Does this tax-deductible mortgage strategy still make sense?

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For years, the Smith Manoeuvre has been a go-to strategy for turning non-deductible mortgage debt into tax-deductible debt, all while helping homeowners build their investment portfolio and pay off their mortgage quicker.

But today is a different world from when the late financial strategist Fraser Smith popularized the approach a few decades ago. Interest rates are higher, borrowing rules are tighter and regulators view investing with borrowed money as the sketchy alleyway of consumer finance.

That leads to the question: Is this strategy still relevant?

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How the Smith Manoeuvre works

1. Get a readvanceable mortgage, which is a mortgage linked to a line of credit (LOC), where the LOC credit limit increases each time you make a payment on the principal
2. Make principal payments on the mortgage
3. Reborrow those principal payments from the LOC
4. Invest that borrowed money in suitable long-term investments
5. Take a tax deduction on the borrowed money, in compliance with CRA rules
6. Use any tax refund at year-end to pay down the mortgage quicker.

Robinson Smith, the president of Smith Consulting Group Ltd. in Victoria and son of Fraser Smith, says market changes over the years have affected the strategy, but far from invalidated it: “We’re regularly seeing 25 yr-amortized mortgages disappear in less than 15 years.”

Of course, its performance depends on one’s assumptions about interest rates and returns, as well as how disciplined the investor is. But done right, after the mortgage is paid off homeowners are left with an investment loan and an even bigger investment portfolio to offset that loan.

This strategy isn’t all sunshine and tax refunds, however. Investment regulators have long considered leverage a dirty word, especially after 2008. Back then, many leveraged investors lost everything in the market crash. Regulators were inundated with complaints from investors who blamed their advisers for encouraging borrow-to-invest schemes.

That regulatory heat has made it harder to find a financial adviser who advocates the Smith Manoeuvre, leaving many mortgagors trying to do it themselves – often with undesirable results.

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What’s changed? Rates

Today’s cost of borrowing in a home equity line of credit (HELOC) is 7.7 per cent – give or take half a percentage point. That’s virtually double the average of the years since 2002, when Fraser Smith penned his book, Is Your Mortgage Tax Deductible?

So does the strategy still make sense?

Yes, says Brampton, Ont.-based Ed Rempel, a popular blogger, fee-for-service financial planner and tax accountant. “That 7.7-per-cent interest rate is fully deductible,” he says, effectively costing the borrower just 4.24 per cent, assuming a 45-per-cent tax bracket. If the investment makes 8 per cent, and the after-tax borrowing cost is 4.24 per cent, that’s a 3.76-per-cent difference.

From that, one must pay fees and tax on gains. But those gains can be deferred with a tax-efficient investing strategy, Mr. Rempel says. And the taxes that apply are capital gains and dividend rates that are more favourable than tax on regular income.

But is an 8-per-cent return realistic? Only if you trust the last 80-odd years of history. Over that span, the S&P 500 stock market index has returned in excess of 10 per cent a year on average over 10-year rolling periods. According to Credent Wealth Management, there were only two years where the 10-year return went slightly negative, during the global financial crisis of 2008-09.

If you want to be conservative, you can side with the long-term projections of financial planning association FP Canada, which assume a 6.2 to 6.5 per cent return for North American stocks (before fees and taxes) and a 4.3 per cent average borrowing rate.

After taxes and fees, “A 7.7 per cent LOC rate is a pretty high threshold to come out ahead,” says Jason Heath, managing director at Objective Financial Partners Inc. To make it work, you’ve typically got to be heavily into stocks, like a teenager into TikTok.

“Some of the Smith Manoeuvres I’ve seen in real life have people in mutual funds with half stocks, and half bonds, and fees over 2 per cent,” he says. “I think to myself, that’s never going to work.”

Long story short, Smith Manoeuvre investments must yield after-fee returns greater than the after-tax cost of borrowing. That’s still likely long-term but you need to find low-fee tax-efficient investments and invest with the discipline of a drill sergeant.

Even so, when rates and inflation are this high, you’ve got to temper your expectations of success somewhat.

What else has changed? Bank regulation

On Nov. 1, The Office of the Superintendent of Financial Institutions (OSFI) is imposing new rules that limit how much bank borrowers can readvance (i.e. reborrow) after making principal payments on their mortgage.

With OSFI tightening its leash, any principal payments applied to borrowing above 65 per cent of the home’s appraised value must now “be matched by a reduction in the overall authorized limit” of that readvanceable mortgage, until this limit falls to 65 per cent, OSFI says.

What this means is that a typical borrower now won’t be able to readvance as much, and hence they won’t be able to invest as much each month. This could leave you with a somewhat smaller investment portfolio in the end.

One can mitigate some of this effect, however, by refinancing as their home value rises. That resets how big your LOC can be and may allow a larger share of principal payments to be readvanced. This is one reason why OSFI’s new rules could encourage more refinances.

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Parting tips

Some like to pooh-pooh all leverage. But those same people will buy a home at four-to-one leverage (80 per cent borrowed, 20 per cent down), have family members that buy rental properties at four-to-one, take out a business loan at four-to-one, rack up $60,000 of student debt or blow $70,000 of debt on a depreciating car.

Leverage isn’t the issue when handled wisely by well-qualified, disciplined, risk-tolerant investors with a financial safety net.

“All the Smith Manoeuvre does is change the nature of interest from non-deductible to deductible,” Mr. Smith says. “If you make a mortgage payment and you’re not doing anything with your equity, it’s earning less than zero per cent because of inflation.”

All this said, if your ultimate happy place is a paid-up house and you break into a cold sweat at the thought of market crashes, this is not the strategy for you.

By the way, those market crashes can be a gift for disciplined investors. “Most people doing the Smith Manoeuvre are putting money in every month,” Mr. Rempel says, “So, down 20 per cent and back up to even is better than if the market was flat the whole time.” As long as you have a long-time horizon, that is.

If you do fit the target profile, hire a licensed adviser to help you create a plan to maximize success and avoid any pitfalls. And pick the right readvanceable mortgage. Look for one that allows the most readvancability, quick automatic readvances (some lenders make you wait months to readvance or make you jump through hoops like mini-applications), multiple line of credit and mortgage accounts, and online funds transfers (from the LOC to your investment account). Mr. Rempel’s top three picks are the BMO Readiline, TD Flexline and RBC Homeline.

Robert McLister is an interest rate analyst, mortgage strategist and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.