The Smith Maneuver….What You Need to Know?

“Pay down your mortgage in 8 years instead of 25”. “Make the interest on your mortgage tax-deductible.” You have seen the ads in publications around town with free seminars. You’ve heard the ads on radio.

What’s the catch to this seemingly impossible scenario? In theory, if the sun, moon, and stars align properly and all assumptions go according to plan, you may be able to pay down your mortgage in a shorter time frame and get a tax deduction on your mortgage interest.

This is how the plan works. The easiest scenario is to set up your mortgage as a line of credit rather than your typical mortgage amortized over a specified length of time such as 25 years. You would keep your payments the same paying down your mortgage every month just as you always have.

However, every month when the principal on your mortgage is paid down, you reborrow an equivalent amount of principal on the line of credit. The amount reborrowed is invested in a balanced portfolio of stocks, bonds, etc…which is easily done in a mutual fund. Because the funds are used for investment purposes and to generate an income that would ultimately be higher than the interest paid on the line of credit, you are able to write off the interest paid on the line of credit.

The tax refund you receive would then be put on the principal of the home which in turn increases the line of credit. After a few years, the rate that this happens would accelerate allowing you to pay down your mortgage at an ever increasing rate and a lot sooner than just having a regular amortized mortgage.

On the surface, this sounds great and in theory it is. So what are the downfalls? Firstly, you are paying your regular mortgage payment and will then have to make interest payments on the line of credit as well. In the beginning, the interest required is rather small. After just a couple of years, however, the interest required to service the line of credit will run into the thousands of dollars each year.

How do you get this money? Well, you can sell off a part of the investment portfolio that you have adding to each month through what is called a systematic withdrawal plan to cover the interest cost. This is where the problem potentially begins. Assume you have a line of credit for $100,000. The interest cost will run about $5000 per year at current interest rates. If you sold off $5000 worth of funds and the market drops as it has done the last couple of years, your $100,000 investment portfolio may only be worth $70,000 -$80,000 while the line of credit continues to grow from its current $100,000. If the markets stay down for just two years, the possibility of the fund recovering to the level of your line of credit is extremely remote.

The strategy uses something called leverage. The same strategy that created the mess for financial institutions around the world. Before considering the Smith Maneuver as a way to become mortgage free sooner, please speak to an independent financial planner or advisor to learn more about the risks?

What do you think of this plan? Would you consider it for your current financial situation?