March 31, 2007, 9:05 am

The Smith Manoeuvre (2nd part)

by: The Financial Blogger    Category: Smith Manoeuvre

In the previous post about the Smith Manoeuvre, I explained all requirements related to this financial technique. However, I didn’t tell you much about what it does really…Still interested? Here we go!

 

As previously mentioned in the first article, the Smith Manoeuvre requires with a Home Equity Line of Credit. In order to fully understand what a HELOC is, I suggest you click here to read a complete definition. The HELOC must be separated into two accounts. Account “A” will be your mortgage account. Account “B” will be your investing account.

 

The technique is fairly simple. At the beginning, you will have your owing balance only in your mortgage account and nothing in our investing account. On a monthly basis, you will drag part of your “mortgage debt” to your “investing debt”. This step is crucial for Canadian in order to be able to declare a tax deduction related to the interest paid on the investing account.

 

For example, let’s pretend that you can afford a $1500 a month payment on your mortgage. Your monthly interest is presently $750. With a traditional mortgage, you would pay $750 of interest and apply another $750 to your owing balance. The month after, you would have less than $750 in interest charge as your balance dropped from the previous month.

 

With the Smith Manoeuvre, things are working a bit differently. You will make your $1500 payment and pay your $750 of interest. The other $750 will also apply to the capital owing in account A. However, the same month, you will withdraw $750 from account B and invest this money in the stock market. Therefore, you will always owe the same amount of money. The debt will be transferred from your account A to account B. In the end, only your investment will grow.

 

The basic principle of the Smith Manoeuvre is to borrow at X percentage of interest to invest that money at X+ percentage of yield. As long as you are making the same return than your cost of borrowing, you will end up making money. As I did during my first post about the Smith Manoeuvre, I strongly suggest that you read about leveraging strategies and the risk involved. However, will a good investment plan and a horizon of ten years and up, you should not have to worry. You will get your property working for you!

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March 29, 2007, 4:24 pm

Example of debt elimination

by: The Financial Blogger    Category: Pay off your Debts

In the post “Pay Your High Interest Debt first” I was explaining why you should not pay your mortgage first but you should put all your efforts in high interest debt. In order to make your life easier and to understand how by not paying your major debt, you become be debt free, I will explain the technique through an example. In fact, by decreasing your mortgage payment, you will create extra monthly cash flow. Apply this extra cash flow to your highest interest debt in order to pay it off in a timely matter. Here are some figures to show how the whole technique works:

Let’s take the example of David and Tracy, a young couple in their thirties. They bought their house five years ago. At that time, they took a twenty years contract in the amount of $190,000. The property value was $220,000. They wanted to get rid of their mortgage as soon as possible. After five years, their house value increased to $260,000. Therefore, they built $70,000 equity in their home. Here are the details of their debts and monthly payment:

Type of loan

Balance

Minimum Payment

Interest Rate

Mortgage $159 244.74 $ 1 279,50

5,30%

Car lease #1 N/A $ 349,00

8,00%

Car lease #2 N/A $ 390,00

8,50%

Loan (furniture) $ 2 300,00 $ 35,00

14,50%

Visa #1 $ 2 200,00 $ 35,00

17,00%

Visa #2 $ 1 240,00

$ 25,00

19,00%

Mastercard $ 500,00 $ 10,00

18,50%

Americain Express $ 2 800,00 $ 40,00

15,00%

Line of credit $ 8 000,00 $ 60,00

9,00%

Their mortgage is coming to renewal and instead of keeping their existing amortization period, this couple decided to refinance their mortgage over twenty-five years. Therefore, they will pay off their mortgage in thirty years instead of twenty (as they were making their payments for five years already). Actually, they will take less time than that… really? Here’s why:

By refinancing their mortgage, their payment will drop to $953,56. They will then create an extra cash flow in the amount of $325,94 per month. The next step is to apply this extra cash flow plus the minimum required payment to the highest interest debt. Therefore, they will start to pay off their Visa #2 with a 19% interest charge. Every month, they will make a payment in the amount of $350,94 ($25 minimum payment in addition to the $325,94). After less than four months, their Visa will show a 0$ balance. Who’s next? Mastercard!

The payment will increase to $360,94 a month for this one (we take the monthly payment of $350,94 and we add the minimum payment required for the Mastercard; $10). This debt will be paid off within two months only.

Every time one of your debts is paid off, you will free up more cash flow. Always apply your total monthly cash flow on the next debt and you will pay them off in no time. In the present situation, our young couple will take 39 payments to pay off all their credit cards, personal loan and their line of credit. After a little bit more than 3 years, they will be left with a mortgage and two car leases payments. They could also decide to buy off their lease and apply the same technique.

If they decide to keep their car leases, they will still have an extra monthly cash flow of $530,94 (add up all minimum payments in the above chart plus the first $325,94). They could then decide to increase their mortgage payment up to $1810,44 per month! The mortgage would be paid off within nine years. David and Tracy would have taken seventeen (5+3+9) years to pay it down instead of twenty years from their original plan. All this was possible just by changing their debt structure and without taking any risks. I told you, do NOT pay your mortgage!

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March 27, 2007, 4:03 pm

Pay Your High Interest Debt First

by: The Financial Blogger    Category: Pay off your Debts

Another reason why you should not put your mortgage as the first debt to be paid is because you probably have other debts with high interest charges. I’ll go through this debt elimination technique that will allow you to save money in no time. By paying your high interest debt first, you will create more cash flow each time a debt is paid off.

Instead of having a well balanced investment portfolio, most individuals have a much diversified portfolio… of debts! In fact, most of us have 4 to 5 credit cards for shopping; furniture loans to redecorate your bedroom, 1 or 2 lines of credit that were used to pay off the latest kitchen’s renovation, 1 or often 2 car leases and some even have a mortgage.

Of all of them, the mortgage has the lowest interest. In addition to that, the mortgage has the longest amortization as well. The amortization is used to define the lapse of time during which you will pay off your debt. In the mortgage language, we use the term to define the duration of a contract. At the end of the term, the loan is not necessarily paid off, but need to be renegotiated. Therefore, you can borrow to buy a property with rates as low as below prime in a case of a regular mortgage. If you wish to setup a HELOC, you will then pay around the prime rate. In both cases, you will pay less than for any other credit product.

The technique itself is very simple. It is based on the fact that your mortgage is your lowest interest debt. Then, why the heck would you like to pay it off first? By renegotiating your mortgage for the lowest rate and the longest amortization, you will be able to decrease mortgage to a maximum. I can already hear you say “But it’s going to take forever to pay off my mortgage. I didn’t make that much effort so far to being told I was wrong”. Well, I’m sorry to say that, but you were…

Decreasing your mortgage payment will create monthly cash flow. The cash flow is a liquid amount of money that is available for any usage on a defined period. Use this extra cash flow plus the minimum required payment on your highest interest debt. It will generally be a credit card. Then, once this first debt is paid off, that will free up more cash flow as you were forced to make minimum payments. Add up the old minimum payment to the cash flow that was created from your mortgage payment and attack another debt. Keep on replicate this technique by adding up the minimum payment of every paid off debt to your cash flow. Use this cash flow to pay off the next debt and so on. As you go in this technique, you will make bigger payment and pay off your debts faster. In the end, you will be left with only a mortgage to pay and a huge monthly cash flow that can be applied to it.

Unfortunately, like any other financial planning technique, it takes time and self discipline to achieve your goal. But in the end, you will pay less interest and you will get rid of those high interest debts. You will never be able to achieve anything if you pay the minimum payments on your cards every month. It’s time to meet up with your banker and setup this plan.

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March 25, 2007, 2:34 pm

The Smith Manoeuvre (1st part)

by: The Financial Blogger    Category: Smith Manoeuvre

In a recent post, I explained why you should not be in a hurry to pay off your mortgage. Actually, with some good financial planning and careful follow up, you might end up never paying it. Did I really write that? Seriously? A mortgage for life? Yep! Fraser Smith, who is a well known financial planner in British Columbia, developed a very smart technique. In this post, I’ll explain the necessary components to achieve this plan. Then, I’ll explain the technique at a later date.

All you need to put this plan in place is a home equity line of credit, a good accountant and a good financial planner (unless you are comfortable in the investment industry).

First things first, you will need a special line of credit feature offered by most financial institution. Your HELOC must be divided into at least two accounts. You will have account “A” where you have your mortgage balance and account “B” which you will use to borrow to invest. The two accounts must have variable limits. The HELOC has a global limit which is the amount of your mortgage, let’s say $250,000. Then the established limits must fluctuate over time in order to never exceed the global limit of 250K. For example, account “A” may have a limit of 100K et account “B” 150K. After a month, the limit must be able to change for 99,5K and 150,5K. We will explain why later.

This technique was first created for Canadian residents in order to switch a non tax deductible debt (the mortgage) into a deductible debt (debt swap). For US residents, the Smith manoeuvre seems useless because their mortgage is already tax deductible. However, the investment part of the technique alone represents an important way of making money out of your property.

A good accountant will help you out to keep track of the interest that will be tax deductible in order to reduce your declared income in your tax report. By having two separate accounts in your HELOC, you will just have to keep your account “B) year end interest statement. Basically, the bank will take care of all calculation. The accountant will be useful to integrate the tax deduction in your tax report and also to verify if the technique is well implanted for maximum tax deduction at the end of the year. I definitely recommend consulting an accountant before setting up this financial technique.

Then again, the help of a good financial planner or financial advisor will assure less volatility in your portfolio. As you are using a leverage technique, you must be aware of all the risk that it incurs. The financial planner will develop a plan according to your risk tolerance and your time horizon. If you are well aware of the risk of any leverage techniques and you are a well advised investor, you may invest on your own. Some people have better results than professional financial planners. It all depends on where you at in your investment knowledge.


Before going into the technique itself, I would suggest you read about leveraging strategies, tax deduction related to investment loan and portfolio building strategies. The Smith Manoeuvre requires several skills in accounting, credit and investing.

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March 22, 2007, 5:20 pm

Life After Debt Consolidation

by: The Financial Blogger    Category: Pay off your Debts

By consolidating your debts, you will definitely feel that you got rid of a huge burden. However, falling into the same traps is really easy. Individuals are confronted to ads, promotions and pre approved credit cards on a daily basis. How to react? What to do to prevent these situations? Here are some tips in order to put your financial situation back on track:

The very first thing to be done when you are doing a consolidation loan is to establish a well balanced budget with your financial advisor. There is no point of consolidating your debts if you know already that you won’t be able to get even at the end of each month. By making a budget, you’ll be able to see your monthly cash flow, pinpoint your unnecessary expenses and to set up goals. It is really important to put time and effort in your budget as it is the base of everything.

The best way to not crumble under a ton of debts again is to get rid off the temptation. By cutting off your credit cards, it will be harder to buy everything you want on the spot as you won’t have the money available to do so. You should keep only one credit card for emergency purposes. A small limit credit card would be preferable. Some credit cards company might send you a new card with more features after you cancelled the previous one. After all, you were a really good customer of theirs. Don’t even bother opening those envelopes; simply throw them in a garbage can. Your life and financial situation will just get better.

Consolidating your debts could be a painful process. You might feel guilty and not responsible. Consider this step more as a lesson and learn something out of it. In order to encourage your effort, you should aim for a specific goal. In order to do so, define a monthly amount that you will put aside. Calculate how much you need to reach your goal and pay yourself first. You probably already hear that expression but nothing can me more true. By paying yourself first, you oblige yourself to live without this money and to spend consequently. Set your goal as your main priority. That will motivate your action to save money instead of wasting it.

At your first meeting with a financial advisor, make sure to build a plan with him. Consolidation is only the first step of financial freedom. Make sure that your goal is integrated to a well balanced budget. Then, you will be in a better position to manage your personal finance. Don’t hesitate to follow up with that person as he is there to help you out. Independent financial advisors are particularly known to offer this kind of service. They will develop a plan related to your specific needs. Make sure to understand every step and term used by them. Sometime, small things are explained by big words for nothing.

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