March 31, 2007, 9:05 am

The Smith Manoeuvre (2nd part)

by: The Financial Blogger    Category: Smith Manoeuvre
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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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Comments

I am in the process of setting this up with Manulife, when this gets setup do I need to setup account B or is this automatic? When I make my mortgage payment this of course reduces my principal owing on the mortgage however when I withdraw does this now show up in account B as debt?

by: The Financial Blogger | July 26th, 2007 (6:45 am)

Hi Scott,
You will have to ask your Manulife broker to setup your HELOC between 2 accounts (A and B).
Let’s say you have 100K mortgage in account A and $0 owing in account B as you are just started the SM. On account A, you pay the interest plus $500 on a monthly basis. After one month, your account statement will show account A : $99,500 and account B : $500 owing. At the end of the first year, you will have account A : $94K, account B : 6K.
This is really important as the interest charged on account B is tax deductible. Therefore, you must need to keep track of it. Having a separate account and interest statement will get your life much easier.
Please feel free to contact me if you have any other questions.
Cheers,
FB.