Take on life’s biggest debt…and win!
Even though much of Canada is still covered with a thick layer of snow and ice, the so-called spring real estate market is gathering momentum. And banks, finance companies, and lawyers are all gearing up to take their cut, mostly in the hyper-competitive mortgage market. You might well feel like a lamb among the wolves here. So here are a few things you should know about mortgages to avoid getting fleeced.
First of all, remember that a mortgage is a loan using your home as security. Lenders offer to provide the difference between what you pay for the home and the amount you shell out personally for a down payment. The minimum down payment without being required to purchase mortgage default insurance is 20% of the purchase price of the home. So, on a $500,000 purchase, your down payment would have to be $100,000, and you would take on a mortgage of $400,000, or 80% of the value of the home. That $100,000 is said to be your “equity” in your home.
Here’s the catch, though. You’ll recover that equity only if you can sell your home for an amount greater than or equal to your purchase price. That’s why, for most average home buyers, financial planners place so much emphasis on increasing your equity by paying down the mortgage as fast as possible. Every dollar of a mortgage payment that goes towards principal is another dollar of equity in your home. (The story is a bit different for speculators, or flippers, whose interest is strictly in short-term price hikes.)
In most Canadian urban residential real estate markets, home values have at the very least kept pace with the annual rate of inflation over the long term. In ultra-hot markets like Vancouver and Toronto, real estate values have far exceeded inflation, especially in the low interest rate environment we’ve had over the past six years or so. This, of course, means that the equity in your home may also increase, simply as a result of an overall rising market. So if your $500,000 home can now be sold for, say, $600,000, your equity has increased to $200,000, and your $400,000 mortgage is now only 67% of the value of your home.
Before you get all starry-eyed about the potential for real estate riches, remember that leverage works both ways – and a mortgage is simply leverage on a real estate purchase. If general price levels decline, you could well end up losing equity – and your home – if your mortgage exceeds the value of your property. This is exactly what happened through much of the U.S. in the 2008 financial crisis, and the real estate market there still hasn’t fully recovered.
When clients who are shopping for a home (that is, a place to live rather than as a speculation to flip in a hot market) ask me about mortgages, I tell them I have six key rules to follow:
1. Make the biggest down payment you can. At the very least try to match or exceed the 20% threshold beyond which mortgage insurance isn’t necessary. Mortgages for more than 80% of the purchase price must be insured, and the insurance premium is added to the monthly payment. Ka-ching!
2. Get the lowest interest rate you can. The mortgage market is ultra-competitive. Don’t be afraid to bargain (yes, even with the big banks). It’s amazing how quickly a prospective lender will price-match a lower rate if you are a good risk. Consider variable rate mortgages, which typically have posted rates 30 to 50 basis points (that is, up to one half percentage point) lower than fixed-rate mortgages, only if you have a monthly cash cushion to withstand a sudden rate increase.
3. Reduce the amortization period as much as possible. This is the period over which the mortgage is scheduled to be paid off in full. The longer the amortization, the lower the monthly payments will be, but the smaller the monthly principal repayment and the higher the total interest paid will be. It’s a great deal for the lender – not so much for the home buyer. Cut your amortization, even it’s only by a year to begin with. And keep reducing it at the end of every term (that is, the length of time your agreement with a specific mortgage lender is in effect), while maintaining or increasing your monthly payment.
4. Make prepayments. Lenders will often sweeten the deal by offering prepayment privileges – giving you the ability to pay off a lump sum of your principal amount without penalty every year up to a certain maximum percentage of the outstanding mortgage amount. Do not fail to take advantage of this feature! It reduces your principal amount immediately, so that more of your subsequent monthly payments also go towards principal repayment, while your interest costs shrink dramatically. Another way to pay down principal faster is to establish a schedule of weekly or bi-weekly payments instead of monthly payments.
5. Watch for fees and penalties. Check for fees and penalties the lender may include for prepayments (including any that might apply if you sell your home before the mortgage matures and wish to pay off the mortgage in full). Also, check whether the mortgage is transferable or portable (in other words, determine whether a new owner can take over the mortgage if you sell, or whether you can apply the mortgage to a new house you buy).
6. Ask for help. Mortgage math can get complicated and downright confusing when you try to compare various rates and amortization periods, increase payment amounts, apply pre-payments, or increase payment frequency to weekly or bi-weekly. Online calculators can give you the basics, but your financial advisor is likely to have more sophisticated tools at hand to help you with one of the most important financial decisions of your life.
© 2014 by Robyn K. Thompson. All rights reserved. Reproduction without permission is prohibited.