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How Being Cheap VS. Frugal Can Hurt Your Mortgage Freedom Goal

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The following is a contribution from Michael at Mortgage Truth Canada. If you’re interested in contributing to Frugal Rules, please consult our guidelines and contact us.

We all want to pay off our mortgage early. But did you know that there are two very different approaches to this goal and serious potential implications? Cheap vs. Frugal. Let me explain.

We have all felt the awful feeling of a cheap decision that has backfired and cost us twice as much in time and or money. What was the point of that? And do you think we learn from this horrible experience? A surprising amount of Canadians find themselves moving two steps forward with their mortgage only to fall three back over time. This is due to short sighted goals, not understanding your mortgage contract and buying into the bank’s mortgage plan for you. Here is what you need to know.

No Frills Low Rate Bank Mortgage

The curse of the cheap is interest rate. There is nothing more important than getting a lower interest rate on your mortgage. The question you need to ask yourself is ‘what is the bank asking me to give up to get such a low interest rate?’ Quite often it is something that will cost you a lot down the road. Here are a couple of common privileges you lose when choosing this mortgage product:

1) Prepayment privilege – the common amount in a fully featured mortgage is 20% of the original mortgage amount prepaid annually without penalty. This is reduced or removed all together meaning if you were to come into a bonus at work or an inheritance you are not able to take advantage of this and save thousands in interest.

2) Bonafide Sale Clause – this means you can only break your mortgage if you sell your home to a non blood related party. If you were to find a lower rate elsewhere and wanted to move your business elsewhere you would have to sell the home and pay the related penalty to do so.

3) Early Payout Penalty – often the mortgage contract stipulates a 3% early payout penalty of the remaining balance vs. the standard 3 month interest penalty. This is ensuring that if you have to break your mortgage early for any reason that you will be paying a hefty penalty. With the average mortgage in Canada being broken at the 3.8 years of a 5 year contract – you can see how this is dangerous.

Collateral Mortgage Charge

One of the ways we have been taught to save money is by doing all of our banking business with one institution. The banks play into to this with the new collateral mortgage charge which causes all of your loans (line of credit – credit cards – auto loans) to become interconnected. Yes you are saving on fees every month by not having accounts with multiple institutions. But what power we have given over to the bank by being penny wise yet pound foolish. Under Canadian law – the bank has far reaching power if you were ever to fall out of their favor:

1) Missed Payment – If you were to miss a payment on your line of credit the bank has the right to take the equity in your home and pay out your line of credit. They can also close this credit facility making this not available to you in a time of need.

2) Default – If you were to fall behind on your mortgage for any reason – the bank has the right to raise your interest rates by as much as 10%. On a debt as large as your mortgage – this is not something to take lightly. No one plans to fall behind on their mortgage but it is comforting knowing that this is not a possibility ahead of time.

The Bank’s Plan vs. Mortgage Planning

Many generations and millions of bank marketing dollars have gone into shaping our idea of how to pay off our mortgage early. Don’t you know they are still earning record quarterly profits in spite of our best efforts and historical low interest rates? Buying into a bank mortgage product does not come with unbiased mortgage planning advice.

Where we can become cheap is in locking into an aggressive repayment term that leaves us vulnerable to the ups and downs that life presents on our journey. Our laser beam focus of paying off a mortgage in 15 years versus 25 can backfire when the economy turns or our hours are cut back at work. Accelerated payment plans make no provision for emergencies and paying off debt borrowed at less than 3% for a fixed term can be better allocated for the family’s benefit.

What is more excellent is to have a mortgage that provides provision for your best day as well as keeping the family afloat in the worst possible crisis. This planning considers many aspects:

1) Income Streams – How well diversified is the family’s income? If you are a single parent, the type of mortgage product considered will be different than a family with multiple streams from diversified sources.

2) Employment – Are you employed in a one industry town? Or, are you seasonally employed or self employed? These are all considerations towards the type of mortgage and the specific terms we will consider.

3) Available Equity – With unprecedented low fixed term interest rates available – there are opportunities to utilize prudent leverage to invest in investments providing 8-15% annual returns and ‘bank’ the spread moving you closer to your mortgage freedom goal sooner.

It is important to save as much money as possible in paying off your mortgage early – this can’t be argued. How we approach this is the deciding factor whether we get there or just end up with the frustrated feeling that being cheap leaves behind. If we take the time to disseminate the restrictions that bank low interest rate mortgages entail, dig past the gloss of their mortgage contract and ask the hard questions, as well as take the time to plan for our best case/worst case scenario – we can get the most out of a frugal approach to paying off our mortgage as quickly as possible.

 

I am a passionate educator about mortgage and finance. I also am an investor in asset backed and real estate based investments. My wife and three boys live with me on a 30 acre horse farm up in Barrie, Ontario where we enjoy all four seasons. Find me at http://mortgagetruth.ca/

 

Editor’s note: Michael brings up some interesting points in regards to the mortgage planning process. I would encourage you, of course, to do your due diligence before signing loan paperwork to make sure it’s the best fit for you.

 

Photo courtesy of: James Thompson

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I'm the founder of Frugal Rules, a Dad, husband and veteran of the financial services industry. I'm passionate about helping people learn from my mistakes so that they can enjoy the freedom that comes from living frugally. I'm also a freelance writer, and regularly contribute to GoBankingRates, Investopedia, Lending Tree and more. If you're wanting to learn how to monetize your blog, check out my blog coaching services to see how I can help you take your site to the next level.

28 Comments

  • This is excellent information for my wife and I. We’ve been discussing a home purchase in the upcoming months and have much to consider. Thanks for the great article!

    • Michael says:

      Hey Jacob, love the comment here! So good to know that the information will stir up the conversation pot around what are best practices in reaching your financial goals with your mortgage. If you need any more specific answers you know where to reach me. Cheers

  • I don’t think we have the lowest 5 year rate going in Canada but we did get the best rate back when we picked up the mortgage for our home. We are able to pre-pay up to 20% of our mortgage each year which has helped us speed up the process of becoming mortgage free in the next month. If we didn’t have this privilege then we would have had to break the mortgage which would cost us more money to find a mortgage that would allow the pre-payments. I’m glad we did our research. Great post Mike.

    • Michael says:

      Hey Mr. CBB – you bring up a great point here. Having the lowest rate is not the end all be all – for you it was how to save you the most money right 😉 and taking advantage of your pre payment privileges is commendable and beats a no frills mortgage without the perks anyday. Way to go!

  • Justin says:

    I wouldn’t purchase a mortgage that had a prepayment clause in it. It just doesn’t make sense for our family. You end up paying fees if you want out early etc…
    I want to make sure I get out as early as possible, and those types of mortgages just don’t do that for me.

    • Michael says:

      Well said Justin – the sad truth is that you are one of the few that would read through the contract and ask the pointed questions to ensure you are getting exactly what your family needs and wants.

  • This is a great write up. From my understanding, many of these catches also make appearances in the US.

    • Michael says:

      Thanks FI for the kudos! I believe bank contract verbage isn’t hindered by the thin line that separates Canada and the US. They share notes of that I am sure.

  • Good stuff here. Although some of the products are a bit different here in the US, the same principals apply. That is why we always make sure that there are no “catches” (like prepayment penalties) when we’ve signed a mortgage.

  • Wonderful stuff here, Michael! Thanks for pointing out some crucial things to keep in mind when mortgage hunting.

    • Michael says:

      Hey Laurie – you are most welcome! The details are so important not to overlook and I would go one step further that you always ask your mortgage adviser – what does that mean? – and do not move past the paragraph in the mortgage contract without getting a satisfactory answer. Cheers

  • AverageJoe says:

    That early payout penalty is frustrating if someone signs a loan without catching it. I had a couple of clients who had to make a tough decision between refinancing and taking the penalty or just seeing the mortgage through….. That’s why I like getting the paperwork at least a day or two before you sign. It gives you time to read over the loan documents and to have informed friends or advisors read the contract before you step in it!

    • Michael says:

      Hey AJ – I like how you put the last bit there ‘before you step in it’. 🙂 I know this is probably not what you meant but too many folks see it just this way. They do not take responsibility for their personal finances (especially the mortgage contract) and see this as a necessary evil that the sooner they can get it signed and put to bed – the sooner they can move on to something else more pleasurable. So unfortunate. For my clients – I always make it my prerogative to go over the documentation line by line until everything is completely understood – no room for grey areas in a debt this large. Thanks

  • pauline says:

    Those early repayment fees are outrageous. Credit cards or loans don’t have them, why mortgages? I thankfully have a mortgage with no overpayment penalties, I think there is an exit fee, but you can go around by overpaying everything but $10 and let it lapse the next month.

  • Very good heads-up to check for those hidden landmines!

  • The reasons you mentioned above are the reasons that scare me into going with the typical 30 year mortgage. What happens if something bad happens. I need to make sure we will be ok. I would like to begin at some point making 2 monthly payments to start paying it off a little faster.

  • I really enjoyed this post Michael! Over the next few years I want to really dive into some of the nitty gritty of personal finance, including more of the technical details of mortgages and investments. I definitely have a few things to look into after reading this post. Also, I really appreciate you making this point “Accelerated payment plans make no provision for emergencies and paying off debt borrowed at less than 3% for a fixed term can be better allocated for the family’s benefit.” I think it’s important to not get too crazy about eliminating debt and then having difficulty accessing capital when emergencies come up. I definitely understand why people want to pay off their loans, but keeping a level head about what makes most sense investment-wise and preparing for emergencies is of utmost importance.

    • Michael says:

      Hey DC – you are most welcome sir! Your response is the reason I do what I do. If it causes a stir inside of you to understand more and find better ways to improve your personal financial situation – then I have done my job. Congrats on the journey! 😀

  • If you think about it, pre-payment penalties are a smart move for banks. Flip the tables and imagine you were invested in bonds in your retirement. You are living off the interest income from those bonds, but then the companies start paying off all their bonds early. You would be upset! You were depending on that interest income!

    • Michael says:

      Hey Ed – you are absolutely right and this is one thing I try to teach all of my clients is that my goal is that they are not only a borrower – but that one day they will become one of my lenders. When you lend out your hard earned money – you do want to see a return on it. Thanks!

  • All great points! We were able to get a rate of 3.25% on our home, I made certain that we would incur no penalty for making early payments or paying off the loan early.

  • I am surprised that such terrible terms exist in mortgage products today. It would be very unpleasant to find out that you had a prepayment penalty or couldn’t sell to a blood relative. I guess it’s always “buyer beware.”

    • Michael says:

      Hey Suzanne – buyer beware only goes so far. I believe in simplified financial language and ensuring my clients understand the contract with full disclosure. If the big banks were to do the same a lot of the pitfalls the consumer falls into would be removed. Thanks for the comment.

  • Michael says:

    Hey Jenny – some of the worst culprits are the Canadian arm of their US parent company. Citibank and Wells Fargo may be familiar names? Up until the financial crisis they were alive and well offering mortgage loans to Canadians. I think you may have to dig down the rabbit hole a little further to get to the dirt.

  • Julie says:

    Despite not knowing the full ins and outs of mortgages before I signed my first one, I had a great coach that helped me through the process and I came out with one that makes sense for me. Although the mortgage term was longer than I had originally intended I get to renegotiate this soon and will be realigning the pay back terms to my life today… not the position I was in 4 years ago! Thanks for the added insight!

  • Derek @ MoneyAhoy.com says:

    This definitely falls into the category of buyer beware! Make sure to read the fine print with what you are signing.

    If you can get 8% in the market, it could be argued that pre-payment is not all it’s cracked up to be!

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