Recently a friend was looking into using the Smith Maneuver. His goal was to use it in the more traditional way: borrow money against the equity in his house and invest it in dividend paying stocks. Use the money earned to further paydown the mortgage which would free up more equity to borrow more. Rinse and repeat! At the same time, the interest on the borrowed amount would be tax deductible since it was money borrowed to invest.
While I had previously looked into the Smith Maneuver, I had chosen not to use it because it increases risk. If your investments tank, you still owe interest (and the principal) on the HELOC. I still do not get the stock market enough to be comfortable with so much leverage. However, the discussion got me thinking about a very specific scenario.
This is the Smith Manuever where the investment is real estate instead of stocks. The reasoning being that since the money borrowed from the HELOC is for investment purposes any interest paid on this borrowed money is tax deductible as opposed to the interest paid on the principal mortgage which is not tax deductible in Canada.
Sounds good, right?
Not so fast. It turns out that yes while you will be saving on taxes (take that CRA!) you might actually end up doing worse financially. Why? Because a HELOC comes with a higher rate than mortgages.
I did some quick back of the napkin kind of calculations.
Assumptions:
Down payment needed = 50K.
Cash Available = 50K
Mortgage rate = 1.2% (this happens to be my current mortgage rate)
HELOC rate = 2.35% (this is the current advertised rate by Tangerine and apparently the lowest that I can see online)
So let's pretend we take the cash we have and pay down the principal with the cash. Then we borrow 50K from our HELOC and make the downpayment on the rental investment.
Cost of Borrowing 50K for one year, Mortgage = 50K * 1.2% = $600
Cost of Borrowing 50K for one year, HELOC = 50K * 2.35% = $1,175
Tax Savings:
Of course there are no tax savings on the mortgage interest. However, the interest on the HELOC is tax deductible, i.e., our net income is reduced by the amount of interest we paid. So our next income is reduced by 1,175. Let’s assume a marginal tax rate of 40% if you are making around 100K a year. This means our tax savings are 40% of $1,175 = $480.
Net cost of borrowing:
Mortgage = $600 (as before)
HELOC = 1,175 - 480 = $695
In other words, The Smith Maneuver has ended up costing us 95 dollars more. Suffice to say, this was very disappointing for me.
I started playing with the HELOC interest rate to find the exact point where (all other things equal) the Net cost of borrowing would be the same for the Mortgage vs. HELOC. If you can get a HELOC (or any other line of credit) for 2.16% you will break even. OR more importantly, if your interest rate for the line of credit is LESS than 2.16%, the Smith Maneuver might be of some benefit for this very specific scenario.
NOTE 1: The Smith Maneuver typically comes with increased risk. However, the above scenario, as far as I can tell, has no increased risk since our overall borrowed amount remains the same. I suppose one risk could be if our mortgage was a fixed rate (less risky) but the HELOC is variable (which it typically is).
NOTE 2: The above is a very specific example of where we already had enough money in cash for the downpayment. If we do not have enough for the down payment, then taking out a HELOC to pay for that down payment has the benefit of allowing a real estate investing play. However, now we are back to the situation where we are leveraged more.