New home financing innovations, such as interest-only mortgages and mortgages with 35- or even 40-year terms, are making monthly payments more affordable and giving Canadian consumers more purchasing power.
But what lenders and real estate agents aren\u2019t talking about is the long-term interest costs on some of this apparently easy money, and the detrimental effects they have on the borrower\u2019s financial well-being.
If clients are convinced home ownership is a surefire route to riches and are willing to borrow heavily to buy an expensive home or add a second property, it may be time for advisors to step in with a sobering look at the realities of interest costs and their negative impact on wealth accumulation.
\u201cIt\u2019s quick and easy to get a large mortgage these days. Everybody and his dog is being courted by financial institutions willing to lend money,\u201d says Adrian Mastracci, a financial advisor at KCM Wealth Management Inc. <\/b> in Vancouver. \u201cIn some cases, you don\u2019t even need a down payment to buy a home. Many people are getting a bigger mortgage than they need. But what they don\u2019t realize is that they will be probably be poorer as a result.\u201d
A look at loan amortization tables shows that a mortgage of $100,000, borrowed at 6% and amortized over a typical 25-year period, would cost $640 a month. The total interest paid during the life of the mortgage would be $91,900, almost as much as the loan itself. If this same mortgage was amortized over 30 years, the monthly payments fall to $595, which many borrowers see as a great convenience. However, the total interest paid rises to $114,100. Stretch the mortgage out to 35 years, and the monthly payment drops to $565, while the total interest piles up to $137,400.
Given that many people have mortgages much larger than $100,000, the costs are magnified accordingly. Yet most people would balk if they realized that the $500,000 house they are purchasing could actually cost them
$1 million once the interest costs on a long-term mortgage are factored in. Interest paid over the years significantly erodes the final profit when the home is sold.
\u201cThe cost of long-term mortgage borrowing is astronomical, and one of the biggest impediments to accumulating a large retirement nest egg,\u201d says Mastracci. \u201cPeople can end up paying more in interest than the original cost of the house. They are making the biggest purchase of their lives \u2014 and the advisor can help by showing them how it can cost less.\u201d
If clients can reduce the years of amortization, either by taking on a larger monthly payment or applying some lump sums against their mortgage, the savings can be dramatic. For example, if the amortization on the same $100,000 mortgage at 6% is reduced to 15 years, the monthly payment rises to $840, which is only $200 more than the monthly payment on a 25-year amortization. But the total interest paid is $51,200 \u2014 $40,700 less than for the 25-year term and $86,200 less than for the 35-year term.
\u201cIf you knock 10 years off a mortgage, for only $200 more in monthly payments, the interest savings are significant,\u201d says Mastracci. \u201cA shorter amortization is something most people can manage, and there is good reason to do so. With anything over 25 years, most people don\u2019t realize they are paying huge rent on the money, with very little payback.\u201d
If fact, mortgage debt is on the increase, with many Canadians actually carrying mortgages into retirement, according to some surveys. Statistics Canada reports total mortgage debt for persons and unincorporated businesses stood at $602 billion as of June 30, 2006, up almost 70% from $357 billion five years earlier.
\u201cWhen people are heading into retirement, that\u2019s a particularly scary time to take on more debt because of the cost of servicing debt,\u201d says Peter Andreanna, a certified
financial planner at Continuum 11 Inc. <\/b> in Mississauga, Ont. \u201cIf you get debt out of the picture, it makes a huge difference to cash flow.\u201d
In an environment of rapidly rising house prices, it\u2019s not surprising alternative financing arrangements have sprouted up to help keep monthly payments low enough for people to continue to afford homes. Use of extreme leverage in real estate has become mainstream. As well as mortgages extending to 35 or 40 years, no-money down and interest-only mortgages are being offered by mainstream financial institutions.
@page_break@And homeowners with equity in their homes are tapping into it with lines of credit, using the money to renovate, consolidate other debts or simply to consume more. Canada Mortgage and Housing Corp. <\/b> has introduced mortgage insurance for interest-only loans and mortgage amortizations of up to 35 years, saying its actions would \u201callow more Canadians to buy homes and do so sooner.\u201d When Mississauga, Ont.-based Wells Fargo Financial Corp. Canada<\/b> introduced its 40-year mortgage last summer, it described it as \u201c ideal for those who may consider home ownership beyond their reach.\u201d
\u201cHome ownership is important to Canadians. But 100% mortgage financing is a poor long-term plan,\u201d says Laurie Campbell, executive director at Credit Counselling Services<\/b> of Toronto. \u201cSome of the new mortgage incentives are preying on people\u2019s fear that if they don\u2019t buy a home now they may never be able to.
\u201cPeople don\u2019t recognize the long-term amounts of interest they\u2019re paying \u2014 and nobody is pointing it out to them,\u201d she adds. \u201cThe reality is the real estate market moves in cycles. And, as we saw in the early 1990s, people can end up with a house that\u2019s worth less than their mortgage.\u201d
Paying off a mortgage quickly can be considered an investment, Mastracci says. It offers an incredible sense of financial freedom, and frees up funds and borrowing power for other investments that may allow deductible interest on loans. Because interest on a home mortgage is not deductible, saving 6% a year in mortgage interest is equivalent to receiving a return of 10% on an interest-paying security such as a bond, he says.
\u201cPaying off a mortgage is an absolutely risk-free investment. And I can\u2019t think of any other risk-free investments that pay 8% a year, let alone 10%,\u201d Mastracci says.
Sandra Skoubouris, leader of the banking services division of Edward Jones<\/b> in Toronto, says Edward Jones does not generally encourage clients to hold debt for a long period of time, and the company has devised its own mortgage calculators to show clients how much interest they would pay under various amortization schedules.
\u201cThe amount of interest paid over the life of a 35-year mortgage or an interest-only mortgage is usually an eye-opener,\u201d Skoubouris says. \u201cWe have a conservative philosophy. And when we sit down with clients to show them how to meet their retirement goals, these types of debt products typically are not part of the plan.\u201d
As well as shortening the amortization period, Skoubouris says, making lump-sum payments of 10% or 20% against a mortgage once a year can also be effective.
Painless ideas such as converting mortgage payments from twice monthly to biweekly or applying an income tax refund to a once-a-year bonus mortgage payment also can help whittle down interest costs. \tIE<\/b>
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