Step-by-step Smith Maneuver Guide

Table of Contents

1. Overview
2. Pre-requisites
3. Smith Maneuver Setup using National Bank
4. Interest Capitalization
5. Important Notes

Overview

Smith maneuver (SM) is a strategy of taking out HELOC against your home and use it for investment purpose only, making all interests charged on HELOC tax deductible. The goal is to pay down your regular mortgage, which interests are not tax deductible, as soon as possible using the tax rebate, and at the same time earn higher investment return over the long-term compared to the appreciation of your home value.

The advantage of the SM strategy is that very little additional cash flow will be required to maintain this setup, you will continue paying the same amount of mortgage each month. This is because each mortgage payment will have a portion that goes towards your mortgage principal, which will be added onto your HELOC credit limit each month. We can then use this additional credit to pay the interest of the HELOC. This is called interest capitalization. With this technique, we have effectively turned HELOC into a low-interests, long-term capital source without worrying about monthly payments and margin calls, which is far more superior than a typical investment loan.

Be aware that this strategy will cause your HELOC balance continues to increase, so it will only work well if you are confident in your investing skills, which must yield higher returns than the after-tax interests paid on the HELOC. In this blog, I will cover how to create your own Smith Maneuver setup step-by-step in utmost details and I hope this can become a powerful tool to help accelerate your goal of reaching financial freedom.

Pre-requisites

• Smith Maneuver only applies if you own your primary residence and have a mortgage. If you own rental properties, the mortgage interest is already tax deductible.
• You have paid down more than 80% of your home. The maximum amount of HELOC you can get is calculated by the following: (Appraised home value x 80%) - Outstanding Mortgage.
• You are in a higher tax bracket. The more income tax you pay, the more effective SM will be. For example, my personal marginal tax rate is 43% and I’m paying 6.2% on my HELOC (prime+0.25%). After tax rebate, my effective interests paid on HELOC is 6.2% x (1-43%)=3.53%, and it is very easy to earn more than 3.53% per year by investing in the stock market. You can easily check your income tax rate using taxtips.ca tables.
• You have an account with one of the big 6 banks in Canada, I’m not aware of any smaller lenders providing this service. SM setup requires an All-in-one mortgage setup. This is a product with both a mortgage portion and a HELOC portion out of the box. This ensures any principal payments towards the mortgage will increase your HELOC credit limit, which is a must-have for SM setup.
• You are a long-term, risk-averse, value-based investor. Research has shown that 90% of active traders lose money. SM is a leveraged investment strategy, so we must keep the risk as little as possible. You would never want to have any permanent capital loss in your SM portfolio, which will leave you deep in debt.

Smith Maneuver Setup using National Bank

You can setup SM using pretty much any one of the 6 big banks with the process described in this section. Here is the pros and cons of using the National Bank of Canada:

Pros

• 0 commission fees when trading stocks and ETFs in NBDB, this is a great deal.
• Instant deposit from National Bank HELOC to NBDB investment account.
• Free transfer between investment and HELOC account

Cons

• $7 monthly fee for having a HELOC account. I know other banks like Scotia Step doesn’t charge this fee, but they charge commissions in their investment account.
• You can only link 1 bank account for transferring funds to NBDB. For SM setup to work, we will have to link the HELOC to NBDB directly. If you have multiple accounts with NBDB, you will need to transfer other accounts to another brokerage except the cash account (Non-registered).

Now let’s get started with the setup process, in the screenshot below you can see my personal setup, you can see my complete setup with exact numbers in this post.

Figure 1. Smith Maneuver Setup

1. Double check your monthly mortgage payment and record how much money is paid towards the principal.

2. Now you are ready to start the setup process. If you don’t already has a all-in-one mortgage, you can get started by contacting a mortgage specialist from National Bank. You must ensure that your monthly mortgage payments will result in an increase of HELOC credit limit. The specialist will help you with the entire process of converting your mortgage, getting your home appraised, and getting your HELOC set up. Make sure your HELOC is linked to your National bank checking account, so that every month it will be charged for the monthly fee and interest payments. This process should take around 2 weeks to complete.

3. Once your setup is ready after 2 weeks, you can start investing immediately. There are 2 things to take note on.

   First, you must invest in dividend paying stocks, or stocks that are expected to pay dividends in the future. This is required for HELOC interests to be tax deductible. If you are investing in dividend-paying ETFs, you must re-invest all dividends as soon as possible after receiving them. This is because ETF dividends may contain return-of-capital (ROC) which will make some of your HELOC interest not tax deductible if not re-invested.

   Second, don’t use up all of your HELOC credit immediately. You need to first make sure the monthly HELOC credit limit increase can cover the monthly interest payment. Based on my experience, only 80% of the monthly principal payments will be added onto the HELOC credit limit. Using the example above, I personally pay $2779 in mortgage per month and $850 of it is paid towards the principal. This means my HELOC credit limit will increase about $850 x 80% = $680 per month. So $680 is the maximum I can pay in monthly interests. Assuming a 6.2% HELOC interest rate, the maximum amount I can take out will be $680 x 12 / 6.2% = $131,612.

4. Now that you have made some investments using HELOC, and after about a month, you will receive your first HELOC statement. This statement will specify the minimum payment amount (interest payment + monthly fee) and the due date. Your checking account will then be charged on the due date. The monthly fee portion of this payment cannot be used to deduct tax, so we need to pay it separately. The exact steps to perform the payments will be described in the next section.

Interest Capitalization

Interest Capitalization is the process of using additional HELOC withdrawals to pay for the minimum required payments for the previous month, allowing our SM setup to sustain itself without any extra cashflows.

As mentioned in the previous section, we will need pay the monthly fee and interest payment separately. This keeps our statement clean so we are well-prepared in case of a tax audit. I will show you how this works using my own example. The first screenshot below shows my HELOC statement, and the second one shows all transactions that happened after I receive my first statement.

Figure 2. Heloc statement

Figure 3. Interest capitalization transactions

First, I transferred the minimum payment amount $136.75 into my NBC Checking account (See figure 1 for the account setup). This amount includes $7 monthly fee and $129.75 interest payment. On Oct. 18th, my HELOC got charged $7 monthly fee, and I paid it back as soon as possible on Oct. 22nd. Ideally you would want to pay it back on the same day the fee is charged, as the interest charged on fees are not tax deductible (I was late for 4 days, but it should be fine as the interests charged is less than 1 cent).

Then on Nov. 8th, my NBC checking account was automatically charged to pay for the remaining amount, and I immediately take the same amount out to my NBC checking account on Nov 12th. This marks the completion of the interest capitalization operation. When the interest payments are due next month, I would already have the majority of the money ready in the NBC checking account. I will only need to put up a minimal amount of additional money to take care of the monthly fee and any additional interests payment if I borrowed more to invest.

The final step will be deducting the HELOC interest expenses against income to reduce taxes next year. Because my marginal tax rate is 43%, I will be paying an effective interest rate much lower than the 6.69%.

Important Notes

Make sure you read all the bullet points below so you can minimize your risks and well-prepared for tax audits.

• NEVER use the HELOC to contribute to any registered accounts, because interest is only tax-deductible if you're investing in a non-registered account.
• DO NOT GAMBLE. Only invest into assets you are most comfortable with. Unlike regular portfolios, you will be in debt if you lost money in a SM portfolio.
• For HELOC interests to be fully tax deductible, you must ONLY transfer money to your investment account and invest it immediately. NEVER transfer any money from HELOC to other accounts. If you have any leftover cash after buying investments, transfer them back to HELOC as soon as possible.
• If you decide to invest in ETFs, make sure to re-invest the dividends, or transfer the dividends back to HELOC as soon as possible. This is because ETF dividends may contain ROC (return of capital), which means the dividends returns some of your principal investment, and any interest charged on this part of the principal is not tax deductible when left un-invested.
• If you want to invest in US stocks in the Smith Maneuver portfolio, always invest in CDRs. This is one of best ways to use CDRs that justifies its 0.6% fees, because it eliminates the foreign exchange risks completely. Remember, you are using a Canadian dollar denominated loan which must be paid back in Canadian dollar eventually. You will be put into a difficult position if US dollar were to depreciate significantly against Canadian dollar. It is better to eliminate this risks completely even though it is a low possibility event.

I hope this blog post will be helpful to you. Feel free to leave any questions under my Blossom post, I will try to answer them as much as I can.

I will also share my personal Smith Maneuver portfolio updates from time to time under the Portfolio Update section of my blog, make sure to sign up to my newsletter if you want to be notified when I post an update there.

DISCLAIMER: Solofire is not a registered financial advisor. This post contains author's personal opinion only and it should NOT be considered financial advice.