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By Jonathan Chevreau
National Post
Tuesday, September 19, 2006 |
While grocery shopping on the weekend, a neighbour accosted me, asking if I still "endorse" the Smith Manoeuvre. Then, commuting to work Monday morning, another local acquaintance mentioned the same thing.
Adrian Mastracci, Portfolio Manager at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “For a 7% mortgage rate over 25 years, a homeowner in the 40% tax bracket would enjoy a 11.67% before tax equivalent return just from paying down the non-deductible mortgage: a return that is risk-free.”
Apparently, a marketing package is circulating which includes an August column I wrote about this particular method of making mortgages tax deductible. As sometimes occurs in this line of work, that column appears to have taken on a life of its own. The piece reported on the enthusiasm of some financial planners and mortgage brokers for the manoeuvre, which I've described a few times since I first reviewed Fraser Smith's book in 2002.
To avoid redundancy, some earlier caveats weren't repeated in the latest column. However it was not intended as an "endorsement" per se. I have never personally used this strategy. My own preference is to first pay off a mortgage and clear all debts, then to invest gradually in the markets with cash as it is earned.
What I do "recommend" is what I'd call a "Half Smith" -- paying down a mortgage quickly is the smartest thing any homeowner can do since that one act alone saves literally hundreds of thousands of dollars in interest payments.
Fully half the "Manoeuvre" comes simply from this commonplace fact. It's no secret. Vancouver-based portfolio manager Adrian Mastracci of KCM Wealth Management Inc., says that for a 7% mortgage rate over 25 years, a homeowner in the 40% tax bracket would enjoy a 11.67% before tax equivalent return just from paying down the non-deductible mortgage: a return that is risk-free.
But what about the other half, which involves borrowing to invest in the stock market? This is the riskier part of the strategy and certainly not necessary for those worried (as my neighbour was) about "losing his house." If that's your fear, do the half-Smith, not the full enchilada.
There's nothing new under the sun. This strategy is a variant of many schemes before it, such as Garth Turner's "The Strategy" -- unlocking otherwise fallow home equity to build a non-registered investment portfolio. A simpler variant is to sell off non-registered investments, use the proceeds to wipe out the mortgage, then repurchase the securities with a tax-deductible investment loan.
There's little doubt these techniques "work" and are legal. That's not the issue. If you structure the Manoeuvre properly with the appropriate flexible mortgage and investments, and ensure that your accountant and tax advisors concur with the details, you should be able to gradually "convert" the non deductible mortgage debt to a "deductible" investment loan.
But not everyone has the temperament to borrow to invest. "Leverage" is often described as a two-edged sword. If your investment returns exceed your borrowing cost, you should end up ahead -- as financial educator Talbot Stevens indicates in a self-published booklet on the topic. Of course, if the markets fall or "crash" right after you invest this way, you'll wish you'd never heard of these strategies.
Smith's view is homeowners already use "leverage" when borrowing to buy a home. If you're willing to bear the risk of borrowing to buy a house which might fall in value, then a loan of the same amount tied to the stock market shouldn't be any scarier, he argues. If the proceeds are in a diversified investment vehicle and the interest is tax deductible to boot, that's arguably less risky than investing in a single concentrated asset class (a "house" in one particular geographical location).
Smith's projections assume an optimistic 10% annual return from the markets. When I observed this in an earlier piece, he said he would revise his returns down to a more conservative 8%. This does not appear to have occurred in the recent wave of promoting the strategy.
Some people -- including me -- prefer to eliminate all debts, including a mortgage. Smith's technique means remaining indefinitely indebted by the same amount of your initial mortgage --- $200,000 in his examples. I'd prefer starting retirement without a $1,000 a month or more investment loan hanging over my head.
Still, such an investing program can be a form of forced savings. It imposes some discipline on a homeowner who might otherwise fritter away the tax breaks and interest savings on consumption.
I noted last time that in the United States, where homeowners can easily write off mortgage interest, the savings tend to go to consumption rather than investments. At least with the Smith Manoeuvre, it's necessary to invest in the markets, which should ultimately pay off if you have the temperament to stick with the program and not get scared off by market volatility.
For some, that's a big "if." And as always, those contemplating such strategies should check with their accountants and financial advisors.
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