Wednesday, April 4, 2012

Is Your Mortgage Tax Deductible: The Smith Manoeuvre by Fraser Smith

Would you like to make the interest on your mortgage tax-deductible? This book can show you how (or more precisely, how to convert your mortgage into an investment loan). Using a very creative approach, Fraser Smith explains how a reversible mortgage can be used to reduce one's taxes. In a nutshell, a reversible mortgage is a financial instrument that is comprised of two parts: first, the mortgage on the house; and second, a line of credit that allows a homeowner to borrow from the equity in their house. The line of credit increases as the principal on the house is paid down. For example, if you pay off $600 of principal in a month, then you can borrow $600 from the line of credit.

The trick to this strategy is found in the tax rule that allows Canadians to deduct interest from investment loans. Using this rule, if a homeowner uses their line of credit to purchase investments (e.g. stocks, mutual funds, investment properties, bonds, etc.), then they can deduct their interest payments on this line of credit from their taxes. As such, the strategy does not allow a person to deduct the interest on their mortgage per se from their taxes, but rather to deduct the interest on their credit line that is based on the amount of principal that has been paid off.

In the first step of the Smith Manoeuvre, a homeowner will use all of their tax refunds to pay down their mortgage as quickly as possible, and then borrows an amount equal to the paid-off principal to buy more investments. Through this process a person can convert their mortgage from a "bad debt" (i.e. a loan in which interest cannot be deducted) to an investment credit line that is a "good debt" (i.e. a loan in which interest is tax deductible).

In the second step, once the mortgage is paid off, the homeowner can either use the tax refunds on their investment line of credit to buy more investments, or decide to use their now sizeable investment portfolio to pay off their line of credit.

I liked this book because it proposes a very creative approach to investing. As long as you are comfortable with having the same amount of debt, (this strategy doesn't reduce debt, but  rather converts it from a non-deductible mortgage to a deductible investment line of credit), you can use the Smith Manoeuvre to build up an investment portfolio much faster than you could have otherwise.

On the downside, I found this book to be very, very repetitive, with the same point being recycled numerous times. As well, the rates of return that are projected are highly unrealistic. In several parts of the book examples are given with a rate of return of 10 per cent. In this economic climate, it is highly unlikely -- if not delusional -- to expect an investment portfolio to grow by 10 per cent per year. It is also unfortunate that Fraser Smith does not acknowledge the risks in his strategy. For instance, in 2008, anybody using this strategy could have found themselves holding onto an investment portfolio that was worth less than the value of their house, while still having to pay interest on an investment line of credit. Most people in this scenario would not be calmed with the knowledge that interest paid on this line of credit is tax deductible. That being said, this is an interesting concept and the book does prevent food for thought.

3 out of 5 stars

Enough Bull: How to Retire Well Without the Stock Market, Mutual Funds, or Even an Investment Advisor by David Trahair

The 2008 financial crisis convinced David Trahair that the stock market is too risky for anyone saving for retirement. After watching the investment portfolios of too many people evaporate into thin air, he wrote this book to make the case that one can ignore the stock market altogether and still retire comfortably. With interesting arguments, Trahair counsels that one should first pay off all debt (and in particular mortgage-debt) before even considering to invest. Bucking conventional wisdom, he even advises people to stop making RRSP contributions until they are debt free.

But what about compound interest? Won't a person miss out on the slow accumulation of wealth if they wait until their late-40s or 50s to make RRSPs contributions? Not so, says Trahair, who is a chartered accountant. Relying on straightforward calculations, he points out that a person who is debt-free in their early-50s can: a) save significant more amounts of money than someone in their 30s or 40s who is paying off a mortgage and / or raising children; and b) because they are reaching their top earning years their tax refunds will be much higher. These refunds, in turn, can be used to make more RRSP contributions.

When analysed this way, the "tax turbo-charged RRSP" strategy is much better than the "start early" approach. To paraphrase the book, one can save $200 a month in RRSPs during their 30s, 40 and 50s, (and in the process pay off their mortgage more slowly, resulting in higher interest charges), or alternatively, one can focus on paying off their mortgage during their 30s and 40s and then, once debt free in their early-50s, save $1,500 a month in RRSPs for 10 years. At the end of the day, the latter approach will result in greater savings. (Note: This example is not in the book, it simply paraphrases the argument).

What should someone invest in when they have paid off their debt? The book's answer is clear: Guaranteed Investment Certificates (GICs). After watching the stock market plunge in 2008, Trahair is adamant that stocks are too risky. Furthermore, he argues that the rate of return on GICs are not that much different from stocks.

It is at this point that the book's thesis starts to weaken. Given the financial meltdown in 2008 and the ensuing recession, it is understandable why some people would want to swear off the stock market. However, Trahair's analysis is overly pessimistic. In order to make his point, he repeatedly mentions how the TSX crashed in 2008, and how this crash destroyed the rate of return for stocks. Unfortunately, this analysis ignores the partial-recovery that has taken place since then. As well, his analysis of the returns of GICs versus stocks tends to ignore dividends, which skews his argument.

Trahair makes a solid argument when he states that Canadians should first pay off debt before investing. He also makes a plausible case that GICs are a much better investment than people think. Where he starts to go off the rails, however, is in his claim that the rate of return for GICs are comparable to those of stocks. This is simply not true. Yes, stocks are risky (you can lose all of your money) but the returns can also be much greater. If you want to protect your investment then it makes sense to consider the GIC, tax turbo-charged RRSP strategy. If you are looking for stock-like returns with GIC safety, however, then you won't find that in this book because such a scenario does not exist.

3 1/2 out of 5 stars