this article Share on Facebook Share on Twitter Share on Linkedin Share on Reddit Share on Email
Your email address will not be published.



Don’t forget the Enhanced Smith Manoeuvre for business owners. Monies borrowed against the HELOC are lent to one’s own business to give it extra working capital. Interest on borrowings is personally tax deductible (thus frees up tax refunds) and now the business has cash to invest in a Personal Pension Plan. That in turn creates corporate tax deductions and puts money to work in a tax deferred environment with all of the myriad of advantages conferred on pension plans (fee deductions, creditor protection, access to non-RRSP asset classes etc.)
Thank you for the article, Jason. I fully agree – The Smith Manoeuvre is a long-term strategy; as long as it gets. Considering market and rate fluctuations, one should be prepared to continue the strategy at least until the mortgage is fully converted from non-deductible to deductible. At that point the homeowner can decide what approach to take – maintain the fully deductible debt or begin to pay it off. All depends on the individual. Also, to expand for the benefit of your readers, because the HELOC debt is tax-deductible, the actual rate being paid is less than the stated rate. For example, if one is at the 40% marginal tax rate and the stated HELOC rate is 5%, considering the deductions, the real rate is only 3%, which further reduces the break-even hurdle.
I’m not sure how Smith got famous with this manoeuvre, because it’s something I did aggressively in the 80’s, 90’s and 00’s without ever hearing of him. Soon as I had a small dent in first house mortgage, used that room to buy a farm. Had a personal rule to not pay non-tax deductible interest. I moved to a lower cost house and had it fully paid. Then used a Heloc to buy more property. Always tried to pay down the Heloc quickly so I could ramp it back up for downpayment on new property. We weren’t in an era of ever increasing property prices so had to use rental cash flow. In the late 90’s money making stocks were out of vogue and cash burn was in vogue (sound familiar?) so there were some great bargains in things like REITS and oil trusts. I recall using the Heloc to buy some with 10-15% dividends, I guess because they were making money and nobody else wanted money-making companies. (It’s all described in my book). Without looking back to verify, my recollection is that virtually all our non-registered accounts grew from that starting point.
That said there is still a lot of asset valuation issues across the investment spectrum and leverage is leverage. It cuts both ways. The process can work great if you’re buying a bargain, but not if overpaying.
Oh and as a last thought, and I don’t mean to be condescending, but if someone is looking for computer or website calculator to figure out if it will work, then it’s probably not a good approach for them.
Advertisement
Investing
Retail inventory glut continues, the eye-opening data on future…
Taxes
What tax returns should be completed when someone passes…
My MoneySense
Having learned to overcome money regrets, the author and…
A Rich Life
The psychology of money, also known as financial psychology,…
Ask a Planner
When the first home savings account opens later this…
Investing
As historically bad a year as it was, 2022…
The Fourth Estate
Sponsored By
Harvest ETFs
Ask a Planner
Between a TFSA and non-registered accounts, what is the…
loans
Created By
Credit Canada
Auto
Why would a dealership bill more hours than its…
MoneySense is a digital magazine and financial media website, featuring content produced by journalists and qualified financial professionals. MoneySense is owned by Ratehub Inc., but remains editorially independent. While our goal is to provide accurate and up-to-date financial content, we encourage readers to practice critical thinking and cross-reference information with their own sources—especially before making any financial decisions. While our editorial team does its best to ensure accuracy, details change and mistakes happen. If you read something you feel is incorrect or misleading, we would love to hear from you. MoneySense is not responsible for content on external sites that we may link to in articles. MoneySense aims to be transparent when we receive compensation for advertisements and links on our site (read our full advertising disclosure for more details). The content provided on our site is for information only; it is not meant to be relied on or used in lieu of advice from a professional. Advertisers/partners are not responsible for and do not influence any of the editorial content appearing on MoneySense.ca. Our Advertisers/partners are also not responsible for the accuracy of the information on our site. Be sure to review the provider’s terms and conditions for all products and services displayed on MoneySense.ca. Product information and details vary for Quebec. For complete and current information on any product, please visit the provider’s website.
© 2002-2023 Ratehub Inc. All rights reserved
© 2002-2023 Ratehub Inc. All rights reserved

source

Leave a Comment