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?
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.
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.
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