Wednesday, December 12, 2007

Smith Manoeuvre

The first things you’re going to need are six pillows and a waterbed. Oh, wait a minute, that’s something completely different. The Smith Manoeuvre is actually a method of deducting interest payments on your taxes. The Canadian Capitalist has had some interesting discussion of this manoeuvre.

In case you’ve heard about this, but can’t make any sense out of it, let me try to simplify things. In the US, homeowners can deduct their mortgage interest on their income taxes. However, Canadians can’t. The Canadian Capitalist describes the Smith Manoeuvre accurately, but in other places it is sometimes presented as a method of deducting mortgage interest for Canadians. This description is somewhat misleading. Let me explain.

Ordinarily, Canadians can’t deduct any interest payments on their taxes unless the loan was taken out specifically for investing with the intent to earn investment income. Borrowing to invest is called using leverage and can turn out badly if the investments don’t do well. In an earlier post, I explained how some financial advisors like to recommend using leverage because it increases the amount their clients invest and increases their commissions.

So what does any of this have to do with a mortgage? Well, you can usually get a lower interest rate on an investment loan if it is secured by the equity in your home. The size of this loan is limited by the amount of equity you have in your home. Now we get to the slightly misleading part of some descriptions of the Smith Manoeuvre. You can deduct the interest on the investment loan (that is secured against your home), but you can’t deduct the mortgage interest on your income taxes.

The last part of the manoeuvre that complicates its description and analysis is the suggestion that you take out a loan that can be automatically increased by the amount of the principal part of each mortgage payment. Normally, with each mortgage payment you pay some interest and some of the loan principal so that your debt gets reduced. With the manoeuvre, your investment loan keeps increasing so that the total amount you owe (mortgage plus investment loan) stays the same. In a variant of the manoeuvre, you can increase the size of the investment loan if the value of your home rises.

As long as the value of your home doesn’t drop, and your investments do well, everything should be fine, right? If things don’t go well, how do you feel about getting a second job to pay all the interest on your investment loan and mortgage?

I suspect that the Smith Manoeuvre is too risky unless your income is high enough to pull you out of any problems with your investments or a drop in the value of your home. But, if your income is high, why not just go for the low risk strategy of paying down your mortgage and investing some of your excess earnings?

2 comments:

  1. Canadian CapitalistDecember 13, 2007 at 9:14 AM

    Thanks for the link. I think another reason the SM is being "pushed" hard is that it has worked so well in the past few years. Interest rates have been low and equity returns have been in the double digits and even a lousy fund wouldn't have any trouble posting a 10% annual gain. So, it is hardly surprising that people flock to a strategy that worked great in the recent past.

    ReplyDelete
  2. Just before the high tech bubble burst, some of my acquaintances who knew little about investing in high tech companies and seemed the least likely to jump in, did jump in at just about the highest possible prices.

    If this is any indication, then just as the popularity of the Smith Manoeuvre peaks, and homeowners who understand the risks least jump in, real estate prices and the stock market will drop.

    This is definitely not my wish, but it may be an accurate prediction.

    ReplyDelete