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Mortgages: It pays to be frugal
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It is a question on the mind of anyone who has a mortgage or is planning to take one out: “what can I do to cut the cost of borrowing?”
The answers are straightforward – among the leading strategies:
Pay more upfront with a larger down payment
Cut the amortization for a mortgage
Make annual prepayments up to the 10% limit allowed by most mortgage loans.
Move from monthly to bi-weekly or even weekly payments
Use RRSP-based tax refunds to pay down the mortgage
The larger the down payment on a mortgage, the smaller the loan will be and the smaller the periodic payments on the mortgage will have to be. Thus if a $400,000 mortgage has a $2,000 monthly payment, a $300,000 mortgage would have approximately a $1,500 payment.
Reducing the amortization period for a mortgage increases the payments needed each month or at other frequencies, but cuts the total interest due and increases owner equity very quickly. Chances are your bank has an online calculator to help you run the numbers.
Using a calculator to be found on most bank web sites, we know the following: A 5-year closed $300,000 home with a $30,000 down payment at 4.00%, a 30-year amortization allows payments of $1,283.90 per month.
Total interest due over the 30 year period would be $192,200. The same mortgage with a 20-year amortization requires payments of $1,631 per month. Total interest payable would be $121,551. And the same mortgage with a 10 year amortization requires payments of $2729.39 per month. The total interest cost would $57,527.
Cutting 10% off the capital borrowed by means of an annual pre-payment can drastically reduce borrowing costs and total interest due on a mortgage. For example, reducing the $270,000 initial amount borrowed by 10% on the first anniversary of the mortgage of the 30 year mortgage by 2 years and cuts interest due by $21,448.
Moving from monthly to bi-weekly payments can also have a large effect on mortgage costs. For example, the amount of interest due on a $300,000 4.0% fixed rate 5 mortgage on a 25 year amortization would be $173,416 for monthly payments over the full period compared to just $147,961 for bi-weekly payments. The corresponding reductions in interest due at the end
The use of tax refunds produced by RRSP contributions is similar to that of making lump sum payments to reduce loans. However, getting the 10% allowed each year by typical mortgages depends on the tax-efficiency of the RRSP contribution. The higher the tax bracket of the home owner, the more efficient RRSP contributions are in generating tax refunds.
The amounts of money that can be saved by taking on mortgage debt and aggressively paying it down are impressive. Yet, says Registered Financial Planner Caroline Nalbantoglu, it is not always done.
“In spite of the potential savings, paying off the mortgage with spare cash is not really common,” she explains. “It may be that a lot of people equate a mortgage payment with monthly rental. That attitude leads them to use extra money they have for spending or perhaps to buy a cottage. The irony is that the faster they build equity, the faster they can build net worth. And home equity is a terrific way to build up assets, for when you sell a primary residence, there is no capital gains tax. Really, if you don’t take advantage of ways to pay down a mortgage, you are missing a lot.”
“When the rewards of being frugal are so large, it pays to do the obvious and pay as much as you can,” Ms. Nalbantoglu adds. “The mortgage is the biggest debt most people will ever have. And the home they buy will be the biggest investment. It is rational to pay as much as you can and the rewards are both large and, as the numbers show, compelling.”