May 28, 2008, 6:00 am

How To Manage Your Smith Manoeuvre Risk

by: The Financial Blogger    Category: Smith Manoeuvre
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This guest post was written by Mike from Quest For Four Pillars, a blog about personal finance and more. Feel free to visit his site and subscribe to his feed.


There is a popular financial strategy known as the Smith Manoeuvre which basically involves borrowing money to buy investments and then using the proceeds of the investments to pay down your mortgage. You don’t pay down your total debt but rather you slowly convert it from non-deductible to deductible debt in order to get a tax rebate on the interest.


I am a fan of borrowing money to buy investments, however I don’t bother with the true Smith Manoeuvre since it is designed to maximize the financial benefits of your advisor. I put together an investment plan a while ago which uses leverage and it has been quite successful so far. The plan is very basic – borrow money from my home equity line of credit and buy blue chip Canadian dividend stocks. One of the key differences between my plan and the Smith Manoeuvre is that I limit how much I can borrow according to a simple risk analysis exercise. Most SM advisors want their clients to borrow the maximum 80% of the appraised value of their home in order to maximize the advisor’s profits. The problem with this “strategy” is that it might leave the client over-exposed to interest rate risk.
Basically what I did to determine how much I was willing to borrow for my leveraged investment strategy was the following:

  1. Calculate the maximum monthly payment I was willing to pay for my mortgage and leveraged loan.
  2. Assume that in a worst case scenario I can increase the amortization of my mortgage and HELOC to 25 years.
  3. Calculate the amount of total debt which if set to a 25 year amortization, gives me the monthly payment amount from #1.
  4. Subtract the mortgage from the total debt calculated in #3.

You can see my proper analysis in this post for a detailed example.
This particular exercise only looks at interest rate risk which is one of the biggest problems with borrowing to invest. You always have to consider that if interest rates go up a lot then you will have to come up with more money to pay the interest payments.




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Comments

by: Traciatim | May 28th, 2008 (6:41 am)

I thought the smith manoeuvre in it’s strictest sense was:
1) Sell your taxable assets
2) Pay down your mortgage
3) Borrow that money back in a HELOC
4) Buy back your taxable assets

Not just:
1) Borrow money using your house as security
2) Buy investments

I think that’s just called borrowing to invest.

It seems Interactive Brokers has lower margin rates than one could attain through a HELOC. Ever thought of going that route instead?

Traciatim – that may be but most people just do the “SM” using their heloc. I agree that this is just leveraged investing.

Telly – that’s good to know. I don’t like using margin since my leverage account is 100% leverage. Plus I don’t want to get hit by margin calls.

Mike