Recent home buyers, your financial priority for the next few years is clear.
Pay down your mortgage. Give the tax-free savings account and registered retirement-savings plan a brief rest and pay down your mortgage.
I contradict myself here. In a June, 2014 column, I argued that people were obsessing over paying down their mortgages in a way that could cause them to neglect retirement savings. Now, particularly in high-priced cities such as Toronto and Vancouver, mortgages are the more serious worry.
High prices mean big mortgages and serious vulnerability to higher mortgage rates. Ease the financial strain of having to renew a mortgage at higher rates by paying down your mortgage as soon as you can after you buy.
Paying down your mortgage is usually thought of as a way of saving on interest costs. As you chip away at the principal on your mortgage through prepayments, you reduce the amount of interest charged over the life of the loan.
David Larock of Integrated Mortgage Planners says he sees the most eagerness to make mortgage prepayments from people who are close to the end of their mortgages and keen to be done. But from the perspective of saving on interest, there's little gain from killing off a nearly finished mortgage because payments are almost entirely principal rather than interest. "Prepayments in the first few years have the most powerful effect on the interest you pay over time," Mr. Larock said.
You can cut your long-term interest costs by making a prepayment early in a mortgage, and you protect yourself against rising rates. Mr. Larock was good enough to work through an example of how this works. We start with a $500,000 five-year fixed-rate mortgage with an interest rate of 2.5 per cent and a 25-year amortization. Your monthly payments with this mortgage are $2,240.
Let's look at what might happen to this hypothetical mortgage if the best rate you could get on renewal was 3.5 per cent. Using a 20-year amortization (remember, you've paid off five years of your mortgage), your payments would rise by $209 a month to $2,449.
Want an affordable plan for limiting the payment shock on this mortgage, and reducing the amount of interest you pay over the life of the loan? Try making prepayments of $3,000 annually over each of the five years of the mortgage term. If you do this, your payments on renewal of your mortgage at 3.5 per cent would be just $118 higher at $2,358 a month.
A long-term benefit of your prepayments would be having the mortgage paid off a year sooner, Mr. Larock's numbers show. You'd also save $6,908 in interest over the life of the mortgage. This estimate is based on paying 2.5 per cent for the first five years of the mortgage, and then 3.5 per cent for the remaining 20 years.
A lesson for home owners in the past six months or so is that there are two big drivers of mortgage-rate increases. One is what happens to rates in the bond market, which are influenced by what's happening in the economy both here in Canada and in the United States. A stronger economy suggests higher mortgage rates.
The other driver of rates is mortgage regulation. We've recently seen changes that make it more expensive for mortgage lenders to do business, and these higher costs have been passed down to borrowers in the form of higher mortgage rates.
Both of these factors have combined to push mortgage rates a bit higher in the past several months, and we could see further increases in the months and years ahead. After eight years where rates were mostly flat or declining, this warning may sound like dismissible nagging.
Why bother paying attention now? Because, the prices people are paying for homes these days are stunningly high in some cities. People have to borrow more to afford these homes, and that means their mortgages are getting bigger. The more you owe, the harder the adjustment if your payments spike higher on renewal at a higher mortgage rate.
The usual test of whether it's better to pay down your debt or invest is whether you can earn a rate of return that is higher than your cost of borrowing. It's not hard to beat today's mortgage rates as an investor, but never mind that. Paying down your mortgage today is about easing financial stress at your house when interest rates rise.
Protect yourself from rising rates
Pay down your mortgage after you buy a home and you reduce the financial hit if you have to renew at a higher mortgage rate. Here's an example of how to do it:
- $500,000 borrowed
- Five-year fixed rate of 2.5 per cent
- 25-year amortization
- Monthly payment of $2,240
The prepayment plan
Annual $3,000 prepayments in month 12, 24, 36, 48 and 60 of the mortgage.
The result if you renew your mortgage at 3.5 per cent
- New monthly payment is $2,358, which compares with $2,449 if you did not make the prepayments;
- Mortgage is paid off one year sooner;
- Savings on mortgage interest amount to $6,908 if we assume a rate of 2.5 per cent for the first five years, and 3.5 per cent for the remaining 20 years.
Source: David Larock, Integrated Mortgage Planners