DIY Smith Manoeuvre: The Lazy SM

We've already detailed the principle of the Smith Manoeuvre 'SM' in a previous post. So, should you have elected that this strategy fit your own financial situation with competent counsel in the matter of money management, the next step is implementing the SM. In case you've followed the cash flows presented previously, few questions come to mind:

1. - How to relate the SM theory to the actual mortgage schedule sent by my bank ?
2. - How to automate Guerrilla Capitalization 'GC' (considering manually handling cash flows would drain way to much energy to be efficient) ?
3. ... what happened if I want to stop the SM ?

Thereafter, I will present a set-up (and I'm not claiming any mind blowing concept here! It's very simple.) enabling the semi-automatic management of the SM, including GC cash flow; by semi-automatic I mean that, once every mortgage term (and only once), one will need to manually create a cash flow schedule in form of post-dated bank transfers. Such semi-automatic process has a downside that is a sub-optimal payment of interest versus {market investment opportunity & (Broker fees vs Contribution) }. Nonetheless, it provides much benefits in terms of time-efficiency/cost-effectiveness compared to alternatives I've investigated. For that reason I call this set-up the lazy SM.



KEEP IN MIND THAT ONCE YOU'VE STARTED RE-ADVANCING CAPITAL, THAT VERY FIRST DAY, INTERESTS START RUNNING UNTIL SUCH RE-ADV. CAP. IS PAID BACK .... AND THAT IS THE ONLY WAY TO STOP THE SM !!! (that is selling as much as portfolio value as required, and eventually putting additional cash to clear the full amount of re-advanced principal invested).

Implementing the SM from a bank mortgage schedule

Recalling Figure 4 from the previous post, and as illustrated below, there are 2 parts that needs to be scheduled, namely (1) Re-advancing the reimbursed principal and (2) GC.

In the Lazy SM, the objective are (1) to easily track the cah flow, for potential CRA audits as well as for one's benefit in managing the expected cash flows, (2) to automate the Guerrilla Capitalization component, and (3) to know exactly what could be invested, but without doing the math. It appears that if post-dated transfers are timely defined, (2) & (3) can be achieved at once. The required set-up for the Lazy SM is represented much like before (information, details and motivation will be represented thereafter):

Figure 1: Lazy SM set-up. Bank & Broker names are for illustration purposes.

Defining Schedule 1

The re-advanced capital derives from the 'reimbursed principal' section of your bank mortgage schedule which becomes available in the Home Equity Line of Credit ('HELOC'). For the lazy SM to operate, a sub-account line of credit 'S/A' should be created from the original HELOC. It is illustrated in Figure 1 as 'SM HELOC sub-account'. Its mechanic is such that it can access any capital available in the HELOC (= reimbursed principal originating from mortgage, not yet withdrawn). Its purpose is 2 folds: track the amount of re-advanced principal from the HELOC, and most importantly automate Schedule 1 as presented thereafter. This step most probably carries extra fees such as $2.5/month at National Bank (see the relating open question at the end), but should a tax audit happen, this provides a clean state for any tax claim refund for 'interest expenses on money borrowed to purchase investments', which is part of the SM strategy. There is a more important motivation for that cost but we'll come to that later.

Automating GC ... sounds like something the bank back-end system should be doing. Indeed, this is precisely where we do not want to interact manually to make sure numbers do add up and no surprise arises from miscalculated due interests. There are 2 objectives here: (1) make the most of the bank back-end system to automate the capitalization of interests, and (2) to be left only with the remaining portion of the re-advanced capital for SM portfolio investment. Such automation requires a dedicated checking account 'SM/Check'. It is illustrated in Figure 1 as 'SM Checking Account' and will be used to track both (1) the amount of 'interests expenses on money borrowed for investment', further used for tax deduction, and (2) contribute to the SM portfolio as well as receive further dividends from that portfolio (used to attack the main mortgage).

Almost there ... so how to set-up the checking account so that GC schedules are inferred by the bank back-end system ? Well kind of straightforward from that point. Talk to your bank adviser, and simply state that the monthly minimum interest to be paid for using the S/A should be debited from the SM/Check, and define Schedule 1 to represent at most the transfer from S/A to the SM/Check, of the available principal reimbursed in the HELOC in a given 30-days period, BEFORE INTERESTS ARE DUE IN THE HELOC (similarly S/A as it is the same date). Then, at the monthly HELOC interests payment day, interests for using S/A will be charged to SM/Check, that is taken from the re-advanced capital, from which point the remaining will be what's left for contributing to the SM portfolio.   


At this point, one should understand that GC periodicity corresponds to that of HELOC interest charges (monthly), not that of mortgage payments (monthly, bi-weekly, bi-monthly, weekly). So one can still benefit from bi-weekly payments, doubling mortgage payments without fees (straight to principal), and the lazy SM.

As well, kindly remember that following IT-533 (paragraph 30), interests may be deducted only when the money borrowed is invested for the following purpose: "Normally, CCRA considers interest costs in respect of funds borrowed to purchase common shares to be deductible on the basis that there is a reasonable expectation, at the time the shares are acquired, that the common shareholder will receive dividends. Nonetheless, each situation must be dealt with on the basis of the particular facts involved.")! In other words, once GC occurred, the more you wait to invest, the less interests you may deduct (but the bank will charge them anyways) ... Nonetheless current year interests are not as relevant as the interests deriving from aggregating previous years of contributions to SM portfolio .... so invest as you see fit with support from competent counsel in the matter of money management. Mind you, interests starts the day the capital is re-advanced from HELOC, and kindly note that said capital does not work for you until invested, that is after GC interest payment + few days to transfer remaining funds to the SM portfolio, which is the price to pay for the lazy SM to happen

At this point, the said schedule needs to be define. This will translate into determining post-dated transfers from the 30-days period scheduled principal reimbursement available in the HELOC prior S/A interests are charged. There are different ways to determine the post-dated transfers (a) monthly by transferring the 'rounded to the closest minimum integer' capital value available from HELOC prior S/A interets payment day, (b) periodically by transferring bulks of capital (say upon each aggregation of $5,000) although S/A interets must be paid every month or (c) when market conditions are met and enough available capital is available although S/A interets must be paid every month. The lazy SM involves (a).

When determining the schedule, keep the following in mind (obvious but hey!):

1. - Avoid post-dated transfers during the week-ends.
2. - Verify that the cumulative sum of post-dated transfers, at any given time, is less than the cumulative sum of the capital reimbursed illustrated in your bank amortization schedule.

Note: Why not using the HELOC directly and save the S/A costs ? For the lazy SM to operate, S/A and SM/Check need to be tied together for automatic interests payments. There are different ways to use a HELOC to repay one's mortgage faster (subject of another post), and to prevent other transactions and transfers to polute the SM, paying this extra cost is a definite requirement, unless the HELOC is 100% used for the SM ... ever !!!

Economic Drawbacks for Performing the Lazy SM

The drawbacks (=cost) of performing the lazy SM is as follows:

1. - One will have to invest the remaining of the re-advanced capital as soon as GC occurs in order to benefit from further tax deduction, ALTHOUGH (and most probably) that might not be the best investment timing.

... nothing comes for free!

A Practical Scenario

Let's assume the following bank amortization schedule received in the mail: a 1-yr closed term for bi-weekly payment on a $110,750 mortgage at 2.64% interest amortized over 259 months.

Figure 2

To practically implement the lazy SM 2 elements are important:

1. - the monthly recurrent HELOC interest payment day,
2. - the scheduled Principal. We said that Principal shall be rounded to the nearest minimum (I can't explain why the digits forecast in my simulation differ by few cents from that of my bank schedule, and although this frustrates me, I'll live with it considering integers do match. As usual, considering my code is Open Source, any insight are appreciated considering the math should perfectly match that of the bank schedule.), which leads to the following:

For the sake of example, let's assume the HELOC interests are to be paid on the 25th of each month. That is, the S/A interests are to be paid on the 25th as well, as this is simpy a HELOC sub-account. In addition, let's define that we need 2 days of buffers for transfering funds into the SM/Check. And finally, let's assumer this is the very first round of SM contributions. Therefore, the following schedule is to be obtained:

Transfers should not be initiated during week-ends (this was not cross-checked in this illustration)

 

As it can be seen, the very first payment (2014-03-23) is not contributed to the 2014-03 month as it violates the 2 days of buffer 'rule' defined for re-advancing capital into the SM/Check prior the 25th of current month. It is thus contributed in the 2014-04 month.

Although I did not performed an agenda check on that schedule, one should always validate that transfers do not occur during week-ends. Nonetheless, this was the very motivation for the 2-days buffer that wuld take care of such misalignement.

From Theory to Evidence: Understanding Costs

We have detailed the theory of the set-up required for a Do-It-Yourself Smith Manoeuvre with Guerrilla Capitalization, while explaining the mechanic for automating the GC component. The interesting element is now to have an understanding of the lazy SM cost on a complete SM w/ GC. For that purpose, I will reuse the example of the previous post.

From what has been presented so far, one may have the following intuition about such costs:

1. - Small portfolio contributions have to be weighted against broker fees, one of the cheapest in Canada being Questrade (trade stocks for 1¢ per share, $4.95 min / $9.95 max)
2. - Delaying contribution of principal to the SM portfolio will have 2 impacts: (1) a limited impact on yearly distribution through dividends , and (2) a limited impact on the overall capital appreciation. This intuition is motivated by the fact that most dividends and capital appreciation originate from the 'aggregated' principal of previous years (versus current).
3. - Delaying contribution of principal to 'an investment vehicle' will decrease the 'amount of interest claimable as tax deduction under CRA expenses on money borrowed for investment'. This could be eye-balled defining a worse case scenario, assuming rightfully that monthly reimbursed capital increases only slightly during a given year, such that: the 'loss' of deduction can be approximated by aggregating the monthly cost of borrowing half of the last annual contribution (the largest principal reimbursement of a given year); for example, reimbursing 1000$ in December, one could over-estimate that 500$ would be carried over to the next month contribution due to the 2-days buffer rule, and this for every month, representing a 'relative loss' of 500*rate_of_HELOC=500*3%=15$/year.

In my Open Source Code repository,  I have modified 'SmithManoeuvre.R' to account for the cost of a lazy SM set-up (although I've taken a full month of contribution, not half). This is exposed in HouseMortgageStructure.R under LoanStructure$LazySM <- FALSE/TRUE.

To investigate the impact of performing a lazy SM on cash flow, I've re-run the simulated financial situation investigated in the previous post.

SM (non-lazy) Cash Flow

Lazy SM Cash Flow

From these simulation results, it can be seen that the impact of the lazy SM costs on a SM set-up are negligible in view of the overall process, accounting for (1) time to reimburse the home mortgage, (2) building the SM portfolio and (3) repaying the HELOC.

Conclusion

The lazy SM is a simple way for automating the Guerrilla Capitalization component of the variation of the Smith Manoeuvre I have presented in a previous post, for a very limited cost that does not impact the objective of said strategy.

It is my non-financial expert opinion that individuals willing to self-managed their SM portfolio, eventually with competent counsel in the matter of money management, would not really benefit from third-party companies providing, for a fee (>40$/month + 1 time $3,000 set-up), the automatic management of the GC component.

Open Questions

1. - I'm wondering if sub-account line of credit fees ($2.5/month) are tax deductible under the CRA policy as 'fees to manage or take care of your investments', considering this is paid only to manage the SM process (the GC component to be exact) and get a clean track records for CRA?