Friday, January 23, 2009

The Smith Manoeuvre.

Does the "Smith Manoeuvre" Work, and is it a Good Idea?

The Smith Manoeuvre has been talked about in the national newspapers and all over Internet message boards for some time now. It is an attempt to financially engineer your personal finances to make the interest that one pays on their mortgage somehow tax deductible, thus transforming bad debt, into "good debt," as many bloggers have put it. The way this works is by taking advantage of the fact that the Canada Revenue Agency allows interest on an investment loan to be deducted from one's taxes

How to implement the strategy?

Get a home equity line of credit (HELOC). This allows you to borrow against the equity in your house each month as you pay off the principle. The more you pay off, the more you can borrow.

Since interest on money borrowed to invest is tax-deductible, you can then invest the borrowed money to generate returns in a non-registered investment account. If you are in Ontario's highest marginal tax bracket, you will save over forty cents in taxes, for each dollar in interest you pay. Chopping the cost of your loan by a wide margin.

What happens if your investments decline in value? You still owe the money, so make sure that any investments you do buy are well-diversified, and low-risk in nature... ie., stick with either blue-chip dividend paying equities or investment-grade bonds. The rate of return in your investments will have to be above your after-tax cost of borrowing the money, which should not be all too difficult in the present climate going forward. However, if interest rates on your VARIABLE (meaning it will fluctuate) line of credit increases to an uncomfortable level, it is best to pay off the loan to avoid a disaster scenario... Picture trying to invest to outpace interest on a 15% loan... remember the 80's.

Therefore, the strategy works, and yes, it is a good idea. But only if a number of assumptions hold true. Mainly, interest rates on the loan should be comparable to a low-risk rate of return, and you do not let it get out of hand... Do not get greedy and bet the farm just because your investments appear to be doing well for the time being, inevitably you will hit a hiccup.

To read more on this topic in general:

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