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Putting The”More” into Mortgage – How to Best Choose, Arrange and Structure Real Estate Loans

Purchasing and funding a home is one of the most significant financial decisions you will likely ever make. Knowing the ins and outs negotiating and selecting mortgage terms can make a profound difference to your financial future. It’s not as sexy as talking about that junior mining stock you purchased that quadrupled in value or how you saved thousands in taxes through clever tax planning (okay, perhaps that’s not so sexy), but locking in the best mortgage for you and your situation, then managing it properly going forward can have as big an impact or more on your future success, if not more. The benefits of making the right decision can compound and unfold for years to come, one mortgage payment at a time.

I’ll try to limit my use of jargon as much as possible but won’t be able to avoid it completely. In penitence, I have also written a separate article that defines most key mortgage terms and their ins and outs on my website that I also consider essential reading. That article will have a lot more to say about things like the benefits of weekly or bi-weekly payments and prepayment privileges and a bunch of other things that people don’t discuss at cocktail parties.

Getting Started

As a first step, I suggest working with a mortgage broker, like my friend Russ Morrison who has helped me prepare this article and regularly assists my clients. It doesn’t cost you anything, you get the expertise of someone who lives and breathes mortgages on a daily basis and working with a professional allows you to canvass the whole mortgage market rather than just one bank or credit union’s stable of products. Even better, it may also help you get better rates, as banks may not always offer you their best deal unless they know that you can get a better deal elsewhere.

Banks’ posted rates may be 2% or more higher than what they will charge you if push comes to shove. Working with a mortgage broker can hopefully get you lenders’ best rates right off the bat. Although rates aren’t the only ingredient in a great mortgage, they will always be a huge slice of the pie. Almost as importantly, a good broker can also walk you through the fine print regarding penalties, explain how your rate would be determined if you do lock in a variable mortgage later and negotiate better terms with your lenders regarding features like prepayment privileges and porting your mortgage.

The bottom line is that the right broker can not only help you get the best rates and help you weigh the cons of fixed vs variable, but (s)he can also help you weigh the non-rate mortgage features offered by different lenders, as not all mortgages are created equal. In some cases, it may actually save you a lot more money later to go with a lender whose rate may be slightly higher than a competitor offering a similar product if the extra perks of the higher rate mortgage pay for themselves should you want to break your mortgage later or pay it down faster. That is some of the stuff I discuss more in my separate article on mortgage terms.

Big Picture Stuff

Setting up your mortgage is not just about shopping around for the best rate. In some ways, setting up a mortgage is like setting up a proper investment portfolio – balancing risk and reward while also hopefully building in some protection if life goes haywire. Here are some of the things to keep in mind when deciding on the size and type of mortgage that is right for you:

Can You Afford It? Will You Still be able to Afford it Five Years from Now? Just because you qualify for a high mortgage doesn’t mean that you should borrow as much as the bank will give you. Or, even if you can, will it put too much of a cramp in your lifestyle and too much worry into your Sunday nights? Will taking out that big mortgage chain you to a job or career that makes you feel like a wage slave or mean that you only have time to see family and friends on major holidays? Are you planning a family and, if so, do you or your partner want to stay home, or work reduced hours as a result? How would things look if interest rates were 2% higher when it was time to renew? How old will you be when you pay it off and is this after the time you’ve hoped to retire? Are you still able to invest and save for your future? Do you have enough savings or financial backing behind you if you lost your job, got sick or had huge, unexpected expenses?

For better or worse, the mortgage “stress test rules” imposed by the government-linked Office of the Superintendent of Financial Institutions (“”OFSI”) do some of that worrying for us. These rules require that our finances allow us to qualify for a mortgage that is commonly 2% or more higher than the rate we’re actually paying. This applies even for borrowers looking at longer term fixed rate mortgages that won’t fluctuate prior to renewal! Although these rules may protect some potential borrowers from getting in over the heads (and prevent others from buying the home they can actually afford), don’t rely on the government to do your worrying for you. Take an honest, realistic look at your current situation and future plans, crunch some numbers and then borrow only the amount that makes sense to you.

How much certainty do you need? If finances are going to be tight, look long and hard at a fixed rate 5-year (or longer) mortgage, particularly when rates are already low. According financial guru (a Finance Professor at the Schulich School of Business) Moshe Milevsky’s 2001 study, variable mortgage rates beat 5-year fixed rates between 70% to 90% of the time. Other experts more recently echo this conclusion. Although you may win far more than you lose going with a variable mortgage, if you lose on a variable, you might lose big. In the end, even if you may ultimately have done better using a variable mortgage, taking on a 5-year fixed mortgage means taking a bunch of risk off of the table for half a decade and might have also increased the quality of your sleep along the way. If you do go with a variable mortgage, plan ahead to see what your payments would be like if rates do rise to ensure that you can afford to take that risk. Just as importantly, confirm how your rates will be calculated if you do switch into a fixed-rate mortgage at a later date. Some lenders offer far more generous rates than others. If your leading lender contender is on the parsimonious side, it might be worth a second look at some of their competitors. As noted in the next bullet, when making this decision, it’s important to factor in the likelihood of breaking this new mortgage before it comes due and consider the potential penalties you’ll have to pay at that time – the potential costs of breaking a fixed rate mortgage may be many times higher than paying down a variable rate mortgage if rates have gone down. Admittedly, at the time of writing this article, it’s hard to see rates going significantly lower than they are at present.

• How Set Are You in Your Ways? If there is a reasonable chance of you moving within the next 5 years, that might have a big impact on your mortgage decision. As many have found out the hard way, if rates have fallen, fixed rate mortgages can carry a far heftier penalty than their variable friends. Read my last article if you want to know more. In this situation, unless you can’t see rates going any lower, take a second look at a variable mortgage. You might also look at selecting a shorter-term mortgage if you do have your heart set on fixed rates, as the interest rate differential (“IRD”) penalty is based on the remaining term of your mortgage. Thus, the less time left on your current mortgage when you are looking at moving, the smaller the potential IRD penalty. As I’ll talk about in a later article, you would also want to have a “portable” mortgage and rather expansive prepayment privileges so you can either take your mortgage with you from your old home to your new abode or so you can hopefully pay down as much of your current mortgage as possible before breaking it in order to reduce the penalty. A final option, particularly if you’re likely to move sooner rather than later, is taking out a big line of credit or an “all-in-one” mortgage to avoid potential penalties completely. Although you might pay more interest, it could still be worthwhile if the potential penalty would be even higher than the interest you’d pay over the short-term.

Is your Total Debt Load Structured as Efficiently and Effectively as Possible? Many of us with mortgages also carry other debts, 0% car loans aside, that are at higher interest rates, whether it’s unsecured lines of credit, credit card balances, amounts owing on a margin account and more typical car financing payments. (As an aside, when looking at those 0% car financing deals, be sure to ask how paying up front would reduce the purchase price – often, dealers fund the 0% rates by not offering buyers purchasing on credit the same prices they’d offer someone paying cash or borrowing from other sources. If so in your case, this spread represents the hidden interest you’ll be paying on your so-called interest rate loan, none of which is potentially tax deductible.)

When looking at taking out a mortgage, consider whether it makes sense to roll all of those high-interest debts into a lower rate mortgage. Although you’ll still owe the same total amount, you’ll often be paying less over time and will have simplified your debt payments. If some of these other loans are interest-only, you’ll need to keep in mind that rolling them into a mortgage will mean paying back some principal each month and make sure that the cash flow calculations still work. You might also want to look at ensuring that you have a secured line of credit that goes with your new mortgage so you have some wiggle room if you need to borrow additional funds along the way.

What if some of this pre-existing debt is tax deductible, you ask? Many lenders allow you to separate deductible and non-deductible debts into separate mortgage. You may even be able to have different amortization periods for the deductible and non-deductible portions, with a shorter amortization period on the non-deductible debt so that more of your money goes towards debt that doesn’t save you taxes along the way. You can also direct any prepayments you make during the life of your mortgage exclusively towards the non-deductible debt! If you don’t separate out the deductible and non-deductible debt, each payment is applied proportionately against the debt you can and can’t write off. Put another way, if you owe $100,000 and $60,000 of that is deductible, every $10,000 you pay against your debt reduces your deductible debt by $6,000 and your non-deductible debt by $4,000. If you were able to separate out these debts and prioritize paying down the non-deductible debt first, you’ll likely save a lot more over time. In fact, in some cases, you might even consider an all-in-one mortgage where you can pay interest only on the deductible debt until you’ve either obliterated the non-deductible portion or reduced it to a small percentage of the total amount owing.

For those of us with non-registered investment portfolios who are shopping for mortgages, consider whether it makes sense to cash them in and put that towards your mortgage. You will need to take into account any capital gains tax bills that might arise from selling your existing portfolio (although if you’re worried about capital gains inclusion rates increasing anyway, this might be something to consider doing anyway for that reason alone.) Want to stay invested? You can take out a separate mortgage for the amount you want to invest and then put that back into the mortgage. When the dust settles, your mortgage will likely be about the same size as if you left your stocks well enough alone, but now you get to write off the interest on the investment loan mortgage. You may need to work carefully with your real estate lawyer to ensure that you create a clear paper trail showing the investment mortgage money going from the lender to your investment portfolio, preferably without it mixing with any of your other funds. If considering this, I suggest working with a financial professional to weigh the pros and cons and to ensure that you do things right. Finally, if it’s too complicated to take out a separate investment mortgage or if you don’t want to pay any principal on it right now, consider qualifying for a HELOC (“Home Equity Line of Credit”) instead and using this account to buy back your investments. You will likely be paying at a higher rate than if it was part of a mortgage, but you will still have created an interest write-off each year. Borrowing on a margin account instead? Compare the different interest rates and consider using your HELOC to pay down your margin account balance if the HELOC rate is cheaper.

Are you Better off With Different Mortgages: It’s Okay to Hedge Your Bets. Since it’s possible in many cases to chunk your mortgage into different portions, this can open up a lot of different possibilities. We’ve talked about sequestering deductible and non-deductible debt and having shorter amortization periods for the non-deductible portion. That’s not the only way to successfully split your mortgage into multiple chunks. Not sure if you want fixed or variable? You can instead have a bit of both so you can benefit from lower variable rates but still have some protection if rates increase before your mortgage renews.

Likewise, if you might pay down a bunch more of your mortgage along the way than allowed penalty-free, you might have a separate portion as variable to minimize those penalties if you decide to do that, but taking a fixed rate on the portion of the mortgage that you plan on carrying until renewal. Although it still means a potential penalty, it provides maximum flexibility in case you decide not to pay down any extra part of the mortgage along the way and don’t want the hassle of having to renew your mortgage within the next few years, or committing to higher payments each month that go with a shorter amortization period.

You might also want to have different terms for different portions of your mortgage. example, you might want to protection of a 5 year fixed-term mortgage for most of your mortgage, but are expecting a sizeable chunk of money in the next year or so that you’d like to apply to debt. Having a shorter term for a similar amount of your mortgage, whether fixed or term, means that you can pay down that part of your mortgage in full when the cash comes in without having to worry about any prepayment penalties.

Can You Build More Flexibility into Your Regular Payments? In addition to picking longer amortization periods for deductible debt and shorter ones for debt you can’t write off, borrowers who want to build more wiggle room into their monthly budget but can currently afford payments based on a shorter amortization period can have the best of both worlds. If that is you, consider having your mortgage based on a longer amortization period than you actually intend but using the prepayment privileges in your mortgage that allow you to increase your regular payments penalty-free asap so you’re actually on track to pay down your mortgage according to your true target. If your cash flow tightens in the future or interest rates on your variable rate mortgage increases, you can reduce the extra payments without penalty or having to renegotiate your mortgage.

Conclusion

When looking at mortgages, think iceburgs – there is a lot more hidden under the surface than you might see at first glance. The goal of this article is to help you see the full picture so you determine how a mortgage best fits into your overall financial picture and some of the ways you can cut off some edges and round some corners to make it fit even better.

Definitions for a Surprisingly Long List of Key Mortgage Terms and Insight into How They Might Impact Your Mortgage Choices

Introduction

Today’s introduction will be short and sweet, as I think the title above and definitions below largely speak for themselves. My goal today is to provide with a glossary or cheat sheet you can use when learning how to speak Mortgage in order to hopefully guiding you towards making the most informed decision possible about the best mortgage for you and yours. My fervent thanks once again to my friend and mortgage guy, Russ Morrison of The Morrison Mortgage Team for his input in creating and shaping this article.

  • “posted rate”: the interest rate lenders advertise to borrowers for mortgages with different features and for different rates of time. Lenders provide posted rates for both fixed-rate and variable mortgages.
  • “discounted rate”: the actual rate your lender charges you on your mortgage because you’re special rather than the rate they quote to the unwashed masses. You’ll likely need to haggle to get this rate, which is one way having a mortgage broker can help.
  • “amortization period”: the amount of time using a set interest rate and a fixed payment schedule before your mortgage is paid off and you can sleep better at night.  In reality, you will likely negotiate a number of different mortgages for smaller chunks of time (“terms”) at different rates and for different amounts before your mortgage is finally a thing of the past. You may need to reduce payments upon renewal or add to your debt to finance renos or junior’s quest to be a plastic surgeon. Conversely, you may be able to make additional payments ahead of schedule in order to get your debt paid down faster. As a result, your amortization schedule is a moving target that adjusts with each payment that calculates how long until you are debt-free if you keep making your regular payments under the terms of your current mortgage if rates never change.
  • “term”: the length of any mortgage agreement, generally expressed in years, with 5 years being the most common. For most younger mortgagees, the term of your mortgage will be significantly shorter than your amortization period. For example, if you have a 30-year amortization period and a 5 year term, you are currently on pace to take out 6 separate 5-year term mortgages before you’re done unless your amortization schedule changes, which it almost certainly will . When your mortgage term expires, you will need to either renew with that lender, shop around for a new lender who offers you a better mortgage or you have enough cash to pay down the remaining balance. Before it expires, there are usually penalties that apply if wish to pay down more of your mortgage than allowed under your mortgage agreement.
  • “payment frequency”: how often you make payments towards your mortgage. Most mortgage amortization periods are calculated based on you making monthly payments. In reality, you have several other options which call for smaller, but more frequent payments that can often shave several years off your mortgage freedom date.  Each of the first 4 options have you paying the same amount each year as would be the case under a monthly payment scheme, but your mortgage balance declines faster the more frequently your regular payment. Under each of the two accelerated payment options, you are effectively paying an extra month’s worth towards your mortgage each year, which further shortens your amortization period. The bottom line is the longer the remaining amortization period in your mortgage, the more you’ll save by making more frequent payments and accepting an accelerated payment schedule. Your payment frequency options include:
  • Semi-monthly (payments twice per month or 24 payments per year). 
    • Bi-weekly (payments every two weeks or 26 payments per year).
    • Weekly (52 payments per year)
    • Accelerated Bi-weekly (26 payments per  year but each payment is equal to what you’d pay under a semi-monthly payment schedule);
    • Accelerated Weekly (52 payments per year)  Each payment is equal to what you’d pay under a bi-weekly payment schedule; 
  • “closed mortgage”: the most common type of mortgage, a closed rate mortgage offers a lower rate than an “open mortgage” but charges you penalties if you want to make extra payments above those allowed in the mortgage agreement or if you want to pay it down before your mortgage term elapses. Most of the options and features below are designed to provide more flexibility within closed mortgages, but there is seldom a free lunch – you generally pay for this flexibility through a higher interest rate. A closed rate mortgage, as well as an open mortgage, can be fixed or variable.
  • open mortgage”:  a mortgage where you can do what you want, when you want, including paying it down ahead of schedule, renegotiating along the way or getting a new mortgage from a different lender. You pay for this flexibility through a higher interest rate. If you’re looking to potentially, then this might be the mortgage for you.
  • “fixed rate mortgage”: a mortgage where the interest rate used to determine your regular mortgage payments does not change over the term of your existing mortgage, such as 1, 5 or 10 years. Under a fixed rate mortgage, your minimum required payments won’t change during that period, which offers protection to borrowers on tight budgets or worried about future interest rate increases.
  • “variable rate mortgage”: a mortgage where the interest rate charged on the balance of your mortgage is calculated according to a formula based on the lender’s posted prime lending discounted by a set percentage (i.e. prime minus. 75%). In other words, your interest rate isn’t guaranteed and can either increase or decrease during the term of your mortgage.  Although each bank’s prime lending rate often moves in lockstep with the Bank of Canada changes its own prime lending rate, this isn’t always the case or lenders may not always decrease their rates as significantly as the Central Bank.  In any event, when your interest rate changes, your regular payments change as well to keep you on target to pay down your mortgage based on the amortization period you selected. This can mean increased payments when the rates increase or decreased payments when rates go down. During times of lower rates, small increases to rates can mean significant increases to regular payments. For example,  for every $100,000 owing, mortgage your payments will increase or decrease by approximately $12 a month if the prime lending rate increases by .25%.   

One strategy to consider is to structure your regular payments as if your variable interest rate was perhaps .50% to 1% higher than is actually the case. That way, you’re paying your mortgage down ahead of schedule so long as rates don’t change and your regular payments won’t increase until the actual interest exceeds this threshold. Some lenders also offer variable rate mortgages where your payments stay the same even if rates go up, which means no effect to your current cash flow but the amortization period for your mortgage gets pushed back.  Be sure to know whether or not this applies in your case if this is a concern.

  • hybrid” or “combination mortgage”: a mortgage that is really two smaller mortgages, one portion of which is a fixed term mortgage and the other is variable.  This may be a way of hedging your bets if you have a larger mortgage, really like the idea of a variable rate mortgage, but want to minimize the impact if rates do end up rising more than you expect.
  • convertible mortgage”: a variable mortgage that allows you to change your mind and switch to a fixed rate mortgage midstream.  Expect this flexibility to be priced into your original fixed interest rate and don’t expect to get your lender’s best interest rate when converting to a fixed-rate mortgage and expect to pay a fee if exercising this option. Your rate will depend on what the lender is offering at that time and it is often the case that you’ll need to actually lock in at a higher fixed rate than the variable rate you’re paying at the time you make decision, particularly if locking in while rates are rising.
  • “interest rate cap”: some lenders issuing variable mortgages may be willing to cap the maximum interest rate they charge even if rates rise far more than expected.  This may be something to explore if you want to go variable but would like to limit the downside. As you might expect, there will likely be a charge for this extra protection.
  • “breaking your mortgage”: paying down your mortgage before the current term of your mortgage expires (“prepaying”) when amount you’re prepaying exceeds the maximum amount you can prepay under the terms of your mortgage. As you might expect, there is a price to pay, which leads us to . . .
  • “Prepayment Penalty”: If you need or want to “break” your mortgage, then the prepayment penalty what this will cost you.  For a variable mortgage, this cost is typically the interest otherwise owing on your remaining mortgage balance over the next three months.  For a fixed rate mortgage, the penalty is whatever is higher: interest otherwise owing over the next three months or, if interest rates are currently lower than your current rate, you will have to pay the “Interest Rate Differential” or “IRD.”
  • “Interest Rate Differential (“IRD”)”: If breaking a fixed-rate mortgage when rates have decreased, your penalty is the IRD over the remaining term of your mortgage after you’ve made all allowable penalty-free prepayments (see “prepayment privileges”). More specifically, the IRD looks at the difference between rate you agreed to pay originally and what someone could get if taking out a mortgage today for a time period equal to the number of years left in your current mortgage and then factors in the remaining balance of your mortgage. For example, if you’re 36 months into a 5-year mortgage with $200,000 left after all allowable prepayments, this means looking at the difference between 2-year mortgage rates and essentially either the rate you’re actually paying on your 5-year mortgage ( the “discounted rate”) at or, in some cases, the “posted rate” at the time of your original mortgage on $200,000, which is the usually higher advertised rate for that lender.

As I explained in my last article, some lenders calculate the IRD in a very punitive way, as yet again, all lenders aren’t created equal. For example, lenders using the posted rate rather than the discount rate will generally charge a much higher penalty. Put another way, if you were actually paying 3.25% on that $200,000 mortgage just discussed and the current two-year rate was 2.25%, you’d think the IRD would be 1% (3.25% – 2.25%). If the posted rate three long years ago was 5.25% rather than the 3.25% you actually agreed upon, some lenders would use a 3% rate (5.25% – 2.25%) for calculating the IRD. As a result, knowing how the different lenders calculate IRD should be a crucial part of your decision of where to borrow if looking at a fixed-rate mortgage and there is a more than hypothetical chance you might break your mortgage along the way. Not all lenders will calculate their IRD in exactly this way,  but the outcome will be very similar in most cases to this example.

  • “Prepayment Privileges”: There are typically two different types of prepayment privileges – the ability to pay down a set percentage of the original mortgage balance each year without incurring a penalty through one or more lump sum payments, and the right to increase your regular payments that year by a set percentage, also penalty-free. Generally, these benefits range from 10% to 20% paydowns of the original mortgage or 10 to 20% increases to your regular payments each year and it is common but not guaranteed that borrowers can maximize both benefits. For example, you may be able to both pay down 20% of your original mortgage and also increase your regular payments by 20% that year without paying any extra fees. Unfortunately, however, if you don’t take advantage of that year’s prepayment privileges, you can’t carry them forward to later years.  Furthermore, once again, different lenders have different rules and rates for their prepayment privileges:
  •  Some lenders use a calendar year (i.e. December 31st) as the deadline for using up that year’s prepayment rights, while others base it on your mortgage anniversary.
  • Some allow as many prepayments as the heart desires above a small minimum, while others may be far more restrictive. Some lenders allow you to make extra payment whenever the mood strikes,  while others may only restrict extra payments to as little as one day per year, such as the mortgage anniversary.
  • Some offer 10% annual prepayments while others might bump that up to 20% per year.

When looking to “break” your mortgage, maxing out on your prepayments just prior to that time reduces the penalty you would otherwise be stuck paying. If timed just right, you might be able to even take advantage of two years of lump sum prepayments rather than just one to further reduce your penalty. I discuss this in more detail in my previous article. Having more flexibility in how much and when you can prepay can save thousands of dollars in some cases.

  • “blending your mortgage”: When you need to borrow more money before your current mortgage has expired  and you want to roll that into your existing mortgage rather than triggering prepayment penalties and taking out an entirely new mortgage (aka “blend and increase”). The old and new rates and conditions will be combined into a single mortgage and payment with a rate that is somewhere between the old and new rates. Because the banks know that you want to avoid prepayment penalties or want to hang onto an older mortgage at a better rate than currently available (which isn’t today), you may not get the best possible rate for the new portion of your mortgage. Accordingly, it still might be worth determining whether or not it makes sense to break the mortgage instead and start from scratch. You might also look at blending and increasing if you are moving and have the option to “port” your mortgage or transfer it to your new home as discussed later.
  • “blend and extend”:  When your new blended mortgage starts a new mortgage term, such as an additional 5 years from that point onward. You may lean towards that option for fixed rate mortgages if rates are currently delightful and / or you worry about future rate increases and want to lock in for a longer period than the remaining term of your original mortgage. The calculation of your new payments and rates will not extend the rate on the remaining term of your original loan past its expiry, so it’s not like you can extend the savings if the original mortgage was at a lower rate. Instead, the rate on your original mortgage and its remaining term be taken into account when determining the overall interest rate you’ll need to pay for the new term of your mortgage.
  • “blend to term”: When your new blended mortgage doesn’t extend the term of your old mortgage. Thus, if you had 2 years left to run on your original mortgage, your new blended mortgage will still expire when those 2 years have come and gone. This may be the way to go if the goal is to remain as flexible as possible going forward, such as expecting rate drops, considering a potential move or wanting to be able to canvass the market again in a couple years, particularly if you’re not convinced that you got a great rate on your new borrowing but don’t want to break your current mortgage and pay a penalty.
  • “portable mortgages”: when you move, this mortgage moves with you. Even if you aren’t planning on moving, it’s a great thing to have as much flexibility as possible to deal with as many of life’s little surprises as possible, assuming that the cost (i.e. the increase to your interest rate) isn’t too steep.  Unfortunately, however the purveyors of small print now include many “ifs, “ands” and “gotchas” so that many so-called portable mortgages are in fact as portable as the tower of London. Some of the potential caveats, requirements and drawbacks include:
  • Requiring that you restart your mortgage term when you port, which isn’t so wonderful if you wanted the flexibility to shop the market when your original mortgage term was due to expire.
  • Either not allowing borrowers to port variable rate mortgages or requiring that you convert them to fixed rate mortgages at that time. If you have a HELOC (home line of credit), you may also not be able to port that along with your traditional mortgage.
  • Only transferring your existing balance with no right to “blend and increase”, which means having to come up with a bigger down on the new place or having to break your mortgage anyway.
  • Going through the entire mortgage application process again from scratch, including proof of income and reviewing your credit scores, which can’t fall below a certain level, and current debt levels. The lender also has to be willing to lend against your new place, which might not happen with certain types of property.
  • Having to come up with bridge financing to cover the down on your new place before being reimbursed from the sale of your old one if your lender won’t offer you this option.
  • Limiting the geographic area to which you may port. For example, some credit unions may not allow out-of-province porting.
  • Specifying that you must close on your new place within deadlines as tight as 30 days after you’ve sold your old home;
  • You will likely still have to pay a fee to port and have your new place appraised.
  • “assumable mortgage”.  A mortgage that allows someone else to take it over midstream “as is” if they purchase your current home. The new borrower would need to qualify. This option can save money if it means not having to break your current mortgage and may be an attractive selling feature to buyers when your current mortgage is less than the current interest rate offered for new mortgages. In some cases, you will remain liable for missed payments if the new borrower defaults, so find out this detail in advance. On the other hand, mortgage guru Russ Morrison has never actually seen anyone assume a mortgage in his 20 years of inhabiting mortgage-land.

Conclusion

Congratulations for making through this list alive and best wishes in selecting the perfect mortgage to suit your situation. Despite taking the time to educate yourself on this subject, I still recommend using an independent mortgage broker to walk beside you during the mortgage process. Getting a mortgage is a huge financial commitment for most of us. Having someone to walk beside us along the way, access the best rates, crunch the numbers on our behalf and play devil’s advocate as necessary can go a long way to making sure the choices you make are the right ones. Even better, they’re free!

Warming Hearts Through Estate Freezes

Imagine ordering a large drink late in a steamy August afternoon after just completing a day’s toil in the sun. After several thirsty minutes waiting, watch in rapturous delight as the waitress finally brings over a tall, frosted glass, beaded with moisture . . . only to discover that it’s mostly ice. For lawyers and financial planners like me, that’s what I see when calculating actual size of the estate many of my clients will leave to their heirs after paying taxes. Although there are many ways to cut down on the ice quotient, the one I want to talk about today is called the “estate freeze.”

In simple terms, a freeze operates to cap or “freeze” the amount of unrealized capital gains on company assets that is taxed on when the grim reaper comes calling for that freezing shareholder. The freezer swaps the common shares that have grown in value for one or more classes of fixed value preferred shares that maintain control over the company but won’t participate in future growth. Instead, the company issues new common shares that are currently without value to the next generation or to a trust that the freezer controls and, when a holding company’s portfolio skyrockets higher or an active business’ widget sales go through the roof, those new common shares soak up all the new growth. Although the freezer will still need to pay tax on any unrealized gains on the preferred shares (s)he owns after their last gasp, (s)he will have at least minimized the tax (although not emotional) pain for those left behind.

Obviously, timing when to do the freeze makes a profound difference to the tax savings the freezer’s estate will eventually enjoy. If the company doesn’t continue to grow in the future or if the freezer dies within a year or two of implementing the freeze and the new common shares haven’t yet had a chance to significantly increase in value, then the whole exercise was likely a waste of time. On the other hand, for a company that doubles in value over 5 years, the savings to the deceased’s estate can be over $250,000 on every million dollars of gains that would have otherwise been taxed in their hands at this point. If amount of capital gains that are included in income and are taxed increases in the future, as many worry, the savings could be even more. For example, if the inclusion rate for capital gains increases from 50% to 75%, a properly done freeze could save the estate $375,000 per million dollars of capital gains avoided.

When to Consider Getting Chilly

Whether a freeze is worth considering depends on a host of factors. Perhaps the biggest are how much have your company shares already increased in value and how much will they continue to grow before your death if you leave well enough alone, as noted earlier. As a friend of mine once said, ask yourself if the juice (i.e., the benefit) is worth the squeeze (the cost and effort involved in extracting the relevant breakfast beverage.) The best candidates for a freeze own active businesses that they are looking to either pass down to the next generation or sell to an outsider. In the first case, minimizing the tax bill at death may make the difference between a business staying in the family poised for continued success or either a forced sale to pay the taxes owing at death or hamstringing heirs with large bank loans in order to pay that bill.

If the goal is instead to minimize taxes on an eventual sale, capping the original shareholders’ share value and transferring future gains to other shareholders allows more family members to claim the lifetime capital gains exemption on their shares upon sale. Every shareholder can avoid most of the tax on almost $900,000 in increases to the value of their shares at this point (the exempted amount increases yearly due to inflation) if they and the business satisfy certain criteria. By doing a freeze to transfer future growth to spouses and children, etc. after your own shares have unrealized gains of about $900,000 can mean hundreds of thousands of dollars in savings in some cases. For example, someone doing a freeze when her shares have grown by $900,000 in value in favour of her husband and 3 children in the expectation that the company would be worth $4,500,000 upon sale may be able to avoid capital gains tax entirely at that time. In that example, the new common shares owned in a family trust would be worth and could be apportioned equally amongst her hubby and children so each could shelter $900,000 of growth, with mom using up her exemption on the $900,000 in shares she retained after the freeze.

By contrast, if she does nothing, remains the sole shareholder and owns $4,500,000 worth of shares at sale, the tax bill could easily exceed $900,000 at today’s levels and far more if the inclusion rate for capital gains climbs in the future. As an added bonus, in some cases, a freeze might help a family save tax along the way by allowing them to sprinkle dividends to qualifying adult family members who actively work in the business but whose salaries aren’t enough to optimize the family’s annual tax savings.

On a related note, a freeze requires an accountant or business valuator to put a value on the company at the time of the freeze. Businesses hit hard by Covid may be able to turn this to their benefit if they are confident that the blip in value is short-lived by doing the freeze based on the current Covid-influenced levels so the new common shares can reap the rewards when the economy and business value both improve.

On the other hand, freezes are not just for active businesses. Doing a freeze for your holding company can still save your family a host of potential taxes on your eventual passing, particularly if combined with some of the other options I talk about in my next article on “wasting freezes” and share redemptions on death using life insurance. As I will also discuss, investors with large non-registered portfolios or perhaps rental properties might even consider setting up a new holding company, then rolling those assets into the company on a tax deferred basis (but do watch out for property transfer tax) to cap the future tax bill owing at death. This strategy works best if the plan is for the children to keep the assets, such as a real estate portfolio, for the long term after your death but can even mean huge savings if that isn’t the plan in some cases. If nothing else, it may provide your heirs with the flexibility to wait a few years after your death for the real estate or stock market to improve rather than forcing them to sell as soon as you’re in the ground in order to cover your final tax bill.

Reasons for Giving Freezes the Cold Shoulder

Admittedly, freezes are not for everyone. Besides taking into account the cost of doing the freeze and any additional annual expenses that might result, particularly if creating a family trust to hold the new common shares or setting up a new holding company, I suggest taking the following into account:

• A freeze may only delay the day of reckoning. Although shifting part of the potential tax bill from one generation of taxpayers to another is often great tax planning, it might not be so beneficial if the kids will need to wind up the company in short order anyway. It still may be worth proceeding if the freeze provides the heirs with some discretion regarding when to sell assets like real estate or if there are still tax savings to be had despite the desire to wind thing up shortly after your death.

• A freeze only works if the company continues to grow or you use the aftermath of the freeze to decrease the value of the freeze shares. If you plan to draw down the value of any company during retirement and suspect that it will eventually be worth less than it is now, then a freeze is not for you. The only exceptions may be if you also do a “wasting freeze” during retirement, as I discuss in my next article, to more actively transfer some of the capital gain tax bill to the next generation.

• Are you too young? If doing a freeze using a family trust, realize that the trust has an effective lifespan of 21 years in this situation, as all unrealized gains inside the trust are taxed on its 21st anniversary. Although the shares can be transferred out of the trust on a tax-free rollover basis at any time prior to then, some parents may not be keen to gift the shares directly to the children at that point, particularly children with rocky marriages, financial issues or similar problems. On the other hand, 21 years is a long time for children to get their act together and the parents can always just allocate the common shares to back themselves if that has not happened. This would undo the benefits of the freeze but it is always good to have this option if life does not turn out as expected.

• How much does control matter? How solid are your children’s lives? Practically speaking, doing a freeze doesn’t mean having to give up control of the company if the freezers retain all of the voting shares and control the family trust that also owns the new common shares. This allows them to continue with business as usual inside the company and to continue to pay themselves as many dividends and as much salary as their hearts desire and the Income Tax Act allows. If shares are gifted to the children directly, there is less control, which increases the chances of problems if a child is divorced or has creditor issues. Even if the shares are held in a trust, there are at least theoretically potential problems if one of your children divorces. One way of minimizing that risk is making it a precondition of the freeze than any married children get prenuptial or marriage agreements excluding the value of any shares from any divorce settlement.

• Are there other tax fighting weapons in the armoury? A freeze can be a silver bullet in the right circumstances but a empty shell in others compared to some of the other tax minimizing options available. Corporate life insurance can help minimize, reduce or pay the final tax bill, particularly if there is a big tax-free payout on the first death. Loaning money to a family trust (assuming most of your capital gain assets are outside of a company) at 1% so you can actually sprinkle income to your descendants now can be a really effective strategy in many situations. Even if you have to pay more tax now to get a critical mass of assets into the trust, it might be a blessing in disguise if the taxable amount of capital gains increases in the future anyway. Unfortunately, the trust idea may not be a particularly useful one if most of your assets are held corporately.

Conclusion

The tax bill faced by many estates on their corporate assets or non-registered holdings often takes a very big gulp out of what taxpayers want to pass along to their heirs, but proper estate planning can often reduce that large gulp into a small sip. Implementing an estate freeze many years prior your final passing may be one way of making that happen. In my next article, I’ll discuss some ways to supercharge the benefits of a freeze to hopefully make that final sip of taxes into a mere moistening of the lips.

Should I Stay or Should I Go Now – Whether or Not to Refinance Your Mortgage and How To Ease The Pain

Covid 19 is the sort of financial tsunami that bowls over and swamps all but the most conservative of financial projections. As we slowly begin to pick ourselves up, dry out our wet clothes and figure what comes next, I am suggesting to many of my homeowner clients with fixed rate mortgages to look at their existing mortgages to see if there are any opportunities to turn at least some of the lemon that is Covid into perhaps a shot glass full of lemonade.

When diving down into the rabbit hole of mortgage refinancing calculations, many surprises may await. Accordingly, I strongly suggest that you arm yourself with the expertise of an experienced mortgage broker like my friend and fellow Moneysaver contributor Russ Morrison that has been around the block at least twice to help you maximize savings and minimize unnecessary bank penalties.  And, after crunching the numbers, if you believe that it does make sense to pay whatever penalties come with paying up your current mortgage, it’s just as important to ensure that your shiny new replacement mortgage provides you with as much flexibility and as many features as possible in order to hopefully help you continue to save for many years to come. Don’t worry – I’ll save that next topic for another article.

How it Works

Trying to understand the ins and outs of whether or not it makes sense to pay down your existing mortgage ahead of schedule is a lot like trying to read a book in a foreign language upside while not wearing your glasses – extremely frustrating, confusing and open to misinterpretation. I’ll talk about the details of how this is calculated in a second, but at the end of the day, these calculations determine whether the savings you’d reap under the new mortgage would be enough if you continued your current payments going forward to pay down the mortgage penalty that you’d be adding to your new mortgage by the time your old mortgage expired. Put another way, if your mortgage balance would be $500,000 after taking advantage of all the prepayment options I’ll discuss later to lower your penalty, with 3 years until renewal, and your monthly payments are $3,500, would a new mortgage for $515,000 (current balance plus an arbitrary $15,000 penalty) and $3,500 in monthly payments leave you with a smaller mortgage balance 3 years from now than would be the case if you just kept paying down your current mortgage? If so, and the hassle factor and any associated costs from making the change aren’t too significant, then you’d want to look at making that change. I highly suggest getting your broker to spell out any additional costs or other downsides in advance so that you’re not surprised later. For example, will there be any legal or appraisal costs and, if so, how much?

Furthermore, if you want access to a new secured home equity line of credit (“HELOC”) from your new lender, how do those rates compare to what you currently have? HELOCs are usually variable and are also based around the bank’s prime lending rate. It is quite possible that in these days of Covid that your new HELOC rate might not be as attractive as your old one. You’ll need to take the extra interest you might be paying on the HELOC in the future into account before making your final decision if you’re planning on using your HELOC extensively going forward.

If your new mortgage is fixed term, then the calculations to determine whether you’re better off refinancing your mortgage are relatively straight forward. If you opt to go variable, however, then these calculations will need to take into account how your variable rate might change over the remaining balance of your current mortgage.  Although in these days of Covid, it is hard to imagine when rates might start to climb again, I still suggest taking this into consideration and crunching the numbers to include at least a rate increase or two at different points of time during the period in question. Taking on a variable mortgage does mean taking on more risk.  Factoring in what things look like if rates do climb, however how unlikely that may currently seem, forces you to see what could happen if life throws us yet another curveball. If you’re still ahead of the game despite these more pessimistic estimates, then you can proceed with more confidence and certainty. If the numbers no longer work, you can either stay with the status quo or, if the savings if rates don’t change are too much to pass up on, then at least you’ll have made an educated decision with a better idea of the downside if things don’t go entirely your way.

Calculating Your Prepayment Penalty

If you pay down a typical fixed rate mortgage ahead of schedule, it’s going to cost you. The penalty is generally whatever is higher – the interest you would have paid on the remaining balance of the mortgage over the next three months, or what they call the “interest rate differential” or (“IRD”), which is allegedly based on the difference between what you would have paid in interest over the remaining term of your existing mortgage vs. what you would have paid in interest over this same period on a fixed term mortgage at current rates for the remaining mortgage term. For example,  if you had 36 months left on your existing mortgage, the IRD would look at the interest you would have paid over those three years under the status quo minus the interest the bank can get now lending out your current mortgage balance to someone else based on their current posted 3-year mortgage rate. In theory, you are compensating the bank for not being able to get as much interest on the money you’re returning to them ahead of schedule when they have to lend it out to someone else now at lower rates.

There is one very important exception to the IRD calculations just discussed. Banks are only allowed to charge an IRD penalty during the first 5 years of your mortgage. After that point, they can only charge three months’ interest. Although longer term mortgages (i.e. like 10 years) are not particularly common (they are generally priced higher than 5-year mortgages for several reasons, one of which is to compensate them for lost IRD payments if the borrowers do cancel beyond the 5 year mark), if you’re the exception to the rule and already beyond the 5 year mark, you should have your mortgage broker on speed dial. You’ll be able to avoid the sticker shock that I’ll be taking about in the ensuing paragraphs if you do refinance.

Calculating a typical IRD penalty sounds pretty straight forward, but all lenders are not created equal and the devil is in the details.  For the naive, if your current 5-year mortgage rate was 3.39% and the posted rate for a three-year fixed rate mortgage today was 2.39% on a remaining mortgage balance of $300,000, you’d expect that the interest rate used to calculate your penalty would be 1%. Not so fast. Your original 3.39% rate was very likely not the “posted rate” advertised to the masses but a discounted rate that is referred to as the “bank rate” or the “discounted rate.” That is also true for the 2.39% rate currently posted – it’s likely that because the bank truly loves you and values your business that they would be willing to go a little lower than the posted rate, but only just for you, of course. As a result, the rate some banks use to calculate the IRD is the difference not between the actual 3.39% 5-year mortgage rate that you are currently paying and that 3-year posted rate of 2.39%, but the posted rate when you took out your mortgage two years ago and that 3 year posted rate. The difference between the posted rate and the bank rate on your original 5-year mortgage may actually be 2% or more higher in some cases! Thus, instead of using 1% (3.39% – 2.39%) to calculate your IRD, some banks might use 3% or more using this example (5.39% – 2.39%). Alternatively, they might get to the same 3% result by subtracting the 2% discount you received 2 years ago from the current 2.39% posted three-rate. Never mind that shorter term mortgages don’t get discounted nearly as much as 5-year fixed mortgages, nor that banks aren’t discounting their rates nearly as much these days in these times of Covid. Put another way, how many lenders out there do you think would be willing to discount their posted 3-year rate of 2.39% by 2% to 0.39%? In the end, there are currently a lot of horror stories regarding some potential prepayment penalties, particularly for those poor souls who aren’t refinancing in order save money under new rates but who might be losing their homes due to the financial crisis or are forced to refinance purely for cash flow reasons.

It’s important to note that banks aren’t the only way to get a mortgage in Canada. In addition to banks, or private mortgages, your choices include monoline lenders (lenders who only do mortgages rather than the whole array of products banks offer) and credit unions.  Generally, banks charge the highest penalties on fixed mortgages, although it really varies from lender. Bottom line: it’s vital to do your research prior to entering into your next mortgage to determine how lenders calculate their IRD penalties, as well as other key considerations like portability (the ability to transfer your old mortgage to your new home) and penalty- free prepayment privileges that can reduce any penalty if you do need to get out of your mortgage at a later date.

In the end, as Russ Morrison, licensed mortgage god, advises, picking the right mortgage is a lot more than just comparing interest rates. That’s why I suggest working with a mortgage broker rather than going it on your own. It’s free, you get to shop the entire mortgage market and you also get lenders’ best rates up front rather than only after you’ve found a lower rate elsewhere.  Perhaps most importantly, however, a good broker will walk you through the other considerations I’ve just discussed so the mortgage you pick fits you like a glove and you know how to optimize its features.

If it still makes sense to prepay your mortgage, there are a few things that might minimize the pain:

  • Be strategic when picking the time to pay down your mortgage. Get your broker to calculate both the savings and penalty happen to be if you pay down at different points in time. One of the big things to keep in mind, however, is that you won’t know for sure what the posted rate for the period closest to your remaining mortgage term will be in advance, nor the rate that you’d be able to get on the new mortgage that you will actually take on. If you try to get too cute, you may not be able to get the same mortgage rate offered today, which could more than offset any reduction to your mortgage penalty you might get by waiting. As well, using our previous example, if you wait until there are only 2 years left in your current mortgage, the IRD would look at the 2-year posted rate rather than the 3-year one. It could well be that the 2-year rate is lower than the 3-year posted rate, which means that, although the calculations would only look at 2 rather than 3 years of lost interest for the bank, the rate used to calculate that penalty may actually be higher: for reducing the IRD, you usually want the posted rate offered for the remaining term of your current mortgage to be high, not low so that the difference between the two rates (and thus, the rate used to calculate your penalty), is as low as possible.
  • Prepay the pain away.  When calculating the best time to pay down, it’s vital to remember that the penalty is only applied against the outstanding balance at the time of paydown.  Thus, the less you then owe, the smaller the penalty you’ll incur when repaying the bank’s dough. This will occur naturally over the lifespan of any mortgage, although if you’re still 25 to 30 years before it’s scheduled to be paid down completely, each payment at this stage is likely mostly interest anyway. There are steps you can take, however, to hammer down your mortgage balance before you pay it out and, as a result, significantly reduce any mortgage penalty. Most mortgages allow you to pay a set percentage of the original balance loan (a range of 10 to 20% is pretty common) each year in one or more lump sum payments. You may also be allowed to increase your regular payments by that same percentage, too, often without this affecting how much you’re able to prepay in lump sum payments. I’ll dive into the ins and outs of prepayment rules in a separate article but here are the basic things to keep in mind when looking at these options:
  • The early bird gets the worm. The earlier you start prepaying, the smaller your mortgage balance when it’s time to calculate the penalty.  Each prepayment means that every regular payment you make thereafter will be directing more money towards the mortgage balance rather than in interest payments. Just like when looking at investment returns over the long term, the magic of compounding also casts its financial spell when trying to reduce your mortgage balance by making extra payments as soon as possible.
  • Read the fine print and use it against them. Different lenders offer different prepayment percentages and features. Some allow you to make as many lump sum payments each year over a small minimum payment amount as your heart desires, while others aren’t as generous. Others may even restrict when you make your annual prepayments to a set date, such as each year’s mortgage anniversary! Since you’re stuck with these rules and limitations, it’s essential know the hand you’ve been dealt so you can employ these rules to your best advantage. For example, are the prepayment periods based on your mortgage anniversary or the calendar year? If you’re planning to pay down your mortgage, you could save you a lot of penalty dollars if you diarize the earliest date you can make your next lump sum prepayment and time your mortgage paydown for after you’ve done just that. If you have a 20% yearly prepayment privilege, getting to make an extra 20% prepayment reduces your mortgage penalty by that same 20%!
  • Let your HELOC lend a hand. Although taking advantage of the prepayment privileges propounded in the preview paragraph may sound promising on paper, it might be another thing entirely coming up with the money to make this happen in the real world. That’s where your existing HELOC comes in.  If you use your existing HELOC or even arrange a new one in anticipation of paying out your mortgage early to fund lump sum prepayments or also free up the cash to also increase your regular payments as well, this can take a huge bite out of that future mortgage prepayment penalty. And, when it’s time to take out that cheaper, lower rate mortgage, you can borrow enough to pay down the balance of the HELOC. Even better, since the prime lending rate has fallen so fast so soon, the interest you’re paying on it in the meantime may actually be significantly lower than the rate that you’re paying on your current fixed rate mortgage anyway.  Not only will you be reducing the penalty you’ll pay the bank down the road – you’re doubling down your savings by reducing the rate of interest you’ll be paying along the way as well!
  •  Consider using your TFSAs to turn the tide. If you’ve got a lot of money already tucked away in your TFSAs and you’re still struggling to come up with your prepayment, consider dipping into your TFSAs to come up with a bit more cash.  You can always borrow back the money to fill up your TFSAs as part of your new mortgage, although you will have to wait until the next January before you can replace the money you’ve withdrawn. This option works best for investors who don’t expect a lot of growth or income from their TFSAs between now and then, as the opportunity cost for reducing the prepayment penalty using your TFSA loot is the tax-free income and growth you would have received had you stayed invested. If you’re one of those people who have calendar prepayment privileges and want to make that final penalty-free prepayment in January before refinancing your mortgage, consider pulling your TFSA money out in late December if you want to minimize potential lost investment growth. Your new mortgage can include enough money to restock your TFSAs and you can start earning tax-free TFSA dollars once again with minimal opportunity cost. Just don’t try to claim a tax deduction on the money used for TFSA purposes, as that’s not allowed.
  • Cash in your cash accounts. Another potentially useful way to prepay that mortgage is to sell existing non-registered investments to raise the cash. There will be a tax bill to pay on any capital gains, so you’ll need to take this into account before making this decision. If you were going to be selling some of the investments anyway within the next couple years and are worried about having to pay more tax on capital gains in the future like I am, this might be something you could consider doing anyway. Want to stay invested? Perhaps you can use your HELOC to buy back those investments. Not only will this reduce your eventual prepayment penalty and perhaps even lower your combined interest rate if your HELOC interest is lower than your fixed rate mortgage, you can now write off the interest on the money you’ve used to repurchase those investments! If selling investments at a loss, however, be sure not to repurchase the exact same ones or wait for at least 30 days after selling to do so or you won’t be able to claim that loss for tax purposes. When eventually getting your new mortgage, you’ll likely need to pay down the existing HELOC, which might mean having to sell your investments again, but you can take out a new HELOC at that point with whoever is issuing your new mortgage or even look at carving out a separate mortgage just for investment purposes if that gives you access to a lower interest rate.Either way, try to keep the investment loan portion of your mortgage or any HELOC as a separate mortgage or portion of any HELOC for tax purposes. Not only will this make your accountant far happier, it will also likely save you a bunch of tax dollars going forward. If the debts are kept separate, you can arrange your finances so that you pay as little as possible towards your deductible debts and direct more towards your non-deductible ones. As a result, more of your debt and more of your interest will be tax-deductible, which can result in significant tax savings.

Final Considerations

When refinancing your mortgage, there may also be some opportunities to reduce your current expenses if times are tight. Although the break-even calculations assume that you’d continue your normal payments under the new mortgage and keep your amortization period (i.e. the number of years before your home is completely mortgage-free) the same, you don’t have to do either of these things.  Under your new lower rate mortgage, your minimum regular payments will probably be lower despite adding the interest penalty to the balance. If your focus at this point is on keeping your monthly costs lower, you could likely reduce those payments slightly and still have the penalty paid down by the time your current mortgage would have expired. Or, if cashflow is particularly tight, you might decide to decrease your payments and increase your amortization period which could significantly reduce your regular payment costs to make ends meet until your finances improve. At that time, when funds permit, you could look at increasing your regular payments under the prepayment privileges provided under your new mortgage in order to get things back on track. For some of us, the decision to pay down our current mortgage may even be based purely on reducing our regular costs even if the size of the penalty doesn’t otherwise justify making the change. If you’re in that boat, you’ll just have to make sure that you still qualify for a mortgage or to see if you have any relatives willing to act as guarantors.

Conclusion

Although 2020 has caused many financial problems for far too many Canadians, there may at least be a few ways of easing the sting and helping us get our houses back in order. For some of us, paying down our mortgage early might be one such opportunity.