Welcome to the second 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. Let’s look at the second myth in this series.
Keep an ear and an eye out and you’ll notice people stating, “The Smith Manoeuvre is accomplished by selling assets and using the redemption proceeds to pay down your mortgage then reborrow it back to invest.” No – that is simply the Debt Swap accelerator.
The Debt Swap is not The Smith Manoeuvre.
The Debt Swap is an accelerator of The Smith Manoeuvre. Technically the homeowner is executing a small Debt Swap on a monthly basis when the amount of the non-deductible principal reduction of the mortgage is reborrowed from the line of credit, or investment loan component and invested, thereby swapping non-deductible debt for deductible debt, but the Debt Swap in our context is a periodic or infrequent use of a relatively large amount of money to prepay the mortgage and reborrow to invest.
Near the beginning of my book, Master Your Mortgage for Financial Freedom, our wealthy example, Rebecca, starts out with a non-deductible mortgage just like everybody else, but she smartly decides to redeem enough of her existing investment assets in order to pay out that bad-debt mortgage entirely. At that point she has clear title to the house.
But she quickly recognizes that it does not make good financial sense to own a house clear title and have hundreds of thousands of dollars of equity earning her zero percent – in fact, less than that considering inflation. So what she does is, with available mortgage financing, she pulls back out the same amount that she paid down on the mortgage and she buys back the investments. She has converted 100% of her non-deductible mortgage to a 100% deductible investment loan and she still has the investment assets she had before the transaction. That is the Debt Swap on a grand scale, but the Debt Swap can also be accomplished with smaller amounts – $5,000, $10,000, $50,000, for example.
What Do The Numbers Say?
Let’s look at an example where we have a mortgage balance of $400,000 at a rate of 2.5% amortized over 25 years and a marginal tax rate for the homeowner of 38.3%.
Without The Smith Manoeuvre, this homeowner will take 25 years to pay out this expensive mortgage debt, will not have generate any tax refunds, and have $0 in investment assets at that time. With the basic Smith Manoeuvre, over the course of that original amortization period, the homeowner will enjoy tax refunds totaling $54,598, will have reduced the amortization by 2.33 years, and will have an investment portfolio valued at $828,181. Not bad at all. However, if they also execute a $50,000 Debt Swap from funds they already had available at the outset, these values improve to $71,636 in tax refunds, amortization reduced by 6.33 years, and the investment portfolio will jump to $1,138,435. Now we’re talking!
The Debt Swap is simply an accelerator for The Smith Manoeuvre. The fundamental concept behind The Smith Manoeuvre is to convert non-deductible debt to deductible debt and the faster you can do that, the better, but the basic essence of The Smith Manoeuvre entails simply the conversion of the amount of debt that is reduced by the regular mortgage payment. Anything in addition to this is an accelerator.
For more information, visit the What is The Smith Manoeuvre page.