What is Interest Capitalization?

By Melany Eastman -- Financial Advisor
Bick Financial Security Corporation

For the past several years Fraser Smith has popularized a strategy called the Smith Manoeuvre. The Smith Manoeuvre essentially transforms your mortgage into an investment loan, so that your interest can be tax deductible. The result is that you pay off your mortgage faster and invest more for your retirement.

One question we get asked from time to time pertains to interest capitalization, a technique used in the Smith Manoeuvre. Here is how interest capitalization works.

Suppose you have a $1400 per month mortgage payment and you want to implement the Smith Manoeuvre. In the first month you would make your $1400 payment as you normally do. Roughly $1,150 of it would go to the bank for interest and $250 would be paid towards your mortgage principal.

You would then immediately borrow back that $250 from a line of credit (LOC) secured against your home. Then you’d invest it. Doing so would yield tax deductions because the interest on an investment loan is tax deductible.

The next month you would make the same $1,400 mortgage payment. However, this time, more would go towards principal reduction (say $252). On your LOC, you would now have access to another $252 with which to invest.

Of course, you need to pay interest on a line of credit. So, in our example, you would pay roughly $2 of interest in the 2^nd month to cover the $250 you borrowed the previous month.

Now comes the point of this article.  Fraser Smith recommends that you “capitalize” this interest. In other words, you would need to leave $2 in your LOC to pay the LOC interest.

Each month you would therefore invest a flat $250. You would likely never need additional cash because the interest on your investment loan would be paid by the extra money you leave in your LOC each month.

This process continues all the way until your mortgage debt has been fully converted to an investment loan. In the end, interest capitalization serves to keep everything in balance.

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A leveraging strategy involves added risks as it is apparent that leveraging magnifies gains or losses. It is important that an investor undertaking a leveraged purchase of mutual funds be aware that a leveraged purchase involves greater risk than a purchase using cash resources only. The information provided is intended for information purposes only and is not, and under any circumstances, to be construed as investment advice. Any numerical values have been described for illustrative purposes. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Consult with your financial advisor before acting on this and/or any investment.

Comments

[Canadian Mortgage]

Our thanks go out to Melany for this excellent explanation!

[Donovan Murphy]

Interesting. I didn't realize the investment each month stayed the same. Thanks for clarifying this point. /DM

[Paul]

Hopefully more lenders will start automatically capitalizing the interest on lines of credit. It would make life a lot easier if you're using the SM.

[Quentin D'Souza]

Would mortgages like Manulife One and the New Canadian Tire program make a good fit for the Smith Manouvre? Since it capitalizes on your savings from other areas.

[Canadian Mortgage]

Hi Quentin, The Canadian Tire All-in-One mortgage is a solid contender. We prefer it over the Manulife product because of better pre-payment privleges and seamless re-advancing. However, for most people, FirstLine's Matrix is a better deal than either of them.