Do you know of any Smith Manoeuvre calculators? The more variables I add, like inflation, ROI, different interest rates for principal, HELOC vs. variable-rate mortgage, the more my head spins.
I am not familiar with any Smith Manoeuvre calculators, Warren, but I can try to simplify the math a bit. First, what is the Smith Manoeuvre? It was developed by Fraser Smith in the 1980s as a method to make mortgage interest tax-deductible while building investment assets.
Lenders will typically allow you to have a home equity line of credit (HELOC) for up to 80% of the value of your home minus your mortgage balance. (If you are refinancing, your HELOC may be limited to 65% of the home’s value.)
As an example, say you have a $750,000 home and a $600,000 mortgage with an interest rate of 4%. Your HELOC would be $600,000 less your mortgage. As you pay down your mortgage, the equivalent amount of room is added to your HELOC limit. Assuming a 25-year amortization, the first monthly payment for your mortgage pays down $1,173 of principal. After 12 months, you will have repaid $14,330 of principal and added the equivalent amount of room to your HELOC.
The Smith Manoeuvre involves borrowing the new room available on your line of credit to invest each month. The interest is tax-deductible if the funds are invested in a taxable non-registered account, and you end up with more investment assets growing over time. If you use all the new room, your mortgage debt level stays the same, because you’re borrowing back every dollar of principal you repay—but more of your debt becomes tax-deductible.
How inflation affects your borrowing costs
You mention a few variables that you are having trouble addressing in your calculations, Warren, including inflation. Inflation will have an indirect impact on the numbers.
If inflation is high, interest rates will also typically be high to fight inflation. According to the Bank of Canada, it aims “to keep inflation at the 2 per cent midpoint of an inflation-control target range of 1 to 3 per cent.” Right now, inflation is over 6%, so inflation is on everyone’s mind. But over time, inflation will return to the target, hopefully by 2023, based on the Bank’s assessment.
If high inflation were to persist, not only would interest rates stay high, but investment returns would also likely be higher. Interest rates would be higher for bonds and guaranteed investment certificates (GICs). Persistent high inflation as represented by increasing prices for goods and services would generally lead to higher corporate profits and stock returns as well. (More on interest rates below.)
Warren, I’m inclined to assume that your calculations are over a long enough period that inflation is back under control and not a factor in deciding whether to borrow to invest. I would not recommend borrowing to invest as a short-term strategy. Market timing is very difficult, and leverage increases investment risk. So, if an investor decides to borrow to invest, it should be over a long time horizon.
What is a realistic ROI for borrowing to invest?
The return on investment (ROI) is relevant and is impacted by two primary factors: your risk tolerance and your investment fees.
The Smith Manoeuvre probably works best with an all-equity or high-stock-exposure portfolio, so if you are not an aggressive investor, it probably does not make sense to consider borrowing to invest.
If you do borrow to invest, however, what ROI is realistic? Over the past 50 years, the Toronto Stock Exchange (TSX) returned 9.6% annualized and the S&P 500 returned 11.7%. That said, inflation was much higher over that period—3.9% annualized—compared to the current Bank of Canada target of 2%.
Over the past 20 years, during which time inflation was 2%, the TSX returned 8.1% and the S&P 500 returned 8.4%. All rates are as of December 31, 2021.
For any long-run ROI projections, I would be inclined to consider more conservative assumptions than the returns of the past 50 years. For example, a globally balanced portfolio with 20% emerging market equities and the balance split between Canadian and foreign developed-market equities might be assumed to return 6.6%. This is based on FP Canada’s 2022 guidelines for Certified Financial Planners, which estimate a 6.3% return on Canadian equities, 6.6% on foreign developed-market equities and 7.7% on emerging-market equities.
What about interest rates? The prime rate is currently 3.7% and is widely expected to rise another 0.5% in July, potentially followed by a couple more rate increases before the end of the year. So, the interest rate on a HELOC could be over 5% by 2023, and five-year fixed mortgage rates are already around 4.5% at the Big Five banks.
FP Canada’s current guidelines suggest assuming a borrowing rate of 4.3% over the long term. So, in a simple example, borrowing at 4.3% and investing at 6.6% should produce a profit. For every $100,000 of leverage (money borrowed to invest), the profit would be about $2,300 per year pre-tax (6.6% return minus 4.3% interest), and likely $1,500 or so after tax.
However, not everyone who borrows to invest will put 100% into stocks. And if you work with an investment advisor or use mutual funds, your returns could be 1% to 2% lower due to fees. That basically negates most of the potential profit based on the assumptions above.
So, the best candidate for borrowing to invest may be an aggressive investor paying low fees. The potential upside is there, but it may not be worthwhile unless you get lucky and invest at the bottom of the market. I am not a big fan of market timing, given that data shows how hard it is for investing professionals, let alone anyone else.
Another consideration is that most people would be better off maxing out their tax-free savings account (TFSA) and registered retirement savings plan (RRSP) before borrowing to invest in a non-registered account. Interest on money borrowed to fund these accounts is not tax-deductible, mind you, but the returns are tax-free (TFSA) or tax-deferred (RRSP).
Should you borrow with a HELOC or a variable-rate mortgage?
In response to your question about whether to use a home equity line of credit or a variable-rate mortgage for borrowing to invest, Warren, the line of credit is more flexible for taking withdrawals and making repayments, whereas a mortgage is a one-time advance of funds.
HELOC payments are typically interest only at prime plus 1% interest, or sometimes a lower premium. The interest on variable-rate mortgages is typically prime minus a discount, so this could result in a lower interest rate. However, mortgage payments include principal plus interest, so they would be higher each month. To bring down your interest costs, you can typically convert a HELOC balance into additional mortgage debt.
In summary, Warren, there may be an opportunity to build wealth by borrowing to invest. This strategy works best for aggressive, low-cost investors with a long time horizon. It should probably be considered only after maxing out tax-preferred investment accounts. For investors with a moderate risk tolerance or high investment fees, the investment returns may not outpace the interest costs.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto, Ont. He does not sell any financial products whatsoever.
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