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.
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.
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
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.