Smith Manoeuvre In A Financial Plan & The New OSFI Rules (Canadian Financial Summit 2023)

The Smith Manoeuvre is an efficient strategy to use your home equity to invest for your future without using your cash flow, while converting your mortgage into a tax-deductible debt. 

This method is known for its effectiveness in enhancing financial plans and can bridge the gap to achieving your retirement goals.

New OSFI Mortgage Rules

If you do the Smith Manoeuvre, understanding the new OSFI mortgage rules is crucial.

Recent changes to mortgage regulations by the Office of the Superintendent of Financial Institutions (OSFI) have introduced new constraints on readvanceable mortgages (CLPs). Here’s what you need to know:

• Reduction in Readvanceable Limits: If your total mortgage limit exceeds 65% of your home’s value, the new rules will prevent readvancing your credit on a $1 for $1 basis. For instance, if your mortgage payment reduces your principal by $1,000, you might not be able to reborrow the full $1,000 in your credit line.
• Change in Borrowing Limits: The borrowing limit will gradually decrease from 80% to 65% of your home’s value over time.
• Effective Date: These changes will apply to mortgages coming due after October 31. Since most major banks align their fiscal years with this date, expect these rules to impact your mortgage renewal if it occurs after this cutoff.

As OSFI notes, while many borrowers will see no immediate effect, those with a loan-to-value (LTV) ratio exceeding 65% will experience a gradual shift where a portion of their mortgage principal payments will go toward reducing their overall mortgage balance until it falls below the 65% LTV threshold.

Impact on the Smith Manoeuvre

The new rules will have a moderate effect on the Smith Manoeuvre, which is integral to many financial plans. Here’s how these changes could impact your strategy:

• Overall Effect: The changes are moderate for most users. You might experience a modest change in your monthly cash flow. If you’re maximizing the Smith Manoeuvre, the new credit available after each mortgage payment will be about 20% less. For smaller mortgages, the reduction could be up to 80%. However, if your total credit limit is already at 65% or less, there will be no impact.

Effect is not large.

Effect of much higher interest rates this year is far greater.

Formula for the New Rules

To calculate the reduced credit available due to the new rules, use the following formula:

Total credit limit 80%.*

Variable credit limit 65%.*

Total credit limit reduced from 80% to 65% over time.

o   Based on mortgage amortization years. E.g., 25 years.

Loan-to-value (LTV) = Amount owing / value of your home (appraisal).

Credit readvance in your credit line:

Reduced credit = Principal payment x (80%-65%) / LTV of mortgage(s)%

Credit readvance = Principal payment – Reduced credit

* Total credit limit is normally 80% and variable credit limit 65%, but that is not always the case. If they are different, use the actual percentage limits in the formula, instead of 80% and 65%.

• Old Limit is typically 80%
• New Limit is 65%
• LTV is the loan-to-value ratio of your mortgage

Examples of the Effect

Let’s explore a few scenarios:

Example 1: New Smith Manoeuvre

• Home Value: $1 million – Last appraisal
• Mortgage: $800,000 at 6.5%
• Credit Line Balance: $0
• Total Owing: $800,000
• Loan-to-value (LTV) of mortgage(s): 80%
• Payment: $5,334/month; Interest: $4,334/month
• Principal: $1,000/month

Using the formula:

Reduced credit = Principal payment x (80%-65%) / LTV of mortgage(s)%

Reduced credit = $1,000/month x 15% / 80% = $188/month.

Credit readvance = Principal payment – Reduced credit

Credit readvance = $1,000/month – $188/month = $812/month.

Old Rules: New credit available = $1,000 

New Rules: New credit available = $812

Example 2: After a Few Years

• Home Value: $1 million – Last appraisal
• Mortgage: $700,000 at 6.5%
• Credit Line Balance: $80,000
• Total Owing (Reduced total limit 78%): $780,000
• Loant-to-value (LTV) of mortgage(s): 70%
• Payment: $5,334/month; Interest: $3,792/month
• Principal: $1,542/month

Reduced credit = Principal payment x (78%-65%) / LTV of mortgage(s)%

Reduced credit = $1,542/month x 13% / 70% = $286/month.

Credit readvance = Principal payment – Reduced credit

Credit readvance = $1,542/month – $286/month = $1,256/month.

Old Rules: New credit available = $1,542 

New Rules: New credit available = $1,256

Example 3: Mostly Paid Off

• Home Value: $1 million – Last appraisal
• Mortgage: $150,000 at 6.5%
• Credit Line Balance: $530,000
• Total Owing (Reduced total limit 68%): $680,000
• Loan-to-value (LTV) of mortgage: 15%
• Payment: $5,334/month; Interest: $812/month
• Principal: $4,522/month

Reduced credit = Principal payment x (68%-65%) / LTV of mortgage(s)%

Reduced credit = $4,522/month x 3% / 15% = $904/month.

Credit readvance = Principal payment – Reduced credit

Credit readvance = $4,522/month – $904/month = $3,618/month.

Old Rules: New credit available = $4,522 

New Rules: New credit available = $3,618

Effect on Monthly Investment

• New Smith Manoeuvre: New credit of $812, resulting in the same amount available for investment.
• After a Few Years: New credit of $1,256, with $776 available for investment after adjustments.
• Mostly Paid Off: New credit of $3,618, with $438 available for investment.

Under the old rules, monthly investments would remain flat for 25 years. However, under the new rules, investments will decline over time, with a more pronounced decrease in later years.

Best & Worst-Case Examples

Best case:

o   Mortgage 80% LTV.

o   Credit available to invest 20% less.

Worst case:

o   Mortgage 15% (minimum allowed).

o   Credit available to invest 45% less.

Managing the Process

To manage the impact of these changes:

• Credit readvance has 2 uses: Pay tax-deductible interest on your credit line(s) (“capitalize”) &  Invest.
• Adjust Investments: Consider investing 20% less each month or increasing your mortgage payment by approximately 4%.
• Credit Management: Keep some extra credit available to accommodate declining new credit.

Minimizing or Eliminating the Effect

1. Renew Early: Renew your mortgage before October 31 to avoid the new rules.

o   Today’s invest rates – 3-year probably better than 5-year term.

o   Rules don’t apply till mortgage due date after October 31, 2023.

2. Reappraise Home: Reappraise your home regularly to keep the LTV ratio below 65%.

o   Don’t increase total limit.

o   With 23% increase in home value, effect is eliminated.

o   Need 23% increase in home value to bring total limit to 65% LTV.

o   23% increase typically happens in 5 years. Recently less than 5.

o   Better to invest the increase for growth-focused investors.

O If you invest the increase, the effect is slower, not eliminated.

3. Split Mortgages: Consider creating split mortgages to maintain a high percentage of tax-deductible debt.

o   Convert tax-deductible credit line to split mortgage.

o   Try to keep 2 mortgage portions close to 80% of home value.

o   Main non-deductible mortgage + tax-deductible split mortgage.

Effect on Smith Manoeuvre vs. TFSA

When deciding between the Smith Manoeuvre and contributing to a Tax-Free Savings Account (TFSA):

Smith Manoeuvre means pay down mortgage & reborrow from tax-deductible credit line to invest.

All 3 options, you invest the same amount & can invest the same.

Differences are tax differences.

• The Smith Manoeuvre generally offers better tax efficiency compared to TFSA contributions. Tax-efficient investors get refunds in most years vs. TFSA no tax.

• The TFSA might become more attractive since you can invest 100% of your extra cash, whereas the Smith Manoeuvre may only allow for a reduced amount due to the new constraints.

Income in 20% bracket             Income in 30+% bracket

Less than $53,000 (2023)        Over $53,000 (2023)

Priority 1        Smith Manoeuvre                     RRSP

Priority 2        TFSA                                           Smith Manoeuvre

Priority 3        Non-registered (not RRSP)       TFSA

General rule of thumb with new rules:

TFSA generally beats Smith Manoeuvre.

You invest 100% of extra cash, instead of 80% or less.

Income in 20% bracket             Income in 30+% bracket

Less than $53,000 (2023)        Over $53,000 (2023)

Priority 1        TFSA                                           RRSP

Priority 2        Smith Manoeuvre                     TFSA

Priority 3        Non-registered (not RRSP)       Smith Manoeuvre

Old Rules: No TFSA contributions unless mortgage will be paid off before retirement.

New Rules: No mortgage prepayments until TFSAs are maximized.

Conclusion

The new OSFI mortgage rules introduce a moderate impact on the Smith Manoeuvre, affecting how much you can invest each month. While the changes are notable, particularly for larger mortgages or those nearing the 65% LTV threshold, there are strategies to manage and mitigate these effects. Understanding the formula and adjusting your approach can help you continue to leverage home equity effectively for investment.