Let's talk financing for homes! Since the Mortgage is the largest financial headache (for most families), I thought it would be a great way to start this 'crusade' of mine.

Mortgage

Now, let's start with the conventional mortgage. Why do people get mortgages? Most people need to borrow money to purchase a home. There is a down payment for a percentage of money they need to borrow, and the lending company (usually the bank) provides the rest. We do this because most of us don't have the cash sitting in our bank account to purchase a home, which the majority of cases is in the hundreds of thousands. Therefore, we need help with financing the property which we need to purchase.

Most people walk into a bank, and the bank is often more then happy to provide a product called "The Mortgage" (granted the client qualifies for it). First let's break down the meaning of this product. It is actually comprised of 2 words "mort" and "gage": "mort", which is the root word of mortality, i.e. death, and "gage", which is like a 'pledge' i.e. debt. So the word "mortgage" pretty much means 'debt until death'. The way the product is designed today is pretty much to keep the client in debt for the rest of their lives. I often see the case, where there are people in their 50s and even 60s who have $200,000 or even $300,000 mortgages. They don't ever expect to pay it off, all they know is that when they pass on, their kids will be taking over the payments and will hopefully pay it off in their lifetime.

Mortgages are calculated as compound interest, which is calculated semi-annually. In English: every 6 months your mortgage calculates the interest you owe on the balance of the mortgage, at whatever your interest rate is, and then ADDS it to your mortgage balance. So, if you look at your mortgage ammortization payment schedule, you will see your mortgage balance increase a little every 6 months, after the previous months declining. This compounding effect can pretty much mean, after you've paid off your mortgage you would have paid the original value of the house 2 or 3 times over again.

For example, on a $300,000 mortgage, you could quite possibly pay 3/4 of a million dollars over the entire term (assuming interest rates stay around the 5% mark and there are no extra payments made during the term). I'm having a hard time finding proper mortgage calculators online which actually show the compounding effect, but the ones that don't show the compounding effect indicate that on a $300,000 mortgage, you will end up paying almost $600,000 over a 25 year term (assuming a constant 5% interest rate and no pre-payments). I would only assume that on a proper calculator that showed the compounding effect, that figure would be a lot higher.

To the majority of the population (the approximately 90% who will not retire financially independent), this 'mortgage' product is pretty much the 'be all, end all' of home financing. We're just not taught anything else different by the banks, lending companies, or even our mortgage brokers (I know this personally having worked in a bank for 6 years and having people in my family who are mortgage brokers).

But, what other form of financing can we use for our homes? The great mystery, is not really a mystery at all. The strategy that the wealthy have been using for years is pretty much right under our nose as well. It is called a HELOC, or a Home Equity Line of Credit; pretty much just a line of credit used to finance the purchase of your home. What's the difference between the two?

HELOC

-> Simple Interest -- you pay interest only on the balance remaining; therefore, no compounding, which can save you tens of thousands of dollars in interest, and reduce your borrowing term by years. Please also note that I suggest, if you can afford it, to put the same amount of payment toward a HELOC that you would have the mortgage. This is also how you can accurately compare the 2 products.

-> Flexibility -- There is an option to pay the minimum of interest only every month. Anything over and above that is your own choice. This is especially beneficial for those who might go through hard times. i.e. loss of job or large emergency expense incurred, where they are not able to afford the entire full payment that a mortgage would require.

-> Open-ness -- You can pay as much as you want, whenever you want; there is no penalty for paying it off early and no limit to extra payments (as opposed to mortgage which will only allow you pay a certain percentage extra per year -- usually 20% or 25% of the principal-- anything above that will be subject to penalty; there is also a penalty for paying off the mortgage before the term is up).

-> Taxes -- If done properly, some (or all) of the interest paid on the HELOC can be deducted off your taxes. I won't get into the specifics of this now, but if you need more information please consult your financial advisor or contact me directly for more advice.

-> Interest Calculation -- HELOC interest rates are 'open' and usually float with prime. They can be competitive with mortgages sometimes, although usually are a little bit higher. However, the great advantage is that, if you feel prime rate is going too high, you can change the HELOC into a mortgage and LOCK the rate in at any time. Another added flexibility benefit!

-> Qualifications -- Essentially, the process to get approved for both Mortgage and HELOC are pretty much the same. However, it is a little more difficult to get approved for a HELOC because the maximum Loan-to-Value ration is 80%. In English: Means you cannot borrow more then 80% o the homes value as a HELOC. This might be a challenge for some who do not have that amount saved for down payment, or as equity in their home.

Now, begs the question: Why aren't we told about the HELOC?

The answer is very simple: Money talks! This can be said true for both the banks/other lending companies and some brokers out there. It is a lot more profitable for the banks to sell this product as opposed to a HELOC (and remember, every bank carries a HELOC type product), because they make a LOT more money off the interest from selling a mortgage.

For brokers, they get paid more money to sell a mortgage, as they would a HELOC. Some banks don't even pay the broker to sell HELOC, which is why many don't ever talk about it to their clients. The scary thing is, many brokers I've sat down with don't know the difference between the 2 and are not able to distinguish the difference between compound and simple interest.

Now, this is not to say that HELOC is ALWAYS better then a mortgage, and not to say that all brokers are only in it for the money, but if we were to assume the same interest rate on both products, then it might make sense for a lot more people out there. I say 'MIGHT' make sense, because this type of product usually requires more discipline, as there's no requirement to pay anything above the interest, and sometimes what happens is when people have built some equity into their homes, they might see the 'available' credit on their HELOC as "savings" or additional "cash flow" for them, even though it really isn't. For someone who thinks they might not have the discipline required and they need to on a fixed payment schedule, this type of strategy might not work for them.

Also note, that the 'rich' have been dealing with this strategy for decades; those high-network investment firms (the ones who don't sit down with clients unless they have at least $500K of investable cash), mostly deal with this product for their clients, because they know the benefits of going simple interest vs compound interest when you're borrowing money.

Many people would be weary of doing a HELOC because it's not 'fixed rate' (i.e. its variable rate, floating with prime). But, people don't realize the power of using the variable rate. There was a study done by Professor Moshe A. Milevsky, at York University (in Toronto) that I found on the RBC Mortgage website (http://www.rbcroyalbank.com/products/mortgages/variable-rate-advantage.html), and he came up with a couple of conclusions:

- Choosing a variable rate mortgage would have saved consumers $20,000 in interest

payments over 15 years (based on a $100,000 mortgage).

- Consumers would have been better off borrowing at prime rate (variable) compared to a 5-year fixed rate 89% of the time.

(full research paper found here: http://www.ifid.ca/pdf_newsletters/PFA_2007SEPT_Mortgage.pdf)

Also note, that savings of $20,000 in interest is based on compound interest vs compound interest. Imagine how much more would be saved if it was simple interest being calculated vs a compound interest fixed term mortgage. Once again, this is why the rich get richer; because they know these strategies and are taking advantage of them, while the banks try to convince all of us to go into fixed rate mortgages because its "safe".

Again, this is not something that every client should be doing, because everybody's situation and habits are different. This post is just to shed light on another option that is available for home-owners out there, that is not being promoted often. Every strategy has its pros and cons, so best to sit down with your Financial Advisor and they can show you all the numbers, and see what makes sense for you.

My last point will be this: In my opinion, Variable Rate Mortgages should be used when rates are relatively low and stable, or you think will be going down. However, in very low interest rate environments, where you feel rates will increase (and maybe increase drastically) I would generally recommend people to get a Fixed Rate Mortgage, as it doesn't make sense to continue to have your Mortgage Rate increase every time the Prime Lending Rate increases.

I hope you have learned something from this post, and if you have anymore questions about these 2 products or want me to clear something up, please do not hesitate to contact me!

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Are HELOC loans interest calculated more frequently than mortgages?

ReplyDeleteMy HELOC is compounded semi-annually. How bad is that? Also, can you provide interest table calculators on HELOCS. I have a $580K HELOC at 3.7% with a semi-annual compounded rate of 3.7286. I am one of those seniors in this high mortgage situation. Any advice would be great. Should I be looking for some other option? Anonymous since I am somewhat embarrassed by this.

ReplyDeleteWhile I applaud your efforts to investigate and write about finance, this post is filled with so much incorrect information it really is a disservice to people trying to learn about sound financial strategies. I don't know what kind of mortgage you have, but every amortization schedule I have seen charges interest on the balance every month. The scheduled payment that is determined by the term is greater than the interest charged in that month so the balance decreases EVERY month until it's paid off. If you have an actual amortization schedule from a bank that demonstrates what your describing, please share!

ReplyDeleteAs a mortgage lender of 14 years, I wrote thousands of mortgages and even gave advice to clients to consolidate their HELOCs into a fixed rate mortgage. I have studied this for 4 years and have came to the conclusion that a HELOC is actually a better fit for most folks wanting to eliminate their debts faster. I have even ran models showing a HELOC increasing in interest rate by 0.5% each year and the client still paying their home off faster when they use their HELOC like a checking account instead of just another loan. Checking accounts are basically liabilities because the rate of return is 0% excluding inflation, meaning your money is actually moving backwards. So, why keep your money in a checking account doing nothing when you can dump 100% of your income into a HELOC and take draws when you need to pay your bills? This allows your money to work for you even when you are sleeping. Not to mention, they are tons of banks that will offer fixed rate HELOCs or HELOCs based on LIBOR which is now at 0.43% with a lifetime cap of 6%. This doesn't take much discipline as one would suggest. All it takes is for the consumer to abandon the idea of a checking account and use their HELOC as an operating account. The results are nothing short of amazing.

ReplyDeleteBrian is right, this post is nonsense.

ReplyDeleteThere are no compounding mortgages.

HELOC will cost you a higher interest rate because of the flexibility it offers. Mortgages will be more restrictive with rules around paying faster, but there are still many ways to accelerate the payback (which will cost you less in the end.)

What? No compounding mortgages? Sounds like a Dave Ramsey rant. LOL Mortgages are compounded interest which is why they are front loaded, interest heavy (around 75 to 85% of your payment is interest, the crumbs left over pay down your home). How do you think you end up paying for a home for yourself and one for the bank?

DeleteHi Brian and 'Anonymous'.

ReplyDeleteBoth of you are incorrect, in regards to the 'compounding' comments. Section 6 of the Interest Act requires that all fixed-rate mortgages being offered be quoted using only semi-annual or annual compounding periods. If you look at any lender's documents or even website, it is by law required for them to indicate the compounding on the rate - in almost all cases, the rates are compounded semi-annually. This means that a 6% mortgage rate will actually have an effective rate of 6.09%.

Your all "VS" are very nice and good compare with each other. Nice effort and nice post i have read your whole post. mortgage rates Vancouver

ReplyDeleteHi,

ReplyDeleteThis is an excellent article. I have 3 HELOC accounts and I know how much savings I could make in interest Vs having mortgage. Those who complaint about HELOC do you proper math in interest calculations and you will see the difference.

The bank will never tell you the truth and I have been forced to take mortgages always. The banks are there to suck money from our pocket.

Regards,

Nathan.

Hi Nathan, I am considering a home equity loan to refinance my house. so your post suggest you are saving money. would you suggest home equity to refinance vs. a mortgage. i got a fixed 400 % rate over 15 yrs. thanks! rhonda

DeleteGreat simple to understand article. I am already aware of helocs and differences and am working towards using new strategies. For those who think mortgages are better, learn the math behind the repayment schedule and see the front end loaded interest coming out of your payment, compounding interest. Lower interest doesnt always mean lower interest payed. Thanks for the article

ReplyDeleteThank you for your kind words. I'm glad you were able to get some Value out of the article!

DeleteExcellent article with wealth of info! Bank want People to focus on interest rate but you should really focus on interest Volume, the total sum of interest you pay for 30 year mortgage most of time you end up paying close to double of the amount you borrow.

ReplyDeleteThank you for taking the time to read the article and for your kind words. Yes, most people don't realize how much interest they actually pay over the life of their mortgage. In many cases, especially in big cities, you can pay 3 and sometimes 4 times the value of your house over the life of your mortgage. This is especially the case when people continuously dip into the equity of their home and end up extending the life of their mortgage.

Deletethanks for the background information. how does one go about comparing a heloc vs. semi-annual compounded mortgage? i'd like to know how to go about comparing because other sites say you shouldn't use a heloc for long term loans due to the interest fluctuations. thanks

DeleteThank you for the article! I'm still doing some searching, but are there any spreadsheets or models out there that calculate and compare total interest paid between a mortgage (fixed interest rate refinance; cash-out) loan vs a heloc (variable interest rate)?

ReplyDeleteHi Gary, Thank you for taking the time to read the article and for your comments.

DeleteUp to now I haven't found one that can accurately and transparently provide the comparison between the two and give the right numbers on the interest. However, the Manulife ONE calculator (you can just go to their website) does provide you with a good illustration and numbers. That may be one of the better ones I've seen.

The Manulife calculator is misleading because it assumes everything above your monthly expenseswill stay in the account thus reducing your balance. This is essentially making extra payment every month; of course you'll pay down the balance faster than a conventional mortgage. But, there are other things you can do with the extra that MIGHT be more advantageous eg: invest it in an RRSP in something that returns more than the mortgage interest rate. It won't let you compare apples to apples - that is just the cost of the interest over the life of the loan if no extra payments are put in. My hunch is that even if compound interest is more expensive, nothing I've read or found or been told has convinced me its worth the premium you pay to have a HELOC - up to .5%.

DeleteThanks for your article. Please can you share some light on how some or all of the interest paid on HELOC can be deducted before tax. Regards, Joe

ReplyDeleteHi, and thank you for taking the time to read the article.

DeleteThere's only a few situations where the Interest on a HELOC is tax deductible. If you're using the funds from the HELOC to invest, and generate investment income (or have a reasonable expectation to generate income), then the interest becomes tax deductible. Also, if you use money from the HELOC to generate business income (for example you purchased equipment for your business), then the interest also becomes tax deductible. I'm not sure if a portion of the interest is tax deductible if you have a home office (like it is with a traditional mortgage), but that is something that you may want do some research on. It's always recommended to get the assistance of a qualified Tax Professional on these type of matters, as they would have more in depth knowledge.

so which banks in Canada provide a HELOC?

ReplyDeleteMost lenders will provide a HELOC product to clients.

DeleteBut as mentioned in my post, during times of increasing interest rates (such as the current environment), locking in as opposed to going into a variable interest rate type product (such as a HELOC), may be a better option. Not always, but often that is the case. It also depends on personal financial situation, value of home, amount of mortgage left on the home, when you want to have the debt paid off by, how much flexibility you want, etc...

It's always recommend to sit down with a knowledge Financial Advisor to go through all the details and numbers. Generally, I find most mortgage agents/brokers don't have the sufficient knowledge to give you all the information you require, and often have a severe bias for one side (i.e. mortgage) vs a HELOC.

Hope this helped!