Financial Uproar

Do you guys know what rhymes with debate? Masturbate. HEY. I NEVER CLAIMED TO BE MATURE.

Anyway, I know that literally every other blogger in history has done this post. I’m altogether too lazy to check back to confirm this, so you’ll just have to take my word for it. Why do I think I have something extra to add to this already overwrought  debate? Well, first off, I GUARANTEE my post will contain more penis jokes than all those other ones. Besides, I’m 92% smarter and 104% more attractive than all the others who have previously tackled this. And 394% more humble. It’s a very complicated formula. I wouldn’t attempt it.

Anyhoo, back to the debate. Us Canucks don’t typically have 30 year mortgages, 25 year loans are much more common. Some people are ambitious and take 15 year mortgages, but a 20 year mortgage is the norm for people who are trying to more aggressively pay down their debt. Once we get to the end of the post though, you’ll see how the numbers work even for Canadian mortgages. That’s a bigger tease than the cover of Hustler magazine. (I buy it for the articles)

Let’s run some hypotheticals, bitches!

Purchase price: $300,000
Interest Rate: 4%
30 year mortgage payment: $1426
15 year mortgage payment: $2214
Total interest paid 15 year: $98,540
Total interest paid 30 year: $213,560

It’s official, the 15 year wins, right? Over those extra 15 years, you’d save an extra $115,020 in interest if you’d just stop being a slacker and pay off your place quicker. Of course, you won’t be able to afford as much house to begin with if you do take out a 15 year loan, but that’s okay. How many people do you know who live in place that’s way the hell too big anyway? Many of us could easily downsize to a smaller place.

But wait. Let’s assume that our imaginary home buyer can afford both the 30 year and 15 year mortgages. He’s raking in the cash, probably doing boob jobs for that Heidi chick from The Hills. It becomes a choice of preference, rather than necessity. Let’s also assume, just for this example, that if he takes the 15 year mortgage, our hypothetical buyer isn’t going to have much room left over to contribute to his future. Our hypothetical buyer is also a guy, because boys rule and girls drool, at least according to that 6 year old I just talked to.

But, that’s okay, because he’ll have a paid off house, right? That’s true, but that’s all he’ll have, since Mr. Hypothetical is putting all his cash towards his house. We won’t look at whether his house goes up in value or not, because our other hypothetical buyer will also see their house go up in value. We’ll pretend hypothetical buyer B is a girl, to save some grace with my dwindling female readership.

Buyer A pours all his cash into his house, so for 15 years he doesn’t invest an extra dime. But, from year 15 to year 30 he’s going to have all sorts of money to invest – $2214 per month to be exact. After 15 years of investing $2214 per month at an 8% return, hypothetical buyer A ends up with a nest egg of $779,087. He also ends up with a fully paid for house. Assuming he bought the place when he was 30, he’s not sitting bad as a 60 year old. Well done, hypothetical buyer A. Your grandkids will undoubtedly squander your inheritance.

Back to buyer B. She takes the 30 year mortgage, along with the $1426 monthly payment. Every month, she’s got an extra $788 compared to our other buyer. She thinks about going out and spending it on shoes, makeup, clothes and whatnot, but that would be silly. So she invests it in her brokerage account, and uses glimpses of cleavage to get guys to buy her those things. Like our other buyer, she gets an 8% return, but she manages to maintain her’s over a 30 year period.

After her extended mortgage is over, she has investments worth $1.157M. She’s got our first buyer beat, and beat handily. She will leave a much larger estate for her grandkids to squander. How does she end up with so much more than the first guy? Compound interest, stupid.

Compound interest works really well when you start early. By the time the first buyer even begins to invest, buyer B has over $277,000 already invested. It would appear that he gains ground as time goes on, but buyer B just has too much of a head start. Besides, after the mortgage is paid off, buyer B can afford to invest just as much as buyer A.

Americans can deduct their mortgage interest, meaning the extra interest buyer B pays over the life of her loan is mitigated. Canadians can’t deduct their mortgage interest, but interest rates are so low right now that maintaining a mortgage and investing at the same time is a form of leveraging. Mortgage debt is typically the best way for people to borrow money, since the bank has built in collateral, and because most mortgages in Canada are insured by the federal government.

With Canadians, this exercise gets a little more complicated, because we renew our mortgages, usually every 5 years, and there’s no guarantee that we’ll get attractive mortgage rates when we do. Generally too, the 5 year fixed mortgage rate up here is about equal to the rate of return you can get from a basket of low risk debt.

Once you even out the results over 25 or 30 years though, the return on equities will be higher than the return on fixed income. That’s just the nature of investing. Since equities are prone to knee-jerk reactions sometimes, they will have higher rates of return over time. That’s the nature between risk and reward. Long term investors are rewarded for taking additional risk. Short term investors are not, which is why they shouldn’t be taking said risk.

If you are one of those people who feels the need to pay off the mortgage quicker, might I suggest an alternative? Take out the 30 year loan, and make sure you get a mortgage that allows you to make prepayments of 20% per year without a penalty. Then you can make your small mortgage payments, save up some cash on the side, and then put big chunks down directly on principal. You’ll save interest, plus this strategy give you extra flexibility.

Also, a longer amortization is ideal because of inflation. As time goes on, a $1426 mortgage payment is worth less and less in real terms. Inflation slowly eats away at the value of the payment, meaning each payment gets just a little bit more affordable. Well, assuming your salary also moves up with inflation.

Now that I’ve straightened this up, you’ll have to excuse me. I’m off to stand outside the window of the house buyer B bought. Has anyone seen my binoculars?

Since at least half of my readers are intelligent and awesome, (don’t worry, you’re totally in that half) I’m going to take a break from dispensing the advice and turn to you guys for a little guidance. Or, what’s more likely to happen, I’ll come to a conclusion on my own after writing the post, and I won’t need your help anyway. It’s okay though, feel free to leave me your two cents in the comment section. As always, it’ll be ignored.

As Financial Samurai likes to remind us every 17 seconds, interest rates are super low right now. Because so many investors are fleeing the stock market for the safety of bonds, they’ve driven the price of these bonds up substantially. Since there’s so much demand, interest paid to the borrowers is extremely low. This is bad news for investors, but good news for borrowers.

Enter my situation

The skinny:

Amount owed: $150,000

Remaining amortization: 16 years

Current payment: $450 bi-weekly

Current interest rate: Prime minus 0.3% (currently 2.70%)

Term expiry: August 2013

You should note that the mortgage amount owing, payment and amortization are all approximate numbers. I could find out the exact amounts, but I’m lazy. Some people manage to run their finances without micromanaging them.

I was reading the wonderful Canadian Mortgage Trends website, and they informed me of a promotion ATB Financial was having. For the next little while, ATB is offering a five year fixed mortgage for 3.09%. This is only 40 basis points above my current rate. This is a very cheap fixed rate.

First of all, let’s look at the cost of switching lenders. Because I went with the variable rate mortgage back in 2008 when I bought my house, my mortgage rate crept down with rates in general. For a little while, I was paying a mortgage just a hair above 2%.

As you might recall from one of my posts about mortgages, payout penalties are either 3three months interest or the interest rate differential between my current mortgage and the same mortgage now. Since there’s no difference between what I have and what’s offered (because of the variable rate), I’d be stuck paying the three month interest penalty.

Three months interest: $983.06. So I’m looking at a penalty of about a thousand bucks.

Let’s assume I roll that penalty back into my mortgage, so this process doesn’t cost me anything out of pocket. My handy dandy mortgage calculator tells me that if I keep my payment the same, I’ll add about a half a year on to my amortization. The amortization goes to 16.45 years from 15.8 years.

There’s going to be an additional cost for interest, at least at first. Currently I’m on pace to pay $3925 in interest. If I switch to a 3.09% rate, I’ll have to shell out $4527 in interest. $600 a year is nothing to sneeze at, and I highly suspect I’ll be paying it for each of the next two years.

But what happens then? Expectations are that interest rates are going to stay low for an extended period of time. But just how long will that be? Let’s look at a couple of scenarios:

Scenarios

First of all, we have what most people think will happen. Rates will stay low, the Bank of Canada will sit on the current rate, since the economy could use some stimulation. If this happens, I’m better off staying with my current mortgage and only refinancing when my expiring term forces me to do so. I’ll avoid a penalty that way, and I’ll have my pick of lenders offering the same low rates as today.

Scenario two is that rates start to creep up a year from now. The economy has started to recover sooner than expected. For the sake of argument, let’s say the Bank of Canada has raised rates twice, pushing prime up to a still reasonable 3.5%. At this point, my variable rate has become 3.2%.

Traditionally, the spread between five year fixed and variable rates has been between 1-1.5%. So if variable is 3.2%, a five year fixed would be anywhere from 4.19%-4.79%. If the economy recovers, we’ll start to see more normal spreads between fixed and variable rates. If this situation occurs, I’ll be kicking myself for not locking in now.

What Does It All Mean?

As much as I crunch the numbers, this problem basically comes down to one question. Where will interest rates go in the next two years?

If they go up, even just a little, refinancing makes all sorts of sense at this current rate. If they stay the same, I’ve just paid over $2000 in an attempt to guess interest rate trends. While $2000 isn’t a huge amount of money, I’m still risking something on the guess.

The contrarian in me thinks rates can’t stay this low for long. I understand the market is a scary place right now, but we’re approaching bubble territory in fixed income. Just how long will investors accept a 2% return on a 5 year bond, considering inflation is close to 2%? I’d rather have my money sitting on the sidelines.

Remember when I said I’d figure out the situation myself? I’m still stumped. Readers, the floor is yours.