# New Regulations on HELOC - Impact on Smith Manoeuvre?



## HackNSlash (Apr 3, 2009)

I just read on Garth Turner's blog that the government is implementing new regulations on HELOCs...

http://www.greaterfool.ca/2012/03/19/bidding-wars/

And yeah, I know, it's Garth, but for a moment let's all pretend to be civil and not devolve into a "Garth Turner is/is not an idiot" argument. His views on the housing market are NOT the question here.

The question is: How do these new regulatory changes to HELOCs affect people using the Smith Manoeuvre? From my understanding, the new regulations would
1) Limit the amount of home equity you could leverage to 65%
2) Eliminate interest-only payments on the loan. The bank would impose an amortization period similar to a regular mortgage and require the borrower to make blended payments of principal + interest.

I'm curious as to how these changes would affect people currently (or thinking of) implementing the Smith Manoeuvre. Do these changes completely break the strategy?

FrugalTrader, I'm especially curious to hear your thoughts...


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## Ethan (Aug 8, 2010)

My bank grants HELOC's at a minimum amount of $25,000. The total mortgage and HELOC balance cannot be greater than 80% of your houses value. My last mortgage payment put my equity at $25,000 greater than 20% of my purchase price, meaning as of last Friday I'm eligible to apply for a HELOC. Looks like I better hurry and get this done.

As for the effect on the Smith manouver, I think it would just make it more difficult to be cash flow positive. You're either going to have to purchase riskier higher yield stocks, rely on trading to generate capital gains, or infuse cash from time to time to meet the payment requirements. You would also need more equity in your house before being able to do the Smith manouver.


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## Causalien (Apr 4, 2009)

I am curious about this too.
Can this apply to a HELOC retroactively? If not, then the next thing that everyone will probably do, is rush to the bank and max their HELOC to 80%

Also... what is with eliminating the interest only HELOC? I thought that's the whole point of HELOC, otherwise just go out and get a traditional mortgage.


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## Lucy (Mar 10, 2012)

HELOCs are revolving. Mortgages are not. Many Canadians are using homes as ATM machines. Sound familiar? HELOC are creating a US style bubble. If something is not done fast we'll regret it severely. It may already be too late. 

Anyway. Yes, this will make the smith manouve cash flow negative.


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## FrugalTrader (Oct 13, 2008)

First, I wouldn't worry about it until it becomes official. However, if payments become interest+principal then capitalizing the interest will be much trickier (using the loan to pay for itself). As well, tracking the deductible interest for tax season will be a bit more of a pain. I'm going to consult other SM experts and report back.


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## houska (Feb 6, 2010)

I may be misreading the OSFI proposal, but I see "...to limit the HELOC component of a residential mortgage to 
a maximum authorized LTV ratio of less than or equal to 65 percent." This wouldn't stop someone from having a HELOC with 50% LTV *plus* a mortgage of another 30% (or vice versa) for a total of 80%. Just that the interest-only, non amortized HELOC part no more than 65.

I do note the proposed limitation that HELOCs could only defer making principal payments for 5 years and then would have to become "mortgage-like" with a reasonable amortization time period. I see that as a reasonable step to avoid careless use of home equity as an ATM. But for the committed Smith Manoeuvre devotees I'm sure we'd see some product innovation on how to keep readvancing the principal you might now need to pay down.


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## andrewf (Mar 1, 2010)

You can approximate SM with:

1) a HELOC
2) a 1 year fixed rate second mortgage

Borrow from the HELOC to fund investments. Once a year when the second mortgage is due, refinance it and roll the HELOC balance into it (pay off the HELOC). The mortgage interest (but not principle) is deductible. You can also advance the principle repaid on the first mortgage.

For simplicity, you could skip the HELOC. Once a year when refinancing the second mortgage, advance the principle paid on the first mortgage to invest.

I have no experience with second mortgages, but I would guess that if it is with the same lender as you use for your first mortgage and the total LTV is under 80%, you should be able to get a rate as good or better than a HELOC.


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## andrewf (Mar 1, 2010)

I'd also say to anyone concerned about cash flow implications: if your cash flow is tight enough for you to be worried about it, you probably should not leverage yourself more. You should be able to comfortably service the first mortgage and HELOC/other loan out of your cash flow without relying on cash flow from the investment.


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## houska (Feb 6, 2010)

andrewf said:


> You can approximate SM with:
> 
> 1) a HELOC
> 2) a 1 year fixed rate second mortgage
> ...


Or a variable rate open readvancable mortgage. In fact you can already do this under the various bank "omnibus" mortgages (e.g. Scotia STEP) where they register on your title for the maximum LTV and then structure the mixture of mortgage products underneath, all at equal priority. The differences are in the details of what can be readvanced how; doubtless that would get tweaked as a consequence of any changes in regulation.

Basically, a Smith Manoeuvre is a complicated construct to allow gradual leveraged investing and profit from tax arbitrage. As long as there is value in that for some people, products will be tweaked to be suitable for it. To really kill it dead would require a change in the tax treatment of interest expenses or a wholesale shift in allowable LTV. My 2 cents.


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## andrewf (Mar 1, 2010)

My thoughts exactly. I'm lukewarm on HELOCs, anyway. I don't think it is necessary or important to readvance to the max LTV immediately after your biweekly payment on the 1st mortgage.


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## doctrine (Sep 30, 2011)

This could possibly be the type of overregulation that has unintended consequences. If a bank can only lend you 65% of the value of the home, they may adjust by offering you a 15% unsecured loan on top of that. This is already done, for example, for people who don't have the 5% minimum downpayment - the bank will loan you 5%, then you use it for a downpayment on a mortgage for the other 95%. 

The payback will not mean a lot for SM users. It means you won't be directly capitalizing the interest, but you can just withdraw the money the next day and invest it.


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## Causalien (Apr 4, 2009)

I guess I am too responsible.
When I opened my HELOC, I told the bank to only use 50% LTV. I wanted it to be hard for me to borrow at 80% so I won't do it unless necessary. The implementation of this rule will probably make me go ahead and take 80%, just because it won't be available later.

Thinking about it from the average joe's point of view... yeah, it's usually the other way around and it is a necessary change and it definitely kills the Smith manoeuver's appeal to me, because if there's one thing I hate most, is to be forced to sell something at the wrong time. Perhaps there'd be a whole industry created to take advantage of people's annual smith maneuver reset.


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## andrewf (Mar 1, 2010)

I don't think most barely-qualified buyers would be able to get unsecured loans for ~35% of their home value. For the average home, that's over $100k--a lot for an unsecured loan.


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## Causalien (Apr 4, 2009)

35 + 20 = 55% LTV So the house needs to have at least 55% principal paid down. Average house $348k so 55% principal payment = $191.4k count 20k in interest over 4 year term. A couple, baptised by CMF fanatism, who saves vigorously for 5 years should be able to achieve this. This is also probably what most baby boomers have in their house. As for the rest of the population. I say phat chance.


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## Jungle (Feb 17, 2010)

I just use a mortgage because the rates were much lower and I could lock in. It does require cash flow but then again I want to pay this off someday anyway.


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## Ed Rempel (Apr 4, 2009)

Hi HackNSlash,

Great question. We will have to see what is actually implemented and how it applies. After reading it, I don't think it would affect the Smith Manoeuvre much.

Here are some specific initial thoughts:

- It is unclear whether the 65% LTV limit for the HELOC portion of a mortgage would apply to the entire readvanceable or only the revolving portion. Most have fixed portion, which is the actual mortgage. The banks may also offer additional conventional mortgages for the extra 15%, or we could make up the difference with an investment loan, if appropriate.

- Having the HELOC payment become P+I after 5 years is not an issue. We can just readvance the principal portion of the HELOC payment each month. For example, let's say your mortgage payment of $1,000/month is $500 interest and $500 principal. You can readvance the principal portion of $500. Let's say you need $200/month to pay the interest on the existing HELOC. Then you can invest the remaining $300/month. Now if they increase the payment on the HELOC portion from $200/month to $300/month, that means we are paying down $100/month principal on the HELOC in addition to the principal portion of the mortgage payment. That still leaves $300/month to invest. The P+I requirement likely will have no effect on the SM.

- For those posts above that think this will make the SM a negative cash flow, you should reread what the SM is. The SM requires no cash flow, since you can capitalize the interest payments. The Smith Manoeuvre has become a generic term used for any leverage strategy. Today, since we are possibly in an income bubble, a lot of people are leveraging into income producing investments and using them to pay the interest. This is not the SM. It is simple leverage. This simple leverage using income investments may run into negative cash flow, but this should not affect the actual Smith Manoeuvre.

- These rules, if they come into effect, should not affect existing mortgages or people already doing the SM.

- The biggest effect may be in making HELOCs harder to qualify for.

- If this results in lower real estate prices, that should not affect the limits for existing HELOCs. In the early 1990s when home prices in Toronto fell 30%, HELOC limits were not reduced even when they were more than the value of the home. It was only an issue if you want to sell or refinance.

- OSFI is not trying to shut down the SM. Their concern is unqualified home buyers buying a home that they cannot afford and people using their HELOCs to spend, similar to what happened in the US. Since SM investors are not the actual target, there should be creative solutions for us to maintain the SM for suitable clients without breaking the spirit of the new rules.

It is also reasonable to believe that banks will try to keep good qualify business, such as the SM. It is very profitable for banks, because we are talking about a HELOC that may be maintained for many decades by a client with a strong financial position. It is a competitive environment and current bank share prices include a lot of optimism in profits, so banks will have to work to make sure any new rules do not affect their profitability.

I will likely have more comments once it is clear what rules changes will happen and how they are implemented.


Ed


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