Welcome to the first in a series of articles that will bust the myths and misunderstandings held by many Canadians – homeowners and financial professionals alike.
If you’re new here, the first thing to know is that The Smith Manoeuvre is a financial strategy which Canadian homeowners can implement in order to:
1) significantly reduce their tax bill,
2) pay out their expensive mortgage much faster, and
3) start investing for their future with money that otherwise wouldn’t exist.
And it doesn’t take any extra money from the homeowner’s pocket to generate these benefits. More can be found at www.smithman.net but first on to the first myth!
This first myth is a point of contention for many – they believe The Smith Manoeuvre is a leveraging strategy. That is understandable to a degree, but you’ll find that’s not the case when you look at the whole picture…
The Smith Manoeuvre is a Debt Conversion Strategy
The Smith Manoeuvre should be considered a debt conversion strategy. Leverage typically occurs when one increases their debt in order to invest. With The Smith Manoeuvre, there is no increase in debt. The amount of debt that the homeowner starts with – the amount of mortgage debt – is the amount of debt that the homeowner will end with, and this debt was incurred – the leverage occurred – when the homeowner bought the house, regardless whether they implement The Smith Manoeuvre or not.
The following anecdote will hopefully explain why this is considered a debt conversion strategy, not a leveraging strategy.
Let’s look at the fact that some people have an interest-only line of credit as their ‘mortgage’ as opposed to an amortizing loan with principal plus interest payments as most do. Let’s look at Emily in this example. Each month Emily makes an interest-only payment and her total debt changes not one dollar. Beginning of the first month, end of the first month, beginning of the next month, and on and on, her debt load is always and forever $300,000. By its very nature, an interest-only payment is less than a principal plus interest payment of an amortizing loan.
Emily is Starting to Think About Retirement – You Too?
Emily has started to think about retirement and like many Canadians, she has become concerned and realizes that she needs to take action. So, what does she do? She talks to her buddy Adam who is a mortgage broker and Adam informs her that based on the $300,000 balance and current rates, if she were actually making principal plus interest payments, on top of the $1,000 interest-only payment she already makes, she would be paying another $1,500 for the principal component for a total monthly payment of $2,500.
So, Emily decides to start saving for her future by directly investing $1,500 from personal cash flow each month. With an interest payment on the line of credit of $1,000 and an investment contribution of $1,500 she is out of pocket $2,500 – the exact same amount he would be if she were making a regular P&I mortgage payment like most Canadians with mortgages.
What does her situation look like after two months? $300,000 of total debt and $3,000 invested. After three months? $300,000 of total debt and $4,500 invested. After four months? $300,000 of total debt and $6,000 invested.
But if Emily were implementing The Smith Manoeuvre, what would her numbers look like after a year? Exactly the same. Each and every month she would be coming up with $2,500 for the mortgage payment and each and every month she would have the same total mortgage balance as if she were following the above interest-only process. She would have the same amount of dollars invested as well.
No matter what month you looked at for the first twelve months, her total debt in either scenario would be the same and the amount of dollars she had contributed to her investment portfolio would be the same.
Would You Rather Have Non-deductible Debt or Deductible Debt?
The differences however – and they are big ones – are that if she continues to make interest-only payments, Emily will have $300,000 of non-deductible debt until the day she decides she’s has enough of this world and is ready to move on to the next. With The Smith Manoeuvre, she will also have $300,000 of debt until the day she moves on, but it will all be 100% tax-deductible, meaning she will have received thousands and thousands of dollars back from the government in the form of tax refunds over the years and she will have a much bigger retirement portfolio because of these deductions.
And why do I only say, “No matter what month you looked at for the first twelve months…”? It is because as soon as she receives her annual tax refund and runs it through the mortgage and invests it, she now has more total funds invested than if she were following the interest-only scenario, it didn’t increase her total debt, and it still did not come from out of pocket. Because of this new money, she also has more invested. And more is better.
So if in one scenario there was absolutely, positively, 100% FOR CERTAIN no ‘borrowing to invest’ and in the other there appears to have been in one isolated moment of the whole process but the net result is the exact same amount of debt each year forever, where is the leverage?
When you ‘leverage’ to invest, your debt increases. If the debt does not increase, and it doesn’t, no leverage has taken place, and it won’t. The Smith Manoeuvre is a debt conversion strategy, not a leveraging strategy.