Critics of Longer Amortizations Need to Consider More Than Just Interest Cost

The Royal Bank of Canada recently issued a report that 50% of borrowers of insured mortgages are opting for extended 35 and 40 year amortizations (a mortgage is insured when the down payment is less than 20% of the purchase price). Critics of the longer amortization argue that borrowers will pay more interest in the long run. In a recent National Post article on the topic, an example of a $340,000 home with 25% down and a 7% mortgage rate was used -- the article stated that the borrower would pay an additional $47,000 by opting for a 40-year amortization instead of the traditional 25-years.

There are a number of factors influencing a home buyer's decision when choosing the amortization on their mortgage. Firstly, there is an affordability issue -- you can't ignore the fact that over the last 10-years real estate prices have gone up considerably. Given the high cost of real estate in Canada, especially in Toronto, the payment on a mortgage amortized over 25-years is just not realistic for some people. In looking other countries, you find that Canada one of the last developed countries in the world to introduce mortgage amortizations longer than 25 years.

By reducing your monthly payment, it might make it possible for you to buy a bigger house, or a house in a more desirable location that will better meet your long term needs. No-one wants to move into a home they are likely to outgrow in 3-years.

Couples may want to start a family and reducing their monthly mortgage payment will give them a bit of extra breathing room. As a result they may be under less stress to have mom or dad get back to work as quickly after having a baby. Less stress on families today probably isn't a bad thing.

Finally, just because you choose a 40-year amortization when your mortgage closes, it doesn't mean you have to be paying the mortgage for the full 40-years! There are ample prepayment privileges with most mortgage products, and if your financial situation changes you can accelerate your payments and pay down the mortgage much faster.

Fixed rate mortgages up in the U.S. -- that was unexpected

The best explanation I could come up with for why this happened is as follows...

With the Fed lowering the prime rate dramatically in the last few months, investors have started moving their money out of the bond market and into equity markets where higher returns are expected. To attract investors, bond sellers must offer a higher rate of return. Since bonds are used to fund fixed rate mortgages and the costs are now higher, people taking out fixed rate mortgages must now pay a higher rate. If you have a better explanation or something to add, your comments are welcome.

How To Make Your Mortgage Tax Deductible

You've heard about the Smith Manoeuvre and you want to make your mortgage tax deductible. Here's an example of how the Smith Manoeuvre works...

Assume you take out a $250,000 mortgage at 5.84%. On a 25-year amortization, the monthly payment on this mortgage would is $1576. Let's also assume that for 25-years, you don't have any extra cash to invest and all you pay is the monthly mortgage payment of $1576.

Scenario A: No Smith Manoeuvre -- After 25 years you'll have paid off your mortgage at which time you'll own your house free and clear but you have no savings.

Scenario B: With the Smith Manoeuvre..
Your monthly payments are still $1576. At the end of each year however, you re-advance on your mortgage by the amount of principle you've paid down, take the money and invest it. You need to have a re-advanceable mortgage or a line of credit to effectively make this work.

You have started to build your investment portfolio, and are still only spending $1576 per month.

In Canada when you borrow money to invest, the interest cost on the money you borrowed is tax deductible, so you get a tax refund. When you get that refund, you use it to pay down your mortgage principle further. At that point, you readvance again and use that money to invest. The cycle continues. You are building your investment portfolio and still only spending $1576 per month. All the while you are replacing the original mortgage debt with debt that is tax deductible.

If you employ the Smith Manoeuvre, here's what your financial picture could look like after 25 years ~ you have $250,000 of investment debt (on which the interest cost is tax deductible), but you also have an investment portfolio worth $602,000. That means you are ahead by $352,000!

* Assumptions are that your marginal tax rate is 46%, you pay 6.25% on the money you borrowed for the purpose of investing (that's the current prime rate) and you earn 8% on your investments.

If you would more information about the Smith Manoeuvre, contact Greg Holohan, CFP at Scotia McLeod. (If you want to use the Smith Manoeuvre, get help from someone who is qualified to advise you on it). Greg's website address is http://www.gregholohan.com/ and his phone number is 905.479.8238.

If you would like more information about the type of mortgage you need to make this strategy work, or if you have mortgage questions of any kind contact me.

RRSP strategy: Creating a down payment

Thinking about buying your first home but you don’t have a down payment? Here’s an RRSP strategy you can use to create one. By taking an RRSP loan and buying RRSP’s, you’ll get a tax refund once you file your taxes. The refund is found money you can use as a down payment for your new home.

If a husband and wife each buy $18,000 in RRSP's, the total refund could be as much as $16,500 -- you should talk to your accountant first to determine exactly how this will work out for you. On a $300,000 house purchase, that’s enough for a five percent down payment, plus you’ll have some money left over to put toward closing costs!

After 90 days, can you withdraw the funds from the RRSP under the provinces Home Buyers Plan and you don’t have to pay tax on the withdrawal. At that point, you can repay the RRSP loan. You have fifteen years to put the money back into the RRSP, which for most people shouldn’t be too difficult.

Call me at 416 876 2031 or call Steve Notis from Investor's Group at 647 200 7308 for more information. I can prequalify you for the mortgage, Steve can get the RRSP and the RRSP loan set up for you.

Are rates going up or down?

In the past couple of days, several lenders have announced mortgage rate increases including CIBC, Firstline, President’s Choice Financial and TD. Other’s may soon follow suit. Why are rates going up you ask? Weren’t they supposed to be going down?

Earlier this month, the Bank of Canada reduced the overnight rate by a quarter of a percentage point. The overnight rate immediately impacts the prime rate, which impacts the rate you pay on a variable rate mortgage. This move was largely precautionary. The very high dollar we were experiencing in the Fall was taking it's toll on our manufacturing and export, and inflation had eased off -- so it made sense to reduce the overnight rate.

Since August, when the U.S. subprime crisis first hit, Canadian banks have been acknowledging that they have some exposure to ACBP's (asset backed commercial paper) -- ACBP's are investments that represents baskets of consumer loans which include U.S. subprime loans. The Canadian government froze trading of ACBP's to avoid panic selling but the problem has not gone away, and it has quietly been putting upward pressure on lending rates. To compensate for losses, banks increase lending rates.

So what does this mean to you? If you are in the market for a property, get a preapproval/rate hold in place good for 120-days to protect you against possible further increases. Even if you would like to go with a variable rate mortgage, the spreads on variable rates could change too, so it's wise to get something locked in as soon as possible. If your mortgage rate is coming up for renewal soon, ask your lender for an early renewal.

How I learned to recycle

I was the king of garbage. I am not proud of it, but it's true. And when throwing out garbage was in fashion, I was the best at it. Every one or two weeks, I would grab a big green garbage bag and digging deep into our fridge, I pulled out leftover food. Then I went around from room to room, filling up the bag. You name it, it went into the garbage.

And then something changed and suddenly I realized that it become practically impossible to throw out your garbage anymore. City workers drove by my house once a week with a big truck that looked a lot like a garbage truck, but they weren't taking the garbage. The garbage started piling up in my garage and I knew that something had to change.

When I started complaining out loud about how ridiculous it was that you couldn't throw out your garbage anymore, my step-daughter broke down into tears one day and started telling me all about Al Gore and global warming. "If you don't change your ways" she said, "soon we will all be under water". Whether I agreed or not, one thing was for sure -- if I didn't change my ways, we were all going to be under garbage.

Eventually I reformed and now I am now the garbage nazi in my house. Nobody is permitted to throw food in the trash -- it goes straight into the green bin. And today as I carried this very heavy green bin down to the curb, it occurred to me how much food had gone to waste in the past week, and I realized that we probably could have fed double the number of people in our house with the amount of food wasted -- time for another family meeting.