This post was originally posted in 2009, but brought back to the foreground after some readers emailed me about the same topic. I added a couple of comments below on how my philisophy on this matter has changed over the years.
A reader question that I’ve been getting quite a bit lately is, what if you’ve paid off your non-deductible mortgage while implementing the Smith Manoeuvre? What do you do with the large remaining investment loan?
For new readers out there, let’s get into a little background information. The Smith Manoeuvre is a leveraged investment strategy where you borrow from your home equity to invest in income (or potential for income) producing assets. Basically, you obtain a special kind of mortgage, called a re-advanceable mortgage, which increases the credit line limit as the mortgage is paid down. The credit line is then invested. There will come a point where the non-deductible mortgage gets paid off completely and the investor is left with a large line of credit that’s invested in the market. If you are interested in this topic, you can find more detailed information about the Smith Manoeuvre here.
Besides jumping up and down in celebration, there a few options once the non-deductible mortgage is paid off.
- Keep the investment loan forever. This is the main strategy if you follow the Smith Manoeuvre to a tee. The rationale is to keep collecting the tax deductions for the remainder of your life. I’m personally not too comfortable with that option. More on this below.
- Pay off the investment loan completely over time. The opposite of the above is to start paying off the investment loan once the non-deductible mortgage is wiped out. Basically, the investor here would apply the old mortgage payments towards the HELOC. The tax deduction would still apply, however at a reduced amount every year as the HELOC balance reduces. I’m more in favour of this option, or the one below, as I’m not sure I would be comfortable having a large looming debt during retirement. Even if it’s good debt.
- Pay off a portion of the investment loan. This is a hybrid of the above strategy where the investor would pay down the investment loan down to a point where they are comfortable with the monthly payments. The investor can decide how much per month they can afford to pay indefinitely and pay down the balance accordingly. Of course, the investor would have to account for higher inflation years as it would affect his monthly line of credit servicing costs.
To answer the reader email, the three answers above are all correct, it’s up to the investor to decide how much risk they can swallow. As I mentioned above, I will most likely be paying down my investment loan prior to retirement to ensure that the monthly payments are manageable even in times of high inflation. Hopefully, at that point, the dividends from the investments will be head and shoulders above the required investment loan servicing costs.
For those of you with a leveraged portfolio, what is your long term plan?
Update 2017: Since starting the SM in 2008 and paying off our regular mortgage in 2010, we have not paid down our HELOC – not one dollar. In fact, we continue to borrow from the HELOC as opportunities arise in the stock market. If we ever get to the point of maxing out our credit limit (or if interest rates get out of control), we will likely start paying down the investment loan. In the meantime however, we will continue to maintain the HELOC balance for the foreseeable future. Here is the latest update on my SM investment account which falls within my financial freedom journey.