What Type of Mortgage Should You Get?
If you are buying a home with less than 25% down payment your choices of mortgage products and terms are somewhat limited…3 year fixed rate or longer under the regular CMHC Program and 5 years fixed rate or longer under the 5% down program.
However, if you are not constrained by the insurance requirements of a high-ratio mortgage there are many options available…they are summarized below. (Note: Not all lenders offer all types of mortgages.)
Short-term risk and Variable Mortgages
If rates are low and stable, and/ or you have decided to take the “staying short” strategy regardless…you can generally pay a significantly lower rate (by up to 2%). This is achieved by simply rolling over your term every 6 months, or having your rate float against prime – with the option of locking in to a longer term at a later date. This is not for everyone, however, as sudden upward rate movements – not unknown in Canada – can cause severe stress.
Any term 3 years or longer is considered “long term” in today’s economy. Because long-term rates are usually higher than short-term rates, many Canadians who have a choice do not select this option. There are many, however, that consider a long term mortgage necessary due to their exposure to rate increases relative to their inability to manage a significantly higher payment.
Split Term Nortgage
A mortgage which allows you to minimize – or hedge – your interest rate risk by splitting your mortgage into 3 to 5 parts.For example: A $150,000 mortgage could be split into five $30,000 segments with terms of 6 months, 1, 2, 3 and 5 year terms negotiated at today’s best rates. The average rate (say, 6.25%) would rise or fall much more slowly than changes in the market, however, as only the shorter terms are affected by even the most volatile rate movements over the first few years.
Protected Variable Mortgages
In 1993 several Canadian Banks introduced the protected variable rate mortgage, which floats at about prime minus .50% and is capped at (i.e. will never exceed) the posted 3 year rate. It does offer a way to reduce the risk of floating, while preserving an acceptable long-term rate. (This type is also known as the “capped” variable rate mortgage).
Mortgage Prepayment Options
Annual prepayments… traditionally, 10% to 20% of the original principal balance have been allowed as a lump sum prepayment once a year, often on the “anniversary date”. Recently, options of up to 20% of the original balance payable on any payment date have been added to this feature. Finally, the “double-up and skip-a- payment” feature has been included in many offerings. This allows a borrower to “bank” extra mortgage payments for a rainy day, at which time they can just “skip”, with the added benefit that, if it never “rains”, principal is permanently reduced, along with the interest cost.
Most mortgages now allow the amortization to be adjusted by increasing the payment on closed terms by 10% – 20% per year, once annually.
Most mortgages now come with the option to pay your mortgage at a frequency that matches your cash flow – weekly, bi-weekly or semi-monthly. The added benefit of the “accelerated” weekly and bi-weekly payments is that by dividing a regular monthly payment into two or four respectively, and deducting it at the new interval, an extra payment a year is made directly against principal. The surprising effect of this one extra payment a year is to reduce the amortization of the average mortgage by up to 6 years, with enormous savings of cash at the end of the mortgage term.
If you are risk-avoider…go for a fixed rate long-term mortgage, or hedge your bets with a protected Variable Rate Mortgage. If you’re a risk-taker, simply stay with a short-term mortgage and watch closely for the signal to lock in a longer term deal. Wherever you can stand the additional cash flow requirement, increase your payment frequency and amount, and prepay principal wherever possible. Remember…because mortgage interest is not tax-deductible, every dollar you pay off your mortgage gives you an AFTER TAX RETURN of whatever your rate is, because you’re saving interest you’d otherwise have to pay with after-tax dollars!
Paying Off Your Mortgage Faster
One of the highest financial priorities of Canadian homeowners is to pay off the mortgage as quickly as possible. Most are aware that paying down extra principal in the early years by whatever means possible can shorten the life of your mortgage – and dramatically lower the interest you’ll pay over the long haul. “Pay-Off Tips” below describes some of the most effective methods of achieving this.
Mortgage payments made with After Tax Cash
More Canadians are becoming aware that, since mortgage interest is not tax-deductible in Canada, (as it is in the US), you are making mortgage payments of both principal and interest with money that you’ve already paid tax on – “after tax dollars”. This makes it even more important to eliminate the drainage of disposable income as soon as possible!
Prepayments give great Return on Investment
If you pay an average of 6.5% in mortgage interest, for each $1,000 by which you reduce your mortgage principal you will save $65 in after tax cash every year. If you are paying taxes at a marginal rate of 40%, you have to earn $108.33 each year to pay the interest on every $1,000 of principal outstanding…a heavy burden, but also a tremendous implied benefit to reducing this balance. In fact, the example shows that the “return on investment” for making prepayments on your mortgage is 10.833% before tax and 6.5% after tax – far better than most fixed return investments (bonds, GIC’s etc.), which currently average about 5.0% before tax and about 3.0% after tax for the same individual.
• Increase your payment annually to the most you can afford. The upside is that most lenders will allow you to reduce it again to the previous level if it turns out to be too great a burden, or your circumstances change.
• Use your RRSP-driven tax rebate religiously as a mortgage prepayment method. Even if you can only prepay annually, make sure these funds are set aside for that purpose. Many Canadians will borrow (at prime) to buy an RRSP to ensure the maximum rebate. When applied to the mortgage principal, this refund is a “gift that keeps on giving”. Combining the refund with the tax-free interest earned on the RRSP over the subsequent years will quickly outpace the short-term interest costs of the RRSP loan.
• Make accelerated bi-weekly payments to get a “free” principal reduction equivalent to one full mortgage payment every year – painlessly. Unless you are paid weekly it makes little sense to make weekly payments. All you’d be doing is making a smaller payment, and deferring the difference for a week.
• Make use of double-up privileges wherever possible, telling yourself that you will “skip-a-payment” whenever necessary…then skip only when you absolutely must.
• This discipline has allowed many people to shorten their mortgage life by years within a very short period.
For more information on what mortgage may suit your needs best, please contact us today!