Welcome to the fourth 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 third myth in this series:
Myth – the investment growth rate must at least equal the borrowing rate to break even
While the above statement may make sense at first blush, it is the case that the rate of borrowing you see on your statement is not the rate you are actually paying.
Fact – the true rate of interest is less than the rate applied to your borrowing balance.
Many people over-simplify by assuming that if the investment loan rate is 4% then the return on your investments must equal 4% to simply breakeven. However, because the interest on the line of credit is deductible, the real rate is less than the nominal rate. So, the nominal interest rate on the line of credit can be higher – significantly higher – than the investment growth rate and you are still coming out ahead in the long run.
Let’s look at some numbers. Let’s say I am paying 4% on the investment line of credit. Because the interest on that investment loan is tax-deductible, I get a tax refund of some of the amount of interest I paid throughout the year. Obviously, then, the total amount of dollars I have paid in interest is reduced…which means the actual rate on that investment loan must be lower than the stated 4%. The formula to calculate the real rate of interest is interest rate * (1-MTR). So, if I am at the 40% marginal tax rate, the calculation is 0.04*0.6 = 2.4%. That 4% money only really costs me 2.4%.
Let’s look at an example. The question we are trying to answer here is, at what point does the homeowner implementing The Smith Manoeuvre breakeven when adjusting the investment loan rate and the investment portfolio growth rate.
You can run this experiment with The Smithman Calculator but based on a $400,000 mortgage at 3.0% on the non-deductible portion which is amortized over 25 years, a marginal tax rate for the homeowner of 40%, and assuming a cash flow diversion of $300 per month from ‘squeezed cash’, the result is that even if the rate of interest the homeowner is paying on the investment loan is as high as 10% and the projected growth rate of the investment portfolio is only 2.5%, the homeowner is still to the positive.
This may not be intuitive, after all it seems like the rates are quite a large spread to the apparent negative for the homeowner, but there are a number of factors at play here. Specifically, that, again, due to the tax deductions the actual rate paid on that investment loan is lower than the nominal rate – the rate indicated on the monthly statement from your lender.
Secondly, we must remember that the tax refunds that are received go as annual prepayments against the mortgage and are in turn invested themselves. This puts the power of compound growth to our advantage while also reducing the amount of non-deductible interest payments we must make with our after-tax dollars – that is a huge advantage in our favour.
Thirdly, the higher the rate of interest we are paying on our deductible debt, the greater the tax deductions.
For more information, visit the What is The Smith Manoeuvre page.