The Smith Manoeuvre: What It Is, How It Works And Should You Use It?

“The Smith Manoeuvre is a creative, legal financial strategy designed for Canadian homeowners to convert the non-deductible debt of a house mortgage to the deductible debt of an investment loan,” writes Robinson Smith, author of “Master Your Mortgage for Financial Freedom: How to Use the Smith Manoeuvre in Canada” and son of Canadian financial planner Fraser Smith, who developed this strategy in 2002.

In short, the Smith Manoeuvre is a debt conversion strategy that essentially makes the interest you pay on a residential mortgage tax deductible. In Canada, the interest you pay on your mortgage is not tax deductible unless it’s for an investment property, or if you operate a business from your primary residence, in which case you may be eligible for a partial deduction. (In contrast, homeowners in the U.S. can deduct all of their home mortgage interest in most cases.) However, interest is deductible on money that you borrow to generate income.

The intention of the Smith Manoeuvre is to help homeowners who have a mortgage, but not the cash flow for an investment portfolio, create tax savings and pay off their mortgage while building long-term wealth.

The Smith Manoeuvre is complicated, but this is a simplified explanation:

1. Open a readvanceable mortgage
A readvanceable mortgage has two components: A regular mortgage and a home equity line of credit or HELOC. With a readvanceable mortgage, you can re-borrow the principal (not the interest) you pay off each month. For example, if your monthly mortgage is $2,476 (approximately $1,861 in interest and $615 in principal), each month, you can re-borrow that $615 payment from the credit line portion of the loan. Keep in mind that you need to have at least 20% equity in your home to qualify for a readvanceable mortgage, and you can only borrow up to 65% for the equity portion of the loan; the 15% balance needs to be in a conventional mortgage.

Related: What Is A HELOC And How Does It Work?

2) Invest money from the HELOC 

The second step of this strategy is to invest funds from the HELOC into income-producing assets, such as dividend stocks, in a non-registered investment account. You cannot invest your money in a tax-sheltered account, such as an RRSP or TFSA, because the interest generated on registered accounts like these is not tax deductible.

3) Deduct the income interest from your tax return  

Unlike your non-deductible mortgage interest, the interest paid on a loan for an income-producing investment account is tax-deductible and will generate a tax refund. For example, if you live in Ontario, have a 31.48% marginal tax rate (on a $100,000 salary) and paid $6,000 in interest for the year, you’ll get back almost $1,890 as a tax refund.

4) Prepay your mortgage with this refund

When you apply your $1,890 tax refund to your mortgage, that payment goes directly to your principal balance.

5) Re-borrow the prepayment amount and invest that as well.

The idea is to keep feeding your investment portfolio with borrowed money, so you can keep deducting the interest costs for a future tax refund. As your mortgage debt gets paid off, your investment debt will increase by the same amount, but the investment loan generates the tax refund.

In addition to the above, there are also strategies called accelerators that create opportunities for you to increase your net worth even more:

• Cash Flow Diversion: With this strategy, you redirect your current savings to your mortgage prepayment, rather than another investment account to accelerate how much you can draw down from your HELOC. For example, if you pay $200 per month into a TFSA, you instead funnel these funds into your readvanceable mortgage account.
• Debt Swap: First you redeem the assets in an existing investment account to cash, then make a prepayment against the non-deductible mortgage, re-borrow the money from the HELOC and finally invest it again. However, this will have tax consequences that need to be weighed against the net benefit.
• Cash Flow Dam: If you also have a rental property and receive monthly rent, rather than use those funds to pay down that mortgage (and associated expenses), use those funds as a prepayment on the mortgage on your principal residence. Then use the money freed up in your HELOC to pay for expenses related to the rental property, as it is considered an income-producing asset.
• DRIP: Investors holding income-producing assets that remit regular distributions (such as interest income or dividends) typically have these distributions automatically reinvested through a DRIP or Dividend Reinvestment Program. But instead of reinvesting, this accelerator calls for the distributions to be applied as a monthly prepayment against the principal mortgage.

One of the main benefits of the Smith Manoeuvre, notes Smith in his book, isn’t just paying down non-deductible mortgage debt quickly, but “improving your net worth on a monthly basis and building up retirement savings to allow you to avoid being forced to downsize or having to sell the house back to the bank in retirement.”

Conventional practice has many Canadians approaching these financial goals sequentially—first pay down the mortgage, then save for retirement—says Vicky Bhardwaj, Smith Manoeuvre Certified Professional and Mortgage Agent Level 1 with Safebridge Financial Group in Toronto.

“Most homeowners can’t do both because there’s usually nothing remaining at the end of the month to save. This means losing out to the power of compound growth, which is very expensive,” he says. “The Smith Manoeuvre solves this problem by allowing the Canadian homeowner to do both at the same time: eliminate your expensive mortgage very quickly while also saving for retirement starting now, not in 25 years. And all without any new cashflow from the homeowner.”

Bhardwaj provides this example of how the Smith Manoeuvre works over time: Assuming a 25-year $400,000 mortgage at current rates and $900 per month paid to the principal, this gives you almost $11,000 per year to invest when you re-borrow that money from your HELOC.

“At a 6% growth rate that would grow to almost $720,000 over the course of a typical 25-year mortgage amortization period, compared to $0 if the homeowner did not implement the Smith Manoeuvre,” he says. “Plus because you are able to apply tax refunds that otherwise you would not enjoy as mortgage prepayments each year, that mortgage is gone in about 22.5 years instead of 25, which all goes a long way for one’s retirement prospects.”

Pros

• You can start to build your investment portfolio even if you don’t have sufficient liquid cash flow.
• You can pay off your mortgage and build up your investment portfolio at the same time.
• You can turn non-deductible mortgage debt (“bad debt”) into deductible investment income debt (“good debt”) and generate a tax refund each year.
• Executed properly, your net worth may be significantly higher at the end of the investment timeframe (typically 25 years) than if you simply paid off your mortgage, even with the outstanding investment loan.
• Unlike a mortgage, you can make payments to your HELOC without prepayment penalties.

Cons

• When you re-borrow money each time you make a prepayment, the overall amount of your debt isn’t decreasing as you’re paying down your mortgage but drawing the same amount from your HELOC.
• The Smith Manoeuvre requires a long timeline for your assets to appreciate in value above your loan and interest costs. A shorter timeline may expose you to greater market volatility and the risk of a loss.
• A market downturn and/or rising interest rates will increase the cost of your loan and could lower your rate of return in the short-term.
• While this is a legal strategy, you need to keep very clear records if the Canada Revenue Agency (CRA) asks for additional documentation. For example, Smith’s book emphasizes that it’s critical to keep a separate chequing account for money to flow from your HELOC and into your income-producing investments to prove that the deductions you are claiming originate from borrowed funds. You should also not access your HELOC for other reasons, such as a vacation, as that may create a red flag for the CRA.
• You can only borrow up to 65% of your home’s value in the line of credit portion of your readvanceable mortgage (before 2022 the maximum was 80%), which means you won’t be able to re-borrow as much and therefore won’t be able to invest as much each month.

As the Smith Manoeuvre is complicated, it’s a good idea to ensure your team of advisors (for example, mortgage broker, financial advisor, and accountant) has the Smith Manoeuvre Certified Professional (SCMP) designation among its ranks. These accredited professionals have taken an extensive course and passed an exam on this strategy. You can find a list of these certified professionals online at smithmanoeuvre.com.

The Smith Manoeuvre effectively turns non-deductible “bad” mortgage debt into deductible “good” debt. Done right, once your mortgage is paid off, you could have an investment portfolio worth significantly more than your investment loan. However, with rates significantly higher than when Fraser Smith introduced this strategy in 2002, the margins are tighter and the risk for undisciplined investors even greater. This is a complicated strategy and the majority of interested homeowners should consult a certified professional rather than go at it alone.