This is a post by Sean Cooper.

Mortgages have been a hot-button issue as of late. Finance Minister Jim Flaherty recently reduced the maximum mortgage amortization for high ratio mortgages from 30 years to 25 years (it still remains at 30 years for conventional mortgages). He preached the benefits of a shorter amortization: “(The change) will reduce total interest payments and help build up value in homes and (help people) pay off their mortgage debt sooner.”

It’s hard to argue: a longer amortization does result in paying more interest over the life of the mortgage, so why did I opt for a 30 year mortgage amortization against the conventional wisdom of Minister Flaherty? Here’s why a 30 year mortgage works for me and maybe for others as well.

Minimize Monthly Payment, Maximize Prepayment Privileges

Shopping for a mortgage isn’t just about finding the lowest interest rate – prepayment privileges are also important. Some mortgages from the bigger banks are strict and offer limited prepayment privileges. The lender I went with, First National Financial LP, is has flexible prepayment privileges, allowing 15% lump sum payments, increasing payments by 15% and doubling up payments.

By going with a 30 year amortization I can take full advantage of the prepayment privileges, while not stretching myself financially. My minimum monthly payment is only $1,077.97 (I’m planning accelerated weekly, but for this example I’ll use monthly) – it would have been $1,212.02 if I went with a 25 year amortization. If “life happens” and I lose my job or get sick, I’m not committed to a higher mortgage payment and can stop making prepayments until I’m back on my feet financially.

By doubling up my payments and taking advantage of the lump sum payments I estimate I can have my $255,000 mortgage paid off in approximately 15 years – a far cry from my original 30 year amortization. I also will not pay any additional interest than if I went with a 25 year amortization – if I paid $2,000 a month (including prepayment privileges) under a 25 or 30 year amortization I would still end up paying the same amount of interest over the life of the mortgage. Less risk, same reward – seems like a win-win situation to me.

Greater Financial Flexibility

When you go to the bank for additional financing (a line of credit, HELOC, etc.) the banks look at your ability to service debt. The most common measures for mortgages are your Gross Debt Service (GDS) ratio and Total Debt Service (TDS) ratio. By decreasing my monthly minimum mortgage payment with a 30 year amortization I have greater financial flexibility. If I want to undertake good debt like a rental property, I’ll have the flexibility to do so.

Financial Discipline

Setting goals and sticking to them isn’t easy. We’ve all made the New Year’s Resolutions to go the gym more often, but by February you’ve probably given up. Unfortunately financial goals aren’t any easier.

Going with a 30 year amortization only works if you’re financially responsible and can stick with a strict budget. I am a frugal spender; I had the discipline to save up a sizable down payment of $170,000. We all have to show to financial restraint – if you’re only paying off your credit cards’ minimum monthly payments then this probably won’t work for you.

But if you’ve saved up a large down payment and budge properly, you can put those excess funds towards paying down the principal on your mortgage. This will have a positive effect, especially in the early years of the mortgage.

Guaranteed Rate of Return

While it’s possible for the housing bubble to burst and housing prices fall 15% over the next two years wiping out a big portion of my equity (for example $63,750 for a $425,000 house), history has shown long-term housing increases in value. By paying down my mortgage, it will provide a guaranteed rate of return on my principal repayments, as opposed to an RRSP where mutual fund returns are not guaranteed and can be negative in some years.

Income Property

To help pay down my mortgage even quicker I’m renting the upstairs of my houses. This will bring in monthly rent of $1,400-$1,500 (renting out my basement would only rent for $700-$800 per month). I will pay down my mortgage even quicker – in only 10 years. Best of all the rent from upstairs covers all my fixed housing expenses (mortgage, utilities and property tax) and will trigger rental tax deductions.

The Low Interest Rate Environment isn’t Forever

Interest rates are at an all-time low – prime rate is only 3%. I went with a 5 year fixed rate mortgage over a variable rate for the security of knowing what my monthly mortgage payment will be. We might very well be in a rising interest environment soon.

I’ve decided to take advantage of my prepayment privileges because prime rate is likely to be higher in 5 years – most financial experts are predicting a rate increase in the first quarter of 2013. I will forgo contributing to my RRSP until my mortgage is paid off because mortgage rates are likely to increase in 5 years, while my highest earnings employment years are ahead of me and will yield the greatest tax refund. Plus, I’ll have even more RRSP room thanks to my rental income.

Related: RRSP vs. Mortgage

Final Thoughts

Although I believe this is a sound financial strategy for me, this won’t necessarily work for everyone. You must have the discipline to pay down your mortgage and not be tempted to dip into your surplus for bad debt like a new car or an expensive vacation. Otherwise Minister Flaherty will be right and you’d been better off with a 25 year amortization. What are your thoughts on my strategy? What strategies do you use to pay down your mortgage faster?

About the Author: Sean Cooper is a single, 20-something year old, first time home buyer located in Toronto. He has experience in the financial sector as a Pension Analyst, RESP administrator and Income Tax Preparer. He holds a Bachelor of Commerce in business management from Ryerson University.

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Very interesting! Though I wonder why you’re so worried about getting sick or laid off if renting out your home covers your housing expenses anyway?

If you’re aggressively paying own your mortgage so that there’s really no difference between amortization lengths, then this is another good example of how money is about more than numbers — it’s our risk tolerance and motivation.

Kudos on what you’ve been able to accomplish! I don’t think most people will be as lucky as you though :(

At first when I saw the title I thought, “The comments are going to tear this guy to pieces.” However, the key reason this strategy can work is if and only if you use those prepayment privlages. I wanted a 10 yr amortization, but took a 15 and immediately used my ability to increase my payments up to the same amount it would have been on a 10 yr. As you said, it provides a cushion in case life happens.

Too bad the vast majority of people taking longer amortizations is because they simply can’t afford the house otherwise.

Your reasoning for taking a 30-year amortization seems quite sensible. The key thing is that you could easily afford higher payments. By taking away 30-year amortizations, Flaherty is preventing people from buying too much house with payments they can barely afford and then getting into trouble if their payments shoot up after 5 years if interest rates rise. Good luck with killing off your mortgage within 15 years.

This is a great article. I have not yet bought a house, but I had always planned to take the shorted ammortization period that I could afford in order to minimize interest costs. I have definitely reconsidered after reading the article.

The only thing that I don’t agree with is when the author says: “history has shown long-term housing increases in value”. I would like to see research backing this point up. All the research that I’ve read and what makes the more sense to me is that housing prices historically only go up with inflation. And if you buy at the peak of a bubble (which I believe is where we currently are in Canada) then you likely won’t even match inflation.

Unfortunately 95% of people aren’t disciplined enough to save extra and pay the principle of their mortgage down with a longer amortization. Most people will borrow as much as they possibly can with the longest amortization available with a variable rate. Like my mid-30’s sister who got herself a 35 year amortization mortgage last year (when they were still available) and is now struggling to make the mortgage payments. Does she expect to be paying a mortgage payment until she’s 70? There are a lot of people in this boat.

Mostly good, but this paragraph made no sense:

“While it’s possible for the housing bubble to burst and housing prices fall 15% over the next two years wiping out a big portion of my equity (for example $63,750 for a $425,000 house), history has shown long-term housing increases in value. By paying down my mortgage, it will provide a guaranteed rate of return on my principal repayments, as opposed to an RRSP where mutual fund returns are not guaranteed and can be negative in some years.”

That’s penny smart, pound foolish thinking.

The guaranteed rate of return mentioned here is the savings on interest, which is only one side of the coin. By ignoring the risk to principal, you’re not comparing apples-to-apples. In fact, a stock promoter could truthfully write:

“While it’s possible for the equities bubble to burst and stock prices fall 40% over the next two years wiping out a big portion of my equity (for example $100,000 for a $250,000 portfolio), history has shown long-term stocks increase in value — often at double the rate of other asset classes, such as houses. By investing in the market, it will provide a higher-probability rate of return in the long run, as opposed to houses, where growth is also not assured and which tend to just keep pace with inflation.”

I also opted for a 30 year mortgage, but for very different reasons. Now- my big caveat: I realize that this logic is only applicable for a very small percentage of homeowners. It works if you work in a profession with strong job security and high potential for raises. It also requires that you comfortable being highly leveraged. While I agree 30 year mortgage was a bad idea for many- it was a good tool to obtain cheap financing given the current interest rates.

I opted for a variable rate mortgage (2.2%)- logic being that (a) I do believe that interest rates will remain depressed for the next few years; and (b) I work in a profession where I know that my salary will increase by nearly $10k/yr for the next 5 years… a variable rate allowed me to get more house. When interest rates increase, my salary will have also increased so it will not leave me in a crunch

Now, paying 2.2%, why in the world would I be in a hurry to pay down the principal (if I could have chosen an amortization period >30 years I probably would have!)? Any savings that I don’t put towards my mortgage can be invested (and I’m fairly confident that I can earn more than 2.2% on the stock market over a multi-year period). Yes, I could have obtained a similar result using a HLOC, but its just easier this way (LOC would be prime+, whereas I’m paying prime-0.8%. Tax savings would probably make the difference in interest rates a wash though since under my model, interest is not deductible). I put down exactly 20%, so it would take some time before there was significant equity which could be extracted using a LOC.

There is another downside to taking the longest possible amortization and then using the pre-payment privileges: you hit the max pre-payment sooner. In your example, your minimum payment of $1078 means the most you can increase it to (in the first year) is $1239. Then $1425 the next year… and so on. There’s also the 15% lump-sum payment allowed. So chances are, the amount you are financially able to pre-pay won’t exceed the amount your mortgage allows you pay, but you never know… maybe you’ll get a few promotions or inherit a bunch of cash or something. I’m not saying it’s a huge downside, but it’s something to consider. On my principal residence I opted for a 19-year amortization with a plan to pay it down in 11-12 years using the prepayment options.

Interesting read. I love the notion of flipping *seemly* good ideas on it’s back.

I went about this the opposite way when I refinanced my mortgage. I told the bank I wanted monthly payment X, and to give me whatever amortization that worked out to be. Turned out to be something like 17.5 years, or some other oddball figure.

I also implement the Smith Manoeuvre, so my “calculated” actual mortgage-free date (assuming portfolio yield, dividend tax rate, interest rates, etc.) brought it back to 12 years on the nose. I’m actually tracking better than that now, due to rates being lower for longer, and my portfolio yield (currently 4.45%) is much better than my original estimate of 3.85%.

8.61 years remaining. ;)

@Samantha Please see link below:
Although it’s true real estate has barely increased above inflation, if you plan to rent out part of your property (I’m renting out the upstairs), then it’s an even better investment. My rent of $1,480 is covering my mortgage.

@Colin You have a good point, Colin. I could have stated that better. However, if you’re not going to sell it’s just a paper loss. I plan to hold onto my house for many years, so I’m confident even if houses depreciates short-term, I’ll make money long-term when the housing market recovers.

@ Elbyron “allowing 15% lump sum payments, increasing payments by 15% and doubling up payments” You forgot the doubling of payments. I can double up my payment to $2,156 (2 x $1,078), increase it 15% and make lump sum payment (not just on the anniversary date, a minimum of $100 on any payment date). I can make prepayments of over $38,000… and that’s just prepayments! That’s why good prepayment privileges pay off.

There are a lot of Americans who are holding houses that can’t rent for enough to even cover the mortgage payment because they bought at the top of the market. I sincerely believe that we’re at the same place in Canada right now and we could be in for a 10+ year market slide that will put firm pressure on rents as well. What’s profitable and cash flow positive now may not be in a few years (and impossible to get out of unless you want to incur big capital losses). Invest in real estate wisely!

I agree with other posters that responsible users of 30-year mortgages are far and few in between, but am not convinced that for prudent buyers using them as a risk management strategy, the benefits of having them available outweigh the premium in house prices caused by their availability. Keep in mind that responsible homebuyers are not just competing against other responsible homebuyers for real estate, but against irresponsible ones as well.

Let’s do a grossly simplified example: You make $100,000 a year and firmly believe that the house you buy should not exceed 3x annual gross income, so you are looking at a $300,000 property to be financed with a 30-year mortgage you intend to pay off early. Elsewhere, a couple being able to get a 30-year mortgage is now prepared to get a house that’s 5x annual income due to the lower payments by the extended amortization. All of a sudden, you could be competing against a prospective buyer that only has $60,000 gross income, who would otherwise not be in the running. The invariable result? A higher sale price. Rinse and repeat a million times over across Canada, and you have lots of prudent buyers having to settle for worse homes as a result of having to compete against imprudent buyers enabled by 30-year mortgages. If you have one or two couples enabled by a 30-year mortgage bidding against you, the sale price could easily be $20,000 higher than it would otherwise be. That far outweighs the benefit of added flexibility.

This is very similar to the “Two-Income Trap” described by Elizabeth Warren.

I’d like to comment on the following post:

“12. Over-Educated

and you have lots of prudent buyers having to settle for worse homes as a result of having to compete against imprudent buyers”
This should be obvious but it was eye opener for me. I’m overpaying my house because my neigherboor with a smaller household income bought a bigger house… he is not just reckless to himself… he is hurting me financially!!!

But he’s a nice guy who helped me install my garage door opener and cooks good BBQs… still…. lol.

Guaranteed rate of return? A 15 percent drop in prices is your worst case scenario? This is the kind of reckless advice that drove many people to bankruptcy. My opinion of this blog has taken a real blow.

Ian, he said a guaranteed rate of return on the repaying of the principal. The title of that section and some of the wording may have suggested that he believed that housing appreciates in a guaranteed fashion. I don’t think anyone is suggesting that.

One comment I had is about the increase in payment amount. Most banks I have talked to will not allow you (easily at least) to lower your payments, after having increased them. Of course with lumpsum payments, it doesn’t matter, but something to think about for payments.

@Over-Educated: (#12) “Let’s do a grossly simplified example: You make $100,000 a year…”

Why not base your example on real life?
Less than 6% of Canadians in the work force earn $100,000 or more; 26% take in $50,000 or more per year.

That leaves ~75% of the working population earning $50,000 or less (with ~55% earning $35,000 a year or less).
Seems much more reasonable to me to outline an example based on the majority rather than a few outliers who most likely do not need mortgage advice from the internet.

Average house price in Canada is ~$350,000 (CREA) — at least 7x annual gross income of the majority of Canadians. Even if you had a couple earning $85,000 per year, a 3x gross property would top out at $255,000. I guess they could always buy a house in P.E.I. or Winnipeg…but then they would most likely lose the income power.

Let’s face it, real estate in Canada is not an exceptionally great market. If you can ignore the pressure to keep up with the Jones’, keep renting, wait 5+ years and pick up a steal.

Sean…good stuff man

Not a lot of people can claim to still be in their 20s, have no student or consumer debt, and have put a $177,000 down payment on a house….well done.

The fact that you’re living for free (rental income greater than mortgage and taxes) is gravy….who cares what happens to the value of real estate in the coming few years….you’re living for free!!! All these negative nancies can’t claim that….

On a side note, to those who claim it will be hard to come by renters following a housing correction (crash?)….that is a very real possibility as those who rented during the correction would then have incentive to buy following it.

But it is also a very real possibility that the more severe the correction, then the greater the number of folks entering the rental market, as the credit market dries up and/or the number of forclosures increases. That would lead to people like Sean being able to charge a higher rent….

A 15% drop in equity in the current environment doesn’t seem realistic.

What happens with a number of 25%? That’s a bit more realistic.

Also, lots of people seem to think that crashing property prices mean increases in rents. This is patently false and has been proven over and over again.

Reason being is that money is tight for everyone in deflationary cycles. Yes, there is more demand for rentals, but the number of property owners trying to rent their bedrooms increases even faster.

The renters actually end up looking even better.

When cash gets tight, supply of rental options increases and prices actually drop.

When rates are low and home buying is booming…that’s when rental properties increase.