Running out of HELOC Space with the Smith Manoeuvre

Running out of HELOC Space with the Smith Manoeuvre

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If you’ve been following the blog for a while, you may have heard about the Smith Manoeuvre.

At a high level, it’s a long-term investment strategy for investors with high risk tolerance.  Essentially, it’s where an investor borrows against his home (using a HELOC) to invest in the stock market, business, and/or real estate.  The plan is for the assets to grow over time at a greater rate than the interest accrued.  In the meantime, the investor can write off the interest to reduce their taxable income.

You can get all the details about the SM strategy here.

A big question that I get is what about the HELOC payments?  Wouldn’t that crimp your cash flow? To get around this cash flow problem you can capitalize the interest.  Essentially, this is where you use a loan to make the loan interest-only payments.  In this case, you can use the existing HELOC to make the HELOC payments.  Confusing?  It’s not as bad as it sounds.

Graphically, this is how we have our leveraged investment strategy set up and how we capitalize the interest.

For those of you new to this strategy, capitalizing the interest is one of the bonuses of this strategy.  It’s where you use the investment loan to pay for the interest owed, and everything remains tax deductible.  As funny as that sounds, the rule is if you take out a loan (we’ll call it loan A) to pay for the investment loan (HELOC) tax deductible interest, then loan A interest is also tax deductible.  So technically, if I use the HELOC balance to pay for the HELOC interest, then the entire HELOC balance should remain tax deductible. I utilize this strategy as it allows me to have an investment loan without actually using any of my own cash flow to service the loan interest.

The easiest way is to have your HELOC interest automatically deducted from your chequing account monthly.  Then do a transfer for the same amount from your HELOC to repay your chequing account.  I would also recommend to have a dedicated chequing account for this strategy in case CRA comes knocking on the door for your records.  At least that’s the way that I have it setup.  And yes, I would recommend against maxing out the HELOC as you’ll need the space to pay for the interest incurred.

So to the point of the article, if you are capitalizing the interest, isn’t there a point where you run out of HELOC space (credit available)?  The answer is yes!  If your instalment mortgage is paid off, and you are using the HELOC to pay for itself, your HELOC balance will continually increase.  The question is, are you comfortable with a maxed out HELOC? Note that a large HELOC may impact your credit score as you may be borrowing a large amount of your overall credit available. 

Personally, I have seen the impact with my Equifax scores but not so much Transunion.  You can likely check your credit score for free with your bank.  If your bank doesn’t offer the service, here are some other free ways to check your credit score and report.

Let’s take a look at an example.  Say an initial loan of $100k from a HELOC with an interest rate of 4% and a credit limit of $250k.  Providing that there are no more transfers from the HELOC to the portfolio, how many years will it take for the HELOC to be maxed out?  24 years!  Check out the table below.

Year Balance
1 $100,000.00
2 $104,000.00
3 $108,160.00
4 $112,486.40
5 $116,985.86
6 $121,665.29
7 $126,531.90
8 $131,593.18
9 $136,856.91
10 $142,331.18
11 $148,024.43
12 $153,945.41
13 $160,103.22
14 $166,507.35
15 $173,167.64
16 $180,094.35
17 $187,298.12
18 $194,790.05
19 $202,581.65
20 $210,684.92
21 $219,112.31
22 $227,876.81
23 $236,991.88
24 $246,471.55
25 $256,330.42

Let’s take a look at a personal example – my OWN HELOC.  Right now, the balance is about $140k with $4% interest and a credit limit of about $215k.  If we were to capitalize the interest right up until my credit limit, I could do this for about 12 years (from today).

Year Balance
1 $140,000.00
2 $145,600.00
3 $151,424.00
4 $157,480.96
5 $163,780.20
6 $170,331.41
7 $177,144.66
8 $184,230.45
9 $191,599.67
10 $199,263.65
11 $207,234.20
12 $215,523.57

To mitigate against the HELOC balance from getting too large, you could simply make the payments out of your own cash flow and/or you use the dividends generated from your investments to pay down the loan. 

My SM portfolio generates about $7,800/year in dividends.  What if I were to withdraw those dividends right onto the investment loan.  To keep things simple, let’s assume that interest rates don’t rise AND there is no dividend growth.

Year Balance Deposit
1 $140,000.00 $0.00
2 $145,600.00 $7,800.00
3 $143,312.00 $7,800.00
4 $140,932.48 $7,800.00
5 $138,457.78 $7,800.00
6 $135,884.09 $7,800.00
7 $133,207.45 $7,800.00
8 $130,423.75 $7,800.00
9 $127,528.70 $7,800.00
10 $124,517.85 $7,800.00
11 $121,386.56 $7,800.00
12 $118,130.03 $7,800.00
13 $114,743.23 $7,800.00
14 $111,220.96 $7,800.00
15 $107,557.80 $7,800.00
16 $103,748.11 $7,800.00
17 $99,786.03 $7,800.00
18 $95,665.47 $7,800.00
19 $91,380.09 $7,800.00
20 $86,923.30 $7,800.00
21 $82,288.23 $7,800.00
22 $77,467.76 $7,800.00
23 $72,454.47 $7,800.00
24 $67,240.65 $7,800.00
25 $61,818.27 $7,800.00
26 $56,179.00 $7,800.00
27 $50,314.16 $7,800.00
28 $44,214.73 $7,800.00
29 $37,871.32 $7,800.00
30 $31,274.17 $7,800.00
31 $24,413.14 $7,800.00
32 $17,277.66 $7,800.00
33 $9,856.77 $7,800.00
34 $2,139.04 $7,800.00
35 -$5,887.40 $7,800.00

As you can see from the table above, using the dividends from the portfolio would result in paying off the HELOC entirely by about 35 years (at least in this scenario – it’s faster if you count the tax deduction).  Personally, I’ve just started using dividends to pay down the HELOC and may continue until I reach the $100k mark.  If we get a major market correction, I may reborrow again and continue to slowly pay down the balance.

While a long-term leveraged investment strategy may work, the investor really needs a high-risk tolerance.  If you plan on capitalizing the interest on your investment loan, take note that you will eventually run out of HELOC space unless you plan on: refinancing; paying it off using dividends; and/or using your own cash flow.

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