New Business from your Client's Mortgage

The Smith Manoeuvre is a mortgage management strategy that generates free annual tax refund cheques by converting the existing non-deductible mortgage interest to deductible investment debt.  Client debt is not increased, but the debt conversion process provides the double benefits of new free money via tax refunds, plus the simultaneous creation of an investment portfolio of diversified assets, which are always free and clear.

In order for The Smith Manoeuvre to work for your client (let’s call the client “Brian”), you need to locate a financial institution that will do four things:

1. Lend back to Brian, immediately, every dollar he pays off on his house mortgage, to be used for the purchase of investments.

2. Relieve Brian of the requirement of paying off any principal on the new investment loan until after the first mortgage is paid off.

3. Capitalize the interest expense, so that Brian won’t have to use after-tax dollars to pay the interest on the new investment loan, until after the first mortgage is paid off.

4. Agree that investments purchased using the deductible credit line will be perpetually free and clear, with Brian’s house as the security for both the mortgage and the investment line – even if the first mortgage is with a competing institution.

I would advise Brian to use every tax-paid dollar he could spare to apply against the first mortgage, in addition to the regular payment.  Equally important, he should never use tax-paid dollars to reduce the good loan (the deductible one) as long as the bad one (the non-deductible mortgage) is in place.  All after-tax dollars should be used to overpay the first mortgage, and an equivalent amount is borrowed back immediately to buy investments.

The investments will be purchased with money borrowed at the lowest rates possible, because the house is the prime security.  The interest will be a tax deduction.  Brian will apply the resulting tax refund cheques against the first mortgage and borrow back an equivalent amount immediately to buy more investments, thus repeating the process yet again.

Having also spent some time on Section 20(1) of the Income Tax Act, I had come to realize that if compound interest on a deductible loan is itself deductible, it should be capitalized until the non-deductible loan has been retired.

Finally, with Brian’s house as collateral, not only would he be able to borrow to invest at prime or prime minus, the investments would always be free and clear.  The compounding, diversified investment portfolio of free and clear assets would always be available to reverse the process should Brian lose his job or run into financial difficulty, thus eliminating the risk of losing the home under those circumstances.

If Brian followed these steps, he would soon be enjoying the pleasure of paying down his first mortgage quickly while simultaneously building a rapidly growing, diversified, free and clear investment portfolio.

After a few years, Brian’s debt conversion would be completed, at which time he could decide whether to retain or retire the deductible loan.  I would advise Brian to keep the deductible loan in place paying interest only so his cash could be used to continue his investment program.  This is one of the tactics of the wealthy – they keep deductible loans in place to generate ongoing annual tax deductions.  The funds not used for reducing a good loan are therefore available to invest.

The benefits of converting a non-deductible interest mortgage to a deductible interest investment loan using The Smith Manoeuvre are rather spectacular and can be confirmed using the software I have developed, called The Smithman Calculator.

For example, let’s say Brian has a $200,000, 25-year mortgage at 7%.  His cost to borrow to invest is also 7% and he is projecting his pre-tax investment growth rate to be 10%, the 50-year average in Canada.  At the end of 25 years his tax refunds and portfolio growth will total $451,742.  His net worth improvement will be $251,742 after offsetting the $200,000 investment loan, which is still generating a $14,000 per year tax deduction as it has done for each year of the prior two decades of his life.

Even if Brain’s money cost 7% and he only earned 8% on his investments he would still have a net improvement of $137,513 according to The Smithman Calculator.

These results are the essence of The Smith Manoeuvre and arise solely from the conversion from bad debt to good debt, plus the application of the resulting tax refunds to pay down the mortgage faster.  No new money is required on Brian’s part, and his debt is not increased.

Once your client is operational with The Smith Manoeuvre as described above the infrastructure will be in place to automatically take advantage of tools already known and utilized by most financial planners.  The most obvious next step would be to trigger any debt swapping potential.

Assume Brian has a $30,000 rainy day fund made up term deposits and GIC’s outside his RRSP.  Brian should liquidate these assets, apply the proceeds against the debt of his first mortgage, and reborrow from the deductible interest credit line to create new investment debt.  These are the steps Brian should take to effect a debt swap from bad debt to good debt.

The benefits are huge.

The Smithman Calculator indicates that this move increases the value of the portfolio to $951,362, and after offsetting the $200,000 investment loan, the net improvement to this family is $751,362.

To be fair, Brian’s $30,000 was already invested, so to get a net picture we should deduct the future value of $30,000 which reduces the net effect of The Smith Manoeuvre to $426,321.

The Smithman Calculator also allows Brian to calculate the net benefit of diverting his monthly investment allowance against his first mortgage so that he can subsequently make his investment purchases with borrowed money.  The incremental improvement in his net worth is exciting to see.

This, in a nutshell, is The Smith Manoeuvre.  Borne from a rather simple but glorious concept, it accomplishes for an ordinary, average-income earning Canadian a simultaneous program of rapid mortgage loan reduction and rapid asset accumulation.  The mortgage melts away quickly as new, free money begins to arrive in the family mailbox in the form of tax refunds.  Simultaneously, a free and clear investment portfolio grows, largely tax-free, with the help of a good financial planner.  The portfolio will have many years to grow, and as we all know, time is the friend of compounding investment growth.

Fraser Smith is a retired financial planner and the pioneer of The Smith Manoeuvre.  He resides on Vancouver Island.  Visit his website at www.smithman.net