Smith Manoeuver Break-Even: What Return Do You Need?

Why the HELOC interest is deductible and the mortgage interest is not

Deductibility depends on what the borrowed money is used for, not on which account pays the interest. Money borrowed to buy your home is a personal purpose, so mortgage interest is not deductible. Money borrowed to buy investments that can earn income is generally deductible under paragraph 20(1)(c) of the Income Tax Act, if you can trace the borrowing to the investment (see the CRA's Folio S3-F6-C1). The Smith Manoeuver works by moving debt from the first kind to the second. The full mechanics and the tracing rules are in the complete guide.

The break-even in one formula

Each borrowed dollar costs the HELOC rate h. Because the interest is deductible, the refund returns your marginal tax rate t of it, so the cost after the refund is h x (1 - t). The strategy breaks even when your investment return equals that cost. For the example: 4.65% x (1 - 43.41%) = 2.63%. The calculator's full month-by-month model finds 2.52%, a little lower, because the tax refund also pays down the 3.8% non-deductible mortgage, which costs more than the HELOC does after the refund.

The break-even is an after-tax return: the model does not tax the investment income. Taxes on your returns raise the return you need before tax (at a 20% tax rate on the income, the example needs about 3.2% before tax).

Lever 1: your HELOC rate

A higher HELOC rate raises the bar. Holding the marginal tax rate at 43.41%, each extra point of HELOC rate adds roughly two thirds of a point to the return you need:

• HELOC 3.65%
  1.89%
• HELOC 4.65%
  2.52%
• HELOC 5.65%
  3.19%
• HELOC 6.65%
  3.91%

Lever 2: your marginal tax rate

The HELOC rate is not the only factor. Your marginal tax rate sets the size of the refund: every dollar of HELOC interest comes back as a refund equal to that rate. A higher marginal rate means a bigger refund and a lower bar. With the HELOC at 4.65%:

• 29.65% rate
  3.30%
  30 cents back per $1
• 37.91% rate
  2.84%
  38 cents back per $1
• 43.41% rate
  2.52%
  43 cents back per $1
• 47.97% rate
  2.24%
  48 cents back per $1
• 53.53% rate
  1.90%
  54 cents back per $1

Break-even by HELOC rate and marginal tax rate

Both levers together, with the mortgage fixed at $650,000 at 3.8% over 25 years. Each cell is the after-tax annual return your investments must beat. The outlined cell is the calculator's default.

The best corner is a low HELOC rate with a high marginal rate (1.40%); the worst is a high HELOC rate with a low marginal rate (5.00%). Your own investments need to beat the cell that matches your rates. The marginal rate depends on your province and income: see the marginal rates by province.

What the break-even leaves out

• Tax on your investment returns. The model treats returns as after tax. The return you need before tax is higher.
• Returns are not guaranteed. Markets can fall for years while you still owe the HELOC.
• HELOC rates move. Most are variable, so your break-even rises when rates rise.
• Cash flow. You pay the HELOC interest from your own pocket first, and the refund arrives once a year and covers only part of it.
• The paper trail. Mixing personal and investment borrowing, or letting investment money pass through a chequing account, puts the deduction at risk. Keep the debt separate and keep records.

This is education, not tax, legal or investment advice. Talk to a licensed Canadian chartered professional accountant or certified financial planner before you act.