Using the Smith Manoeuvre: My Scenario

As promised, I will be discussing my personal scenario regarding using the Smith Manoeuvre. The spreadsheet provided by Cannon_Fodder was a great help and reinforced in my mind the power of smart tax planning.

Anyways onto the good stuff. Spring is here which means my wife and I are on the house hunt. With this comes the opportunity to use The Smith Manoeuvre on our future home, but I would like to discuss some of the numbers that I came up with to make sure that they made sense. From the comments on the article “Anti-Smith Manoeuvre“, it appears that some of you are better at analysis that I am. :)

Without further adieu, here are the numbers:

  • Current Residential Home Value: $140,000
  • Current Mortgage: $80,000
  • Equity: $50,000 after Realtor fees.
  • Cash Savings used: $20,000
  • Non-Registered Portfolio: $40,000 (liquidate)
  • Total Down Payment: $110,000
  • New House (estimated): $275,000
  • New Mortgage: $275k-110k= $165,000 (non tax deductible)
  • New HELOC (@ 6%): [ ($275k x 75%) – $165k] = $41,250 (tax deductible)
  • Total Debt: $206,250
  • New Mortgage Payment (accelerated bi-weekly) @ 5.25%: $584.12 (not including property tax, insurance etc).
  • Original Amortization: 16 years

The Criteria:

  • All tax returns will be applied to the non-deductible mortgage balance, which then again, increases the HELOC balance.
  • All dividends will be used to pay down the non-deductible mortgage.
  • HELOC interest payments will be capitalized. That is, the HELOC required payments will be paid by the HELOC itself. This will avoid using any of my own cash flow to support the investment loan. The spreadsheet will account for this.
  • Assume that the LOC will be invested in dividend paying stock that provide an income stream of $1400/year (assume 3.5% average dividend yield). This equates to a $54 / bi-weekly period applied to the mortgage. This should be increasing annually but for simplicity sake, I will be keeping this constant.
  • Assume that since I’m going to continue to max out my RRSP, I won’t have any extra cash to pay down the mortgage.

The Assumptions:

  • Marginal Tax Rate: 40%
  • Average Investment Growth Rate: 8%
  • Diverted Periodic Investments: $54
  • HELOC Interest rate: 6%
  • Mortgage Interest Rate: 5.25%

The Results:

  • Non-deductible mortgage will be paid off in 11.78 years instead of 16
  • Investment Portfolio Value after mortgage is retired: $244,833
  • Portfolio Value NET of HELOC: $38,583
  • Investment Portfolio Value after 25 years: $908,640
  • Portfolio Value NET of HELOC: $702,390

Summary:

  • This analysis shows the benefits of using the Smith Manoeuvre, not the down side. You need to be comfortable with leverage, especially the downside, before you even consider using this strategy.
  • The Smith Manoeuvre will enable me to pay off my mortgage in 12 years instead of the stated 16 years with no extra cash flow out of my pocket.
  • At the end of the mortgage term, assuming that I average 8% returns over the term, my portfolio value minus the loan amount will be approximately $38,000.
  • It is very likely that we will be putting some of own cash flow/savings to pay down the mortgage. If we were to add an extra $100 to our bi-weekly payments, we would reduce the mortgage term down to 10 years from 12.

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FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.
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Ed Rempel
8 years ago

Hi Johnny,

I hope you know I’m not trying to rain on your parade. I am just trying to educate people.

Here’s my issue with the RRSP mortgage. You are putting extra money into your RRSP without getting a tax deduction on it. You will now have to pay tax on that amount.

Let’s look specifically at your situation. Let’s compare it with what most people do, if they essentially want no risk.

Today, you can get a mortgage as low as 2.7% and you can get a GIC as high as 3.1%. For ease of math, let’s say you can get both independently at 3%.

So, you could get a mortgage from the bank at 3% and you could invest your RRSP in a GIC at 3%. No fees.

With your RRSP mortgage, you have a 5.75% mortgage for $200,000 and a 5.75% fixed interest investment in your RRSP. This is 2.75% higher than you would have normally, or $5,500/year higher mortgage interest and RRSP return.

If you look at the math, you are paying an extra $5,500 and putting it into your RRSP. You don’t get 5.75% compound interest on it in your RRSP. It becomes cash in your RRSP that you need to invest in some way.

To see the net effect, let’s say you immediately withdraw that $5,500. If you are in a 40% tax bracket, you pay $2,200 in tax and have $3,300 left over.

If instead of that, you had kept that extra $5,500 in your chequing account, you would still have the entire $5,500.

Do you see my issue, Johnny?

Your artificially inflated mortgage interest results in putting money into your RRSP that you now have to pay tax on to get out.

And you paid $3,250 in fees to do this.

I’m just reading an awesome book called “Thinking Fast and Slow” by Daniel Kahneman. (He is the main guy that proved the “efficient market theory” false.) The book is about all the ways that the human mind is systematically illogical. I would highly recommend it.

I think the RRSP mortgage is one of those situations. It sounds good intuitively because you are “paying your mortgage to yourself” and your RRSP has a “high risk-free investment”. However, the fact that you are making an inflated mortgage payment into your RRSP does not change the fact that you have to pay it with real cash – and then pay tax to get it out.

It’s one of those strategies that sounds great to an intuitive mind, but does not work on paper.

Sandy’s version is better in that he uses a tax-deductible mortgage at the end of the Smith Manoeuvre to put into the mortgage. This of this as a “tax-deductible RRSP mortgage”. This solves the tax issue, since you pay an inflated tax-deductible interest amount into your RRSP – which you then have to pay tax on to get out. The tax evens out.

You still have to pay the fees, though.

Sandy’s strategy is not bad. However, if you can borrow from the bank at 2.7% or 3.5% and then invest in your RRSP and make more than that over time, then you would be ahead of the “tax-deductible RRSP mortgage strategy”.

The Smith Manoeuvre is a leveraged investing strategy designed for people that want to build wealth. It is not for GIC people or people that want little risk. It is a riskier strategy.

In our practice, the people doing the Smith Manoeuvre are usually quite comfortable investing for the long term in investments that should average more than the bank will charge them for a mortgage or credit line (e.g. 3.5%/year) long term. So, they would not normally be interested in the “tax deductible RRSP mortgage strategy”.

Why settle for RRSP returns the same as your mortgage rate when you can make far more with effective investing?

In short, even if the mortgage is tax deductible, I still see little benefit in the RRSP mortgage strategy.

If you doubt me, put all your figures into a spreadsheet and compare them to some other reasonable strategy. The math is needed for the human brain to question what it intuitively believes to be true.

Ed

Sandy
8 years ago

Johnny Canuck:

We don’t really view the Smith Manoeuvre as a competitive strategy to what you are doing – it’s more of a question as to which stage of mortgage homeownership you are in. I routinely recommend this RRSP mortgage strategy to homeowners who have their Principal Residence paid off (or almost paid off) and have a substantial RRSP (typically they will be in their 50’s). It is also good for most post-TDMP clients – after all debt has been converted into a tax deductible loan and where both home equity and RRSPs have grown significantly.

Smith Manoevre and TDMP clients (more typically in late 30’s and 40’s) are not ready for this strategy yet primarily because their personal balance sheets are not strong enough. Even if cash flow is great, homeowners with sizeable mortgages are usually always better off completing the TDMP or SM first and considering this strategy later.

Under your plan, borrowing from your own RRSP not only guarantees a predictable rate of return, it gets your fixed income assets into your registered plans and frees up your cash to invest in your non-registered plans. Tax wise, everything is in the right place and technically, since there is no leverage, the risk is more acceptable – especially as one approaches retirement. However, if you’re too close to the forced RRSP meltdown age (71), this strategy becomes riskier on the liquidity side and I may not be so quick to recommend it.…

At TD Branch, this product is still available through TD Waterhouse. Canadian Western Bank is another option..but that’s it as far as I know. I’d be interested to know if there are any other lenders out there…

Johnny Canuck (Oakville)
8 years ago

Hi Sandy:
Our self-directed RRSP mortgage is handled by TD Canada Trust. It has the same flexibility and terms as a regular TD mortgage (20% prepayment annually, double up payments, skip a payment, etc). The original mortgage term was 7 years with monthly payments and a 20 year amortization, negotiated in March 2008.

In the spring of this year, many of the major banks were offering 3.99% on a 7 year and 4.99% on a 10 year fixed mortgage including TD. We decided to “renegotiate” our self-directed mortgage as follows

1. blended and extended the rate – original was 6.5%, now its 5.75%
2. increased the term – original was 7 yr, now its 10 yr (Note: TD will blend and extend if the new term is longer than the original term)
3. we switched to bi-weekly payments
4. we increased our payment amount (for an effective 10 year amortization)

No additional fees or insurance was required – no new money was advanced.

To get completely new terms, we would need to “break the contract” by paying the break fee penalty (the money would be paid into our RRSP, not to the bank). (Side note: I tried to have the various penalty clauses removed since we are lending the money to ourselves, but TD said that was not possible)

Although this is not a scenario that I hope ever comes to pass, we could “break” the self-directed RRSP mortgage contract, use our TFSA monies to pay the penalty fees into the RRSP, and then negotiate an arms length mortgage outside of our RRSP.

However, on the flip side, if I was to die before the mortgage term was completed (again hoping this doesn’t happen – hehe), the life insurance could be used to pay off the mortgage immediately, as well as pay the penalty fee directly into the RRSP.

Lastly, as previously stated, I did examine the Smith Manoeuvre. Two things stopped me from pursuing it – the possibility of RevCan revoking it retroactively (which has not happened), and the use of leverage which puts you in a delicate situation until such time as the investments grow large enough to have a margin of safe over the investment loan. But the idea was and is a great one for those with a higher risk tolerance and a long investment horizon.

p.s. Not sure if TD Canada Trust would do this now — we set this up in March 2008, before the financial meltdown. I have had a banking relationship with TD and its predecessors for about 30 years. For those old enough to remember, my first loan was from Canada Permanent (a trust co) bought by Canada Trust who merged with TD Bank.

Cheers,

Johnny

Sandy
8 years ago

Hi Johnny Canuck:

Well done! I think your strategy is excellent – and entirely appropriate given the strength of your personal balance sheet and assuming that you’re still earning (i.e. not retired).

You don’t often hear stories from individual consumers who successfully set up a non-arm’s length mortgage in a self-directed RRSP. There are very few CMHC Approved lenders that will actually allow you to do this these days – and there are rules to be followed. However, the tax and investment benefits can be outstanding.

I’m a big fan of the Smith Manoevre (SM) and its variations and I own and operate a program called the Tax Deductible Mortgage Plan (TDMP), but I have to admit, the strategy you describe can be better than all variations of SM and TDMP because there is no leverage – as you effectively act as both the lender and the borrower at the same time. I describe this strategy in my book; Mortgage Freedom under the heading “Be Your Own Banker”. It works best when it’s material enough to absorb the fixed setup costs (e.g. minimum $150K) and only if your balance sheet can handle the lack of liquidity – and by the way – an interest rate of 6 or 6.5% is perfect in the current environment.

What interests me about your Post is the comment that “..since we hold our own mortgage, we have considerable flexibility..” and you cite three examples including changing rates and making your mortgage interest only. My understanding of this strategy is that your mortgage has to be insured and abide by certain rules and I’m only aware of two lenders who offer this product. To my knowledge, neither provides the flexibility you describe. I’d be interested to know who is servicing your non-arm’s length mortgage and why you think you have such flexibility to change the terms – even though your own RRSP is the lender.

-Sandy

Johnny Canuck (Oakville)
8 years ago

Hi Ed:
While I doubt that I can convince you that an RRSP self-directed mortgage is a good thing, I will try to explain my logic on why it works for my wife and I.

The Mortgage Details
Our self-directed mortgage was taken for $200K on a home valued at $700K, with a 10 yr amortization @ 6.5%. Over the life of that mortgage, we will pay a total of $3250 in fees ($1,000 + $2250 for the CMHC insurance and 10 years x $225 as the annual fee to the bank for handling the paperwork). $3250 / $200K = 1.625% which I consider a low fee not a high fee.

The Motivation
The mortgage was taken out 3 years ago at near market top (not bottom) — agree this was blind luck, but the motivation was not about where the market was going or fear. The motivation was risk reduction and cost certainty on our mortgage.

Risk Reduction
We no longer needed to be fully invested in the stock market. By my calculations, if we could achieve an annual return on our investments of 5.5% going forward, we would be able to retire very comfortably and not run out of money until the age of 90 (all without selling our house or counting on any government monies). So, we no longer needed to chase 8-10% returns. And if we could lock in a sizeable chunk of our portfolio at 6.5% for 10 years, we would be ahead of the game.

Cost Certainty – I can’t argue that 6.5% mortgage rate is very high (it is!), however, we are not paying that extra money to the bank –we are paying it to ourselves. In effect, we are increasing our RRSP contributions by paying a higher mortgage interest rate than the best market rate. I am self-employed and my wife has recently started to work after years of raising our children. Our total income is at its highest point ever. The payment on a ten yr am is 20% of our take home income (which is very comfortable) — while leaving room for us to pay it down faster with lump sum payments.

Diversification
My wife and I have other investments comprised of mostly stocks and preferred shares totaling $360K ($40K in TFSA, $320K in RRSPs).

The Worst Case Scenario
While recent history shows that anything can happen, it is highly unlikely that we would lose our home and our RRSP/TFSA at the same time. Even if Canada experienced a 50% drop in housing prices, and a 50% drop in the stock market, we would still have considerable equity in our home ($150K) and in our other investments ($180K). And with a sizeable amount in our TFSA, they could be used as our safety valve for an extended period without work

Lastly, since we hold our own mortgage, we have considerable flexibility to use other means to “save” our home if that became necessary
a) we could renegotiate a lower rate (with ourselves)
b) we could renegotiate the amortization period (to say 20-25 years)
c) we could renegotiate to pay interest only on the mortgage

And of course, we have life insurance and disability insurance to protection against those risks as well.

Thats the logic behind why we used our RRSP to hold our own mortgage.

Cheers,

Johnny

Ed Rempel
8 years ago

Hi Johnny,

The part of the strategy I can’t get past is your 6.5% mortgage. We have all our mortgages between 2-3%. 6.5% is about the most expensive mortgage I have seen in recent years.

Two other points:

1. The risk is that you are not diversified. Your RRSP is now also linked to your income, just like the rest of your finances. If you run into financial difficulties, you could lose your home and your RRSP at the same time.

2. The last 10 years were bad for the stock market, but that is not the normal long term return that it is reasonable to expect.

RRSP mortgage strategies seem to become popular at the worst possible times. When stock market returns are low, RRSP mortgages become more popular, along with any other defensive strategy.

Then the market turns strong again, so people cash in their defensive strategies (after the market rise) and buy into the market close to the top. That is the normal, but unfortunate, cycle.

When you do the math on all parts of the RRSP mortgage strategy and compare it to a normal strategy with good quality investments, the long term expected returns are dreadful. Whenever it becomes popular, I think that is a bullish sign for the stock market.

Ed

Johnny Canuck (Oakville)
9 years ago

Compound Annual Growth Rates

From———————To—————–DJIA——S&P500– NASDAQ
January 2, 2001 – January 27, 2012 1.56% 0.23% 1.88%
January 3, 2002 – January 27, 2012 2.16% 1.22% 3.24%

Source http://www.measuringworth.com/DJIA_SP_NASDAQ

Johnny Canuck (Oakville)
9 years ago

Hi Ed:
Perhaps this should be a separate discussion, but I will post a response in this thread.

While I would agree that a self-directed RRSP mortgage is not for everyone, I disagree with your comments which make it sound like it never makes sense. Here’s how I use it and make it work for me.

1. Most expensive mortgage in Canada ( perhaps you can explain why you believe this is so). My mortgage is only a portion of my RRSP (35%) and I treat it like the fixed income/bond/preferred share portion of my portfolio.
2. Dreadful return. The return is 6.5% which I believe you would have a hard time saying is a ‘dreadful’ return for a fixed income/bond/preferred share type investment. I chose the posted rate rather than the best possible rate that I could get to have a high return.
3. High fees. Yes, there are fees involved. One-time legal fee to setup the mortgage, one-time Canada Mortgage and Housing Corp (CMHC) insurance fee, and on-going annual trustee fee. The size of the mortgage and the amount of equity which you have in your home determines if the cost of these fees is high, medium, or low. General rule of thumb, if less than say 50,000-100,000 the fees may be too high. Also, if you do not have significant equity in your home, the CMHC insurance premium will be too high. However, in my case, the mortgage is larger than 100K, and I have 65% equity in my home so the CMHC premium was low. So, your comment about high fees, while it is a factor, is not always the case.
4. I am well aware that I still have a mortgage. Coincidentally, I recently adjusted the payments on the mortgage to ensure that I will be mortgage free before we become empty-nesters.
5. Risk management — which you do not list — I sleep better knowing that the fixed income portion of my portfolio is extremely low risk, highly flexible. I am not worried about the safety of government bonds, corporate bonds, changes in interest rates as it pertains to my fixed income portfolio. I am not chasing higher bond/preferred share income while increasing my risk.

I recently did a check on the CAGR of the TSX Composite, S&P 500, and the DJI 30 over the past ten years. The GIC investor likely earned more over that 10 year period and slept a lot better than those who have gone through the Financial Crisis in the markets.

Lastly, if your clients have earned 10% per year on your recommendations over the past 10 years, you have served them very well indeed.

Ed Rempel
9 years ago

Hi Johnny Canuck,

You may have lucked out by avoiding the 2008 crash, but it is important to look at these strategies based on reasonable long term expectations.

We are not fans of the RRSP mortgage strategy. In general, it is a combination of:

1. The most expensive mortgage in Canada.
2. A dreadful return on your RRSP investment.
3. High fees.
4. A mistaken belief that you have no mortgage.

In the long term, I expect my RRSP investments to make at least 10%/year (I’m an aggressive investor). I don’t have mortgage, but our clients’ mortgages have all been at rates between 1-3% for the last several years. Normally, the have no mortgage fees at all.

The RRSP mortgage strategy cannot come close to any of these. I think the RRSP mortgage only makes sense for GIC investors.

Ed