With the Government cracking down on $0 down payment mortgages to avoid what’s happening to the real estate market south of the border, banks are resorting to zero down by another name. That is, cash back mortgages.

A cash back mortgage may sound like a great idea; buy a house with some down payment money saved and get the money back on closing to do with as the home buyer wishes. The catch being that the home buyer will face a higher interest rate, at the inflated posted rate, for typically 5 years. No big deal right?

An Example

Lets illustrate a cash back mortgage scenario. Going through some rates on the net:

  • 5 year discounted fixed rate is approximately 5.55%
  • Bank posted rate is 7.15%.
  • This represents a difference of 1.6%.

Say for example that the house purchase price was $200,000 and requires at least 5% down ($10,000). If the discounted 5 year rate was chosen, a total interest of $49,499.01 is paid after 5 years based on monthly payments of $1,165.28 (25 year amortization).

If the “cash back” option is chosen, a total interest of $67,595.35 is paid in the 5 years based on monthly payments of $1,419.40 (25 year amortization).

For the “privilege” of keeping the $10,000 down payment in the home buyers pocket, the higher interest rate will cost an extra $18,096.34 in 5 short years. It’s no wonder that banks are quick to offer this type of product, it’s cash back in their pockets. To put this in perspective, if the $10,000 cash back was invested, it would take an annual return of 23% (before tax) over 5 years to grow $10,000 to $28,000.

Final Thoughts:

To summarize, here are some reasons why a cash back mortgage is a bad idea:

  • The borrower pays significantly more in interest which simply means that the banks are the ones who are benefiting.
  • The monthly payments are higher which can crimp monthly cash flow.
  • The borrower now has the choice of what to do with the money. This is usually not wise for most as the average Joe will simply spent it.
  • Even if the cash back money is invested, it would be crazy short sighted to expect 23%+ annual returns over 5 years in the markets.
  • Paying down the mortgage is, for most, a great idea.

61 Comments

  1. Shayne on September 18, 2013 at 10:35 am

    This is why you should use a good broker. :)

    I will use your brother’s numbers as an example along with your 6.25% rate on your loc. Firstly 5.14% is a good number to use as the 5% cash back rate. Unfortunately you cannot use 3.99% as the discounted rate as that is far from a discounted rate, at least over the last year. I am going to use 3.39% as the best rate in this example. This rate was available as recently as a month ago.

    So the question is, would you rather pay 5.14% on $297,300 or pay 3.39% on the same amount and in addition pay 6.25% on $14, 700?

    With monthly payments being the same the end balances are in favor of using the line of credit to the amount of $6024.

    You come out ahead using a line of credit instead of the cash back mortgage as long as the line of credit rate is not above 15%.

  2. Shayne on September 18, 2013 at 10:43 am

    And…..the effective rate on 5.14% with 5% cash back is actually 3.88%.

    So between the 5.14% with cash back and the 3.99% “discounted rate” the cash back is the better deal. The problem with this scenario is that 3.99% is far was far from competitive.

    Let me know if you want a better understanding off all of this. There is both math and logic at play and not a lot of people can work out these numbers.

  3. Sebastien Benoit on September 18, 2013 at 11:58 am

    I understand what you mean Shayne.. I didn’t take into account the bargaining leverage one would have when cashback wasn’t on the table. That being said, I don’t think my brother would have been able to get better than 3.79% (whether by not having a better deal available, or by not trying to negotiate, either way.)

    but for sure, we should be comparing the best cases for both scenarios, and that’s not what I did.

    Thanks.

  4. Shayne on September 18, 2013 at 12:16 pm

    There is alot to take into account.

    What is done is done but 3.79% would have been far from competative this year.

    @FT Do you want some calculators for your site?

  5. Sebastien Benoit on September 18, 2013 at 12:26 pm

    3.79% is the best bank rate, and currently 3.49% is the best rate listed on ratehub.ca.. so if we take that into account this is what we get:

    3.49% on 279.3k for 5 years, total interest cost for the term: $45,214.81
    5.14% on 279.3k for 5 years, total interest cost for the term: $67,246.61
    Total interest cost difference for the term: $22,031.80

    So for them, to borrow 14.7k for 5 years will cost them ~7.3k in interest, which is an effective rate of ~8.43%.

    This is assuming that a) they would be able to negotiate the rate down to 3.49 (only True North Mortgage is offering a rate lower than 3.79% at the moment, in New Brunswick, according to ratehub.ca) and b) that they wouldn’t be able to negotiate the 5.14% interest down a bit (a fair assumption.)

    Now it’s looking like their line of credit would have been a better option.

    Thanks.

  6. Shayne on September 18, 2013 at 1:40 pm

    You are doing the math wrong. To make a proper comparison you have to use the same monthly payments on both rates.

    But yes, loc is the better way to go.

  7. Sebastien Benoit on September 18, 2013 at 1:59 pm

    The amount of the payment each month doesn’t matter here, it what the difference is at the end of the 5 years that counts… And how would the payments be made the same?

    If you want to make a statement like that, back it up by showing some math ;)

  8. Shayne on September 18, 2013 at 2:22 pm

    Well I can back it up with math, but don’t even need too cause you will get it.

    If you are not using the same monthly payment then you would have to some how factor that in, so it is easier to use the same payment amount.

    And you can’t just take the interest paid, you have to look at the end balance of each mortgage as well. ;)

  9. Shayne on September 18, 2013 at 4:28 pm

    Email me at shayne.slinn@gmail.com

    I have a pdf for you with some numbers to work with.

  10. Aaron on August 25, 2014 at 2:54 pm

    As high as these payments sound its better than paying rent.After 5 years you can renegotiate for a much lower interest rate.

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