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.
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.
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.