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!
