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May 28, 2008, 6:00 am

How To Manage Your Smith Manoeuvre Risk

by: The Financial Blogger    Category: Smith Manoeuvre

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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May 22, 2008, 6:00 am

Answer to a Reader’s question

by: The Financial Blogger    Category: Miscellaneous,Personal Finance,Smith Manoeuvre

Yesterday, I had a question on my latest Smith Manoeuvre Update. Since it was a good situation, I decided to write a full post about Jeff’s question. Here’s what he wrote:

“Hi, I’ve read with great interest your Smith Maneuver progress, especially since I was thinking of doing it when my current mortgage comes due with an All-in-One as well. However, I’m still confused about how it works in this situation (with made up numbers). Perhaps you could explain it to me? Say a home is valued at $400K, so the bank would give an All-In-One (Ai1) up to $300K. Now, assume the property has a current mortgage of $200K. Then I could split the Ai1 into a $200K mortgage portion and an immediate $100K investment LOC. Would I then have to pay my regular mortgage payment plus the interest on my investment LOC each month? I understand that I could “capitalize the interest” but, doesn’t that make some of the LOC not invested in investments, hence, not being eligible for the tax deduction? Sorry for the question if you’ve answered it before! Best of luck to you in your endeavours”.



Hello Jeff,

In your example, you will have 2 accounts linked to your property:

#1 200k regular mortgage (which you will pay capital + interest payment)

#2 100k HELOC (all-in-one) (which you have to pay at least the interest every month)

If you withdraw the 100K from your all-in-one and invest it, you will have to pay the interest on the 100K (so roughly $4,750 if prime rate doesn’t change). That makes payment of almost $400 every month.

In addition to this $400, you still have your mortgage to pay. At 4.25% (let’s say that you selected a variable rate as well and you got Prime – 0.50) over 25 years, that makes payment of $1,079 a month.

In total, you will have to pay at least $1,479 per month to have #1 a 200k mortgage + #2 the all-in-one account fully invested. Please keep in mind that the $4,750 in interest paid on your all-in-one is fully tax deductible.

A few suggestions

#1 If you have enough room in your budget, I would definitely go with a variable rate on the 200K mortgage. You can easily get Prime – 0.50% with such amount (especially that you will be doing a 100K HELOC at the same time!).

#2 If you like to have fixed payment in order to follow your budget, you can always go for the variable rate but with a fixed payment. The bank will calculate a fixed payment at the 5 years rate (around 7%) and the extra money will be applied as a capital payment.

#3 An investment of 100K is big enough to have access to great financial products. I strongly suggest that you deal with a Financial Planner or a recommended broker. They will be able to guide you as of which investment products are the best in your situation. Keep in mind that if you really want to benefit from this leverage strategy, you need to show an aggressive investment profile and will occur several fluctuations.

#4 If you want your mortgage to fully become tax deductible, I suggest you seek for a product that enables the HELOC to increase as you are doing your mortgage payment. I know for a fact that BMO and National Bank are offering this product. As for the other institutions, you will have to ask them.

#5 You are technically not allowed to capitalize the interest. If you leave a few thousand in your line of credit for this goal, the bank system will detect that you are not paying the interest as no new money is going into the account. Unless you find a product that gives you the opportunity, I strongly suggest that you make your interest payment.

#6 Banks are now going at 80% of a property value for a HELOC without charging any premium. Therefore, you can have a 320K mortgage split 200K mtg and 120K line of credit.

#7 If you have any other questions about the SM or any other leverage strategies, don’t hesitate to send me an email at thefinancialblogger @ gmail.com.

 

If anyone has any other ideas, please feel free to comment!

Best of luck with your investments!!!

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May 6, 2008, 6:50 am

My Smith Manoeuvre – April Update

by: The Financial Blogger    Category: Smith Manoeuvre

The recent drastic drop of interest rate occurred by the Bank of Canada made me think twice about my Smith Manoeuvre Strategy. With payment of $1,400 a month, I could easily drop more than $400 in my Investment account. But on the other side, I have about 30 months left to pay off a 31K debt. So leveraging over a short period of time is very risky. In fact, it is more like gambling than investing!


In fact, my original repayment plan was the following: 2 years ago, I wanted to start a Smith Manoeuvre and reimburse the debt after 5 years with this money. While 5 years is a little bit short for a leverage strategy, I was willing to take the risk as my income is still increasing at a steady rate years after years.

Now 2 years had passed and I only started my strategy last year. In fact I did put in place the SM 2 years ago, but I had to cash in all my investment when I bought my second house. This is why I don’t have this much in my account.

So considering that I have now $7,100 in the account (still positive, yeah!) and that I invest $400 per month, I would get about 19k at the time of repayment. Hum… it seems that I am not going to payback in time, right?

Well this is because I decided to not put everything in the Smith Manoeuvre. Am I getting nervous about the market? No way! But I am getting nervous about the fact that I need 31K in 30 months and I don’t think it is too smart to invest that money in highly volatile funds like the Sprott Canadian Equity Fund.

Therefore, I decided to pay back a part of my mortgage at the same time. So there is another $450 per month used to pay down my mortgage. So in 30 months, I have about $13,5K in equity in my property. In the end, chances are that I will be able to refinance my mortgage, reimburse my debt and not touch my Smith Manoeuvre Investment.

So the strategy is steadily going on without much difference this month. I still shove another $400 into it and, thx to Mr. Sprott, the account is positive for a third month in a row :-D.

The idea of buying international funds is still on the table but since I didn’t have much time to think about it recently, I am not planning on making any move in the short term. I’ll probably reconsider this option later on this summer, once all my exams are done!

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April 4, 2008, 11:00 am

My Smith Manoeuvre – March Update

by: The Financial Blogger    Category: Smith Manoeuvre

I would not imagine I could say that with the way the markets are, but my Smith Manoeuvre goes pretty well! Market is swinging on the dance floor like a crazy clown but I am still over the edge. In fact, I am quite happy to notice that my statement is showing some green numbers! While I still can’t buy a brand new car with my investments, it keeps growing at a good rate.


In fact, my Smith Manoeuvre account was showing a total of $6,609 for an overall profit of $109. Since it’s been a full year in February, I decided to go a little bit further in my calculation in order to establish my real rate of returns with my systematic investments.

For simplicity and convenience, I always use what I have in my portfolio divided by what I invested. However, I know that this is not the real rate of return as I didn’t have 6,5K invested the whole year. I built this amount month after month.Another great thing about working as a financial planner is that you have access to all kind of tools built in Excel.

Therefore, I don’t need to bust my mind creating a system that will allow me to calculate my return on investments. I simply have to plug in the numbers!So the real number is 2.7%. I think it is pretty good considering the bad year we had. I believe that if I can continue this way in 2008, I will be more than ready to boom in 2009!

Now I am thinking about my next move in term of diversification. The major flaw in my investment strategy is that I am only invested in the Canadian market. I am now looking for an emerging market fund like a BRIC related fund so I can diversify my investments. If you know any good funds, let me know, that will help me out in my research.

I recently had to put all my stuff together in order to prepare my taxes. This is where I realize that having a separate account for my Smith Manoeuvre was a real charm. It took me 2 minutes to pull out the statement and calculate the amount of interest paid. I shove everything in an envelope and my accountant will take care of the rest!

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March 10, 2008, 7:00 am

My Smith Manoeuvre – February Update

by: The Financial Blogger    Category: Smith Manoeuvre

I finally happen to buy the Sprott Canadian Equity funds last month. It took me about a year to put 5K aside in order to qualify for this investment. In fact, I have been slowed down by the National Bank Dividend Fund that didn’t do so well over 2007 (if you know any dividend fund that did, please include your comment at the end of this post!). Even though I had to register a small capital loss, I still think it was the right thing to do.

bear bull

The only secret about investing is to follow your investment strategy until the end. I can tell you that you are assured to lose a lot of money if you keep switching back from one strategy to another and try to time the market. Be consistent, be systematic and don’t panic.

For those who have been following my Smith Manoeuvre Strategy, you already know that I ended the year in the dark red (about 9% down). For those who just started to read my blog, I strongly suggest you go visit the Smith Manoeuvre Category in order to know more about this financial technique.

Well it seems that 2008 will bring my investment return in the green if everything keeps going this way. I bought the Sprott fund at $42.939 and it is already at 47.21. My overall portfolio is showing a +6% return!. Even though I am well aware that this fund is much more volatile than the NBC Dividend, it is always a good news when you see your money growing (especially when it’s other people’s money!!!).

Since I invested most of my Smith Manoeuvre portfolio in one fund (about 80% of the portfolio value), I thought I would give a little bit more information on it. According to Globefund.com, here are the important stats about the Sprott Canadian Equity fund:

 

Number of Year

Investment Return

1

10.21%

2

14.62%

3

20.10%

5

25.44%

10

28.68%

Since Inception

26.59%

– The fund was created in 1997 and therefore went through the techno bubble.

– If you would have invested 10K in 1997, you would be smiling with a 121K in your account now J

– This is a very aggressive Canadian fund with presently 94% in Canadian stocks and 6% in cash.

– They currently hold 72% of their portfolio in materials and 11% in energy sectors.

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image source: stanart.com

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