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