Mortgages
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Contents |
Introduction
IN A scene from the film “It’s a Wonderful Life”, a happy couple is about to enter their new home. Jimmy Stewart, whose firm has sold them the mortgage, reflects that there is “a fundamental urge…for a man to have his own roof, walls and fireplace.” He offers them bread, salt and wine so “joy and prosperity may reign for ever”.
That embodies the Anglo-Saxon world’s attitude to home ownership. Owning your own roof, walls and fireplace, it is thought, is good for householders because it helps them accumulate wealth. It is good for the economy because it encourages people to save. And it is good for society because homeowners invest more in their neighbourhoods, engage more in civic activities and encourage their children to do better at school than do renters. Home ownership, in short, benefits everyone—not just the homeowner—and the more there is of it, the better. Which is why it is usually encouraged by the government. In America, Ireland and Spain, homeowners can deduct mortgage-interest payments from taxable income.[1]
Buy vs. Rent
Home ownership is not for everyone. Some people don't want the headaches of maintenance and upkeep. Others need the flexibility that renting offers. There are many such highly subjective qualitative factors in the buy vs rent decision.
One large question is the investment question: is housing a good long-term investment? In the United States,[s]ince 1987, when the Case-Shiller index of 10 major cities begins, it's risen from an index value of 63 to 151. Annual return: Just 4.1% a year. During that period, according to the Bureau of Labor Statistics, consumer prices rose by 3% a year. Net result: Home prices produced a real return of just 1.15% a year over inflation over that time.
Critics may point out that the analysis is unfair -- after all, it starts counting near the peak of the 1980s housing boom. Fair enough. Look at the performance since, say, early 1994, when home prices were near a historic trough. Surely someone who bought then has made a bundle.
Not necessarily. Since then the ten-city index has risen from a value of 76 to 151. Annual return: 4.7%. Inflation over that period: 2.5%. That's still only a real return of 2.2% a year above inflation.[2]
In Canada, a Re/Max study[3] found that the nominal compounded annual rate of return was 5.3% from 1981 to 2006. Adjusted for inflation, the compound annual rate of return is 1.6%.Statistics Canada new housing price indexes data shows a nominal compounded annual rate of return of 2.7% for the same period.[4].
Adjusted for inflation, the compound annual rate of return is -0.9%.
Notwithstanding, the decision can be looked at quantitatively[5] by considering such factors as long-term inflation, monthly expenses of renting, monthly expenses of owning, interest rates, after-tax return on portfolio investments, expected (after-tax)return on real estate.
Can You Afford a Mortgage?
Mortgage Calculator[6]
The tool will calculate the maximum house price you can afford, the maximum mortgage amount you can borrow, and your monthly mortgage payments.
GDS Ratio (Gross Debt Service Ratio)
The percentage of gross annual income required to cover payments associated with housing. Payments include mortgage principal, interest, property taxes and sometimes include secondary financing, heating, condominium fees or pad rent.
TDS Ratio (Total debt service ratio)
The percentage of gross annual income required to cover payments associated with housing and all other debts and obligations, such as car loans and credit cards.
Frequency of Mortgage Payments
Let's say that you have a 5 year mortgage for $100,000 at 5% amortized over 25 years. Monthly payments are $581.60. After 10 years, the remaining mortgage is $73,796.14 If you make weekly payments of $145.40, the remaining mortgage is $66,136.06. Your total payment has not changed but, by paying weekly, the outstanding mortgage balance declines more rapidly. More of your payment is going toward principal reduction than interest payment. A calculator which demonstrates the impact of various payment frequencies can be found here[7].
Similarly, making a regular additional payment will reduce your outstanding mortgage balance quickly depending on the size of the additional payment. For example, adding $25 to the $581.60 monthly payment would reduce the mortgage by approximately $1,700 after 5 years and result in about $200 less interest being paid.
Fixed vs. Variable Rate?
- Fixed rate mortgage - A fixed rate mortgage is a mortgage where the rate of interest is fixed for a specific period of time. Generally known as the mortgage term, it usually ranges from between 6 months and 25 years. As time goes on, more of the mortgage payment goes toward the principal and less of the payment goes to the interest.
- Variable rate mortgage - A variable rate mortgage is a mortgage that has fixed payments, but the interest rate fluctuates with any changes in interest rates. If interest rates go down, more of the payment goes to principal and if interest rates go up, more of the payment goes toward the interest.
Which one is better for you depends on your ability to handle risk.
If you lose sleep worrying about the possibility of a .25% increase in the interest rate or get stressed thinking about the impact on your monthly budget if your monthly mortgage payment changes, then a fixed rate mortgage is for you.
You should also take the same test when choosing the length of the fixed rate mortgage term. If you breathe easier knowing that your mortgage payment is fixed for the next 5 years then a 5 year term is right for you.
If risk is not as much of an issue, then according to a detailed study by Moshe Milevsky[8], you should choose a mortgage with a short term floating (prime) interest rate. The study found that a consumer with a $100,000 mortgage and an amortization period of 15 years would have paid $22,000 more in interest payments by borrowing and then renewing at the 5 year rate as opposed to borrowing at prime and renewing annually.
In 2004 when interest rates were at historical lows, Milevsky updated[9] his original article.
- The first-time homebuyer and especially those who placed minimal initial down payments with high leverage ratios, are the ideal candidates for long-term fixed rate mortgages. These folks should not be taking any chances with a fluctuating interest rate. In fact, they might be hit with a double whammy if the value of their (overpriced) house declines leaving them with negative equity. To them I say, “count your blessings, don’t be greedy and lock-in at a fixed rate.”
- The risk-averse worrywart who is constantly looking at interest rates and wondering if ‘now’ is the time, should do what all risk-averse investors do: diversify. Indeed, there is a strong argument to be made for diversifying your mortgage debt, similar to the prudent strategy with your investment portfolio. Now, in general, diversifying your debts is a silly idea since you should put all your eggs in the one basket with the lowest interest rate. But, I do agree that split rate mortgages make some sense in today’s ultra-low environment. The ideal strategy is to partition your mortgage in two halves, one linked to a variable rate and the other closed for a longer period of time.
- The seasoned veteran, possibly with two stable breadwinners in the family and with a substantial amount of built-up equity in the house should still follow Shelly Short’s strategy. They can afford the risk and continue with a variable rate mortgage, making payments based on a high fixed rate schedule. This is an easy way to (think you) have your cake and eat it too. From a purely psychological point of view -- as long as you pick the payment rate to be 1% to 2% above the initial floating rate -- if and when interest rates do start to increase, it should have no noticeable impact on your monthly budget.
- The financially savvy arbitrageur can do even better. Most banks allow you to pre-approve a fixed rate mortgage for between 90 and 120 days. You are guaranteed the pre-approved rate regardless of what happens to mortgage rates over the next 3- 4 months. This is the closest thing to a free lunch (actually, call option on interest rates) you will ever get from a Canadian bank. If you have a floating (open) rate mortgage that allows you to pre-pay any amount anytime without penalty, then walk across the street to your bank’s competitor and ask for a pre-approval on a 5-year fixed rate mortgage. Then, keep a close eye on the Bank of Canada and the bond market. If rates increase tomorrow, exercise your free option and move your mortgage across the street, at yesterday’s rate. Otherwise, do nothing and start the process over in a few months. Understandably, the branch manager might get a bit weary of your constant requests for pre-approval…
Government of Canada Homeownership Incentives
First-Time Home Buyers’ (FTHB) Tax Credit[10]
Expansion of the Home Buyers’ Plan (HBP)[11]
Mortgage Broker vs. Bank Specialist[12]
- A Mortgage Broker works for you, the client, whereas Bank Specialists are employed by the financial institution.
- The benefit of using a Mortgage Broker is the fact that they have the ability to offer you mortgage products from a number of financial institutions. Because a Bank Specialists works for the bank, that means that they can usually only offer you their institution's products.
- Brokers are typically paid the same amount no matter what rate is offered to the client. Bank specialists' rate of pay is generally reduced in direct relation to the amount they discount your rate from the bank's posted rate.
- Depending on your Province, Mortgage Brokers must be licensed and are subject to a strict set of requirements. Accredited Mortgage Professionals (AMP) must take continuing education courses in order to maintain their accreditation. Bank specialists are not licensed and require no formal training.
- Because Mortgage Brokers don't work for a specific lender, your assured that you will be given impartial advice. A bank specialist has a limited number of their own institutions products and while it may not be the best mortgage product out there, they will do their best to sell you their institutions mortgage product cause if they don't your going somewhere else.
- Mortgage brokers use their knowledge and experience to negotiate the best possible rate and product for you from a number of lenders. When you see a bank specialist, that mortgage negotiating is typically left up to you.
- For conventional financing, the services of a mortgage broker are generally provide at no cost to you. If there is a cost, you will be advised of those costs up front.
Insurance
Depending on the size of the mortgage, it is prudent to protect your family by having insurance. A bank will likely try to sell you mortgage insurance but you are better off with term insurance.
Links - Current Mortgage Rates & Glossary
Canadian Mortgage Rates - Variable, Open, Convertible Canadian Mortgage Rates - Closed Canadian Mortgage Rates - Long Term Mortgage and Real Estate Terms Glossary
References
- ↑ The Economist Home ownership. Shelter, or burden? Viewed August 16, 2009
- ↑ The Wall Street Journal Is Your Home A Good Investment? Viewed August 16, 2009
- ↑ RE/MAX Ontario-Atlantic Canada Inc. 25 YEARS OF REAL ESTATE 1981-2006 Viewed August 16, 2009
- ↑ Statistics Canada New housing price indexes Viewed August 16, 2009
- ↑ Industry Canada. Canada’s Office of Consumer Affairs (OCA) Rent or Buy Calculator Viewed August 16, 2009
- ↑ Canada Mortgage and Housing Corporation Mortgage Calculator Viewed May 29, 2009
- ↑ A Consumer's Guide to the World of Mortgages Mortgage Analyzer Calculator Viewed August 14, 2009
- ↑ Moshe Milevsky. Mortgage Financing: Floating Your Way to Prosperity, Viewed July 24, 2009
- ↑ Moshe Milevsky. Mortgage Financing: Should You Still Float? Four Answers, Viewed July 24, 2009
- ↑ Canada Revenue Agency First-Time Home Buyers’ (FTHB) Tax Credit Viewed August 16, 2009
- ↑ Canada Mortgage and Housing Corporation Expansion of the Home Buyers’ Plan (HBP) Viewed May 29, 2009
- ↑ LendingMax Mortgage Broker vs. Bank Specialist Viewed May 29, 2009
