A home is one of the biggest purchases that you can make. Many people see it as one of their biggest and best investments, but for most of us it comes with a huge liability: a mortgage. Either way, we all need to live somewhere and many people argue that owning your own home is far better than paying rent. Although I am a fan of home ownership, maybe we should consider that we all pay rent of some sort. Everyone knows that a tenant pays monthly rent to the landlord, but few stop to consider their mortgage interest payments in the same light.
Mortgages are at worst a forced savings plan unless somehow you have secured one that is "interest only." Your principal payments get you closer to financial freedom, and the interest portion is the rent that you pay to the bank. In Canada, mortgage interest on a personal residence is not tax deductible, so the only real benefit you get from the interest portion is the use of your home for another month. Another portion of your rent is property taxes. You can potentially reduce your taxes with a reassessment but you will never entirely eliminate them.
There are many online mortgage calculators on the internet that will break down your monthly principal and interest payments. You can also get an amortization schedule from your bank or mortgage holder. Let’s look at an example based on ING Direct’s 5 year fixed rate of 4.19%. If you had a $200,000 mortgage with a 25-year amortization your monthly payments would be just over $1,072. A whopping 65% of your first payment would be interest paid to the bank. Add in your monthly property taxes and you have your total equivalent to rent payment. In this case you have $692 + property taxes. The good news is that your interest amount will shrink as you pay down the loan; the bad news is that based on 25 years it’s a slow process. Based on this amortization schedule, assuming the same interest rate holds steady, more than half your payment goes to interest until well into year 9. Keep in mind that this example is based on record low interest rates offered to people with the best credit ratings!
If the above example seems depressing, there are a number of ways you can get ahead of the game. You can do accelerated bi-weekly payments, lump sum payments, and even double down (pay twice your normal payment) depending on the lender and your mortgage terms. Let’s look at an example where you decide to set your payment at a higher amount each month and leave it there for the duration of your mortgage.
Based on our $200,000 mortgage (at a 25 year amortization) the first payment of $1,072 eliminates only $380 of the principal; $692 is interest! The good news is that you can skip payment 2’s interest payment forever by paying an extra $382 in addition to payment 1. Less than $400 buys you 1 whole month off of your mortgage! If you were to continue with this extra amount every month you would reduce your total interest over the life of your mortgage by just under $50,000 and you would be mortgage free in 15 years and 8 months!
Some critics may argue that they cannot possibly pay any more than they already are against their mortgage. My suggestion is to contact your bank and see what options are available. Often you are allowed to increase your payment at least once a year within limits set by the lender. Play with a mortgage amortization calculator such as the one at ING Direct and see the potential benefits of even a slight increase. A runner does not run a marathon on the first day. The trick is to DO SOMETHING. Maybe you only increase your payment a few dollars or add a portion of annual pay increases to your payments. The online mortgage calculator will show you how a few dollars early on can be huge over the long term. Before you know it this strategy will become easier and you won’t even miss the money. If you are concerned that you may not be able to maintain the higher payment, confirm with your lender that you can always drop it to the lower amount if the need occurs. If you have not yet bought your house, you might consider a slightly less expensive home (and mortgage) to help make these strategies less painful.
Maybe you are torn between paying down your mortgage and investing. Consider that your existing interest rate on your mortgage is your guaranteed return when it comes to debt repayment. Even better, the government will never penalize you with taxes on the money you save. These are essentially "after tax" returns. In non-registered accounts, a guaranteed rate in the form of interest is taxed at the highest possible rate, and in an RRSP you will still pay CRA a chunk in income tax when you withdraw the money. Again this will be at the highest tax rate based on your income. I am not saying that you shouldn’t invest or put money into RRSPs, but definitely consider these points when you look at the benefits of debt elimination and investment. If you are really savvy, you might want to google a strategy known as the Smith Manoeuvre. This alternative can help you take advantage of the best of both worlds.
There is one final thing to consider before you go ahead with this strategy. If you have credit card or higher interest debt these amounts need to be eliminated first. When it comes to debt elimination the general rule is to pay off the highest to lowest rate. As you pay off each debt add the payment amount you were making to the next debt. Once higher interest debt is gone you can move on to your mortgage.
Again, the key to moving towards your goal of financial freedom is to TAKE ACTION. Analysis is good, but if you spend too much time analyzing and never put your strategies into action you may know more but you are no further ahead then before.
What actions have you taken to eliminate your consumer debt?
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