June 11, 2007, 2:37 am

Is the Smith Manoeuvre is a Secure Way to Create Wealth? Part 2

by: The Financial Blogger    Category: Smith Manoeuvre
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The first part of this post was part of the Carnival of Personal Finance #104 hosted by Getting Green. There are 78 good posts about personal finance. Getting Green took the time to classified them into categories so you don’t waste your time. Make sure to check this out!

What if, What if, What if. We keep on hearing those famous “What If” from all our relatives. People are afraid of potential risks surrounding investments and leveraging strategies and I can’t blame them. There are risks, that is a fact. However, there is also a risk that you die taking your car to work every single day and we are still alive and doing it. In order to invest properly, you need to keep this in mind; risk is only a matter of perception. Here are some answers to “what if” people.

What if I lose my job and I can’t keep up with the mortgage payments?

First things first, would it really make a difference if you lose your job without doing a Smith Manoeuvre? I guess you would tend to say no as you will be left with a mortgage to pay anyway and no pay cheque. However, there is a slight difference if you are doing the Smith Manoeuvre.

In fact, with a regular mortgage, you are stuck with a fixed payment every month until the end of your term. There is not much room for negotiation. In order to operate this financial technique, you will need a HELOC. The minimum required on a line of credit is the monthly interest. Therefore, you can skip principal payment and just pay interest the time being. I strongly suggest not considering this option as you will end up paying your mortgage till the end of time. However, it is a way to decrease your payment significantly until your financial situation gets better.

Another positive point about this leveraging strategy is that you are building a safety net in case of rough financial times. With a regular mortgage, your monthly payment includes capital. This capital is building equity in your property. You CAN’T get access to this equity until you refinance your mortgage. Do you think you have strong chances to get approved if you are asking the bank for money when you just lose your job? If the bank does so, it is because you are a good client and definitely because you will be paying a higher interest rate.

On the other site, the investments portfolio built through the Smith Manoeuvre is accessible at any time. You can then use this money to pay off your bill temporarily. Once again, I strongly suggest not taking your investment to pay off your bills and building a safety net aside especially for that purpose. This may trigger capital gains and modify your tax situation as your investments are related to a tax deductible debt. However, you are better off using this money than losing your house.

Unfortunately, these options are only available if you are doing a Smith Manoeuvre. With a regular mortgage, you are stuck with fixed payments and you can’t get direct access to the equity built in your property. Banks are usually very impatient when it comes down to taking their payments. Having a safety net will avoid those uncomfortable situations.

Whoa! I thought I would have enough than one post to answer all “What If” questions. It seems that I’ll write another one to answer other questions on the Smith Manoeuvre.

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Comments

In fact, with a regular mortgage, you are stuck with a fixed payment every month until the end of your term.

This isn’t true – you can change the amortization of your mortgage to lower the monthly payment if necessary. I did this several years ago when I almost lost my job.

You CAN’T get access to this equity until you refinance your mortgage.

This isn’t true either – if you get a secured line of credit (while you’re still working) then you can access that equity whenever you need it.

On the other site, the investments portfolio built through the Smith Manoeuvre is accessible at any time.

You don’t need to do the Smith Manoeuvre to have investments which can used to pay the bills. An rrsp works just as well as a safety net – worst case scenario is that you’ll pay the same amount of income tax on withdrawal that you deferred with the contribution.

One other thing – can you add a comments feed for the site?

Mike

by: The Financial Blogger | June 11th, 2007 (3:49 pm)

Hi Mike,

One thing I like about financial blogs is that it gives you the opportunity to debate on several points of view.

1. You can always try to refinance your mortgage in order to change the amortization and then reduce your payments. However, the bank will surely reconsider your present situation and charge more interest as you would be representing a much higher risk without a job. Keep in mind that you were able to do it as you almost lost your job. If you walk into a branch without any sources of income, it might end-up differently.
2. Personally, I make a distinction between regular mortgages and HELOC. Even though HELOC’s are mortgage, they are way different than regular mortgage with fixed payments. Having said that, if you have a HECLOC in place, you rather use it to its full advantage by leveraging.
3. I strongly not suggest dipping in your RRSP account to compensate any income loss if it’s possible. RRSP contributions are limited by your income level and once they ware withdrawn, you can’t put this money back into your RRSP. Therefore, you can’t benefit from the tax deferment over a long period of time. It defeats RRSP program’s benefits.

I appreciate your comments and surely add-up comments feed shortly.

Cheers,
FB.

Actually when I changed the amortization of my mortgage I didn’t have to refinance – just called and asked them to lower the payments.

Withdrawing from the rrsp should only be a last resort – however my point was that if it’s absolutely necessary, the rrsp is a good safety blanket.

by: The Financial Blogger | June 11th, 2007 (5:48 pm)

Which kind of mortgage did you have, usually, banks will reopen your mortgage and profit from the occasion to increase your rate. You are breaking a contract after all. Anyway, that was a pretty good deal you had!
FB.

At that time it was a regular run-of-the-mill mortgage with TD fixed for 5 years. Afterwards I changed it to a line of credit but I always fixed the mortgage portion.

Regardless changing the payment schedule was never a problem. I never broke the contract – the option was always there to change the amortization to either increase or decrease the monthly payment.

Mike

FB: Mike is right. I personally know someone who lost his job and reduced his payment by extending the amortization. All it took was a phone call. You can also get a secured line of credit anytime if you have enough equity on your home. So, what extra protection does the SM offer?

In fact, SM is more risky because you are likely to lose your job and be unemployed for a long time when the economy is in a recession or worse. You think stocks will do great in such a situation?

by: The Financial Blogger | June 12th, 2007 (5:33 am)

CC,
I did further research on my end to find out that Mike was right as you just mentioned. You are able to extend your mortgage term up to 30 years with a simple phone call. This is not promoted by banks as they really want you to use it as a last resort. However, they are better off offering this possibility than taking back to house.

Nonetheless, I don’t think that stock market is necessarily related to your financial situation. As an example, western part of Canada is doing much better than the eastern part right now. As the TSX is driven by the financial and resources industries, there is a possibility that you may lose your job if you work in Ontario but the stock market is doing fine. The key here is that the Smith Manoeuvre gives you access to more liquidity than a regular mortgage.

You can sure extend your amortization without qualifying at the bank but your financial institution is not dumb enough to give you more money on your house if you just lose your job.
Cheers,
FB.

FB: I look at risk as what could go wrong, not what could go right. The reason I focus on risk is because it is under your control; returns are not. The simple fact is that with the SM (or any leveraging strategy), you take more risk.

The fact is that you can take out a secured line of credit (when you have a job) that you can use in case of an emergency situation. So, my question remains: what extra protection does the SM offer?

by: The Financial Blogger | June 12th, 2007 (7:05 am)

CC : The SM offers much more flexibility and therefore more protection than a usual mortgage with fixed amortization when you go through financial rough times. In consideration that you already have a HELOC put in place, the SM doesn’t offer more protection.

Having said that, on a long term basis, there are very slim chances that you will lose by investing on the stock market (unless you are taking unnecessary risk playing with penny stocks, emergent markets and small cap). After ten years, you will surely benefit from more money than just having a HELOC sitting there and not using it to its full potential.

If you want to play safe, you can buy index funds. History has proven overtime that the growth is there. I think risk with leveraging strategies are more linked to a cash flow issues and sleeping well at night. As I just started my SM 3 months ago, only time will prove me right… or wrong!

FB.

FB: While I do moderate leverage (currently less than 4% of my portfolio), I have no interest whatsoever in the SM. I don’t think Home Equity is just “sitting there”. It is working for me by providing us shelter that we’d have to rent otherwise.

The key point is that anyone implementing the SM should know that they are taking more risk than just investing their money and be willing and able to bear that risk. To claim otherwise is incorrect.

by: Kevin Malone | October 28th, 2007 (3:33 am)

Actually CC, your persistent claims that SM is “more risky” are totally subjective. You are ignoring the enormous “risk” of paying tens of thousands if not hundreds of thousands (depending on house value and amortization) more money towards a mortgage than what SM beneficiaries pay. As you know it is common to pay off a mortgage in about half the time.

Furthermore as you have been informed many times and have ignored many times, you don’t invest 100% of your home equity in SM, typically it is 25% which means that your investments would have to go completely to hell and stay there before this “risk” would manifest. And if the market crashed that badly and stayed there, the poor bastard with his 35 year amortization is not going to be doing a dance of joy either.

It’s obvious from surfing around to all these SM discussions that right from moment one you saw the Smith Manoeuvre as some sort of threat to your core beliefs and you are fighting to hang on to those by attacking the concept using various disingenuous methods. I don’t know why you continue doing that, but I suspect there is a part of you that realizes it is about ego and defensiveness, and little to do with concern about the strategy itself.

One has to wonder why “victims” of the Smith Manoeuvre aren’t coming forward in droves to back up your concerns about SM. Forget droves, how about a handful?