I love talking about money…and the word is spreading at the office. I have two very close friends at work and they have patiently listened to me talk about money for years. One of them has a young assistant who was looking to buy her first house with her fiance. My friend told the assistant to come and see me. I was more than happy to talk to her about mortgages, prepayment options, insurance options, and ways to minimize the amount of interest owing on her mortgage.
So I spent about 40 minutes talking to my friend’s assistant. I found out that she was using a mortgage broker. I tried not to ask for too many details about salary and savings, but I wanted to find out if she had considered pre-payment options (she hadn’t), the difference between mortgage insurance vs life insurance (nope!), rates offered by banks vs mortgage companies (yes), and whether they had considered paying bi-weekly rather than monthly (nope). I was also encouraging her to wait until after her probationary period at the office had expired, but I lost that battle.
a) Prepayment Options Matter
If ridding yourself of your mortgage is a priority, then you’ll want to ensure that you get the best prepayment options that you can.
In Canada, borrowers can increase their mortgage payments one of two ways. Firstly, they can increase their mortgage payment by a fixed percentage amount every calendar year. When I first obtained my mortgage, I was able to increase my bi-weekly payment by up to 20% once each calendar year. Some banks allow borrowers to increase their payment by a maximum of 10% or 15%. There is no need to increase the payment by the maximum, but I encourage people to go with a lender who allows for up to 20%. The higher the payment, the faster the mortgage balance disappears and the less interest that is paid overall. Paying less interest to the bank on a debt as huge as a mortgage is a goal worth striving towards.
Generally, once a payment is increased, that increase is in place for the remainder of the term of the mortgage. A bank does not allow a person to decrease the mortgage payment later on down the line.
Here’s an example. The original mortgage balance is $100,000. The annual maximum mortgage payment increase is 20% of the original mortgage payment. The bi-weekly mortgage payment amount is $500. The mortgage term is 5 years.
Year 1: $500 x 20% = $100; new bi-weekly mortgage payment = $600 ($500 + $100)
Year 2: $600 x 20% = $120; new bi-weekly mortgage payment = $720 ($600 + $120)
Year 3: $720 x 20% = $144; new bi-weekly mortgage payment = $864 ($720 + $144)
Year 4: $864 x 20% = $172.80; new bi-weekly mortgage payment = $1,036.80 ($864 + $1,036.80)
Year 5: $1,036.80 x 20%= $207.36; new bi-weekly mortgage payment = $1,244.16 ($1,036,80 + $207.36)
Of course, there is no requirement on the borrower to increase the mortgage payment by 20% every year. The bank would far prefer it if you simply paid the minimum required amount because doing so insures that they squeeze as much interest out of you as possible over the life of the mortgage! A borrower might only be able to increase her payment by 5% each year, or only be able to increase it in years 2, 3 and 5, or might only be able to increase it by the maximum amount at the very start of her mortgage, or any other combination.
It’s a decision that cannot be taken lightly. While making the higher payment as soon as possible is good for minimizing the interest paid the bank, the fact of the matter is that the borrower is going to have to come up with the new higher payment amount every two weeks. As you can see from our example, coming up with $1,244 every two weeks is going to be approximately 2.5 times harder than coming up with $500 every two weeks!
The other prepayment option available to borrowers is to make annual lump-sum payments against the outstanding mortgage balance up to a fixed amount. Lump sum payments are in addition to the regular mortgage payment. They are applied directly the mortgage balance. The larger the lump sum, the more effective it is in decreasing the amount of interest paid on the mortgage.
In my case, my bank allowed me to make a lump-sum payment of up to 20% of the original balance. Again, there is no obligation to make a huge lump-sum payment. Most banks require a minimum lump-sum of atleast $100. Further, lump sum payments can be made throughout the year so long as they cumulatively do not exceed the maximum amount.
Let’s go back to our earlier example. The original mortgage balance is $100,000. The annual maximum lump sum mortgage prepayment is 20% of the original mortgage balance. The mortgage term is 5 years.
$100,000 x 20% = $20,000;
The amount of $20,000 is the maximum annual lump sum mortgage prepayment that can be applied to the mortgage during the term of the mortgage. This means that the borrower can apply lump-sum amounts up to $20,000 to her mortgage in each of the 5 years of the mortgage term.
Full disclosure – I never took advantage of the lump-sum payment option. Instead, I chose to increase my bi-weekly mortgage payment by the full 20% every calendar year. I committed myself to higher payments to avoid the temptation of “forgetting” to set aside money for a lump sum payment. A dear friend of mine made the opposite decision. She made lump sum payments every two weeks. She and her husband had a young family and she wanted the option of not paying extra money to her mortgage in case those funds, which would have gone towards the mortgage as a lump sum payment, were required elsewhere in the family budget.
b) Bi-Weekly Payments
You’ll note that throughout my example, I’ve referred to “bi-weekly” payments. This is because I personally hold the opinion that bi-weekly payments are best for paying off a mortgage. Monthly mortgage payments mean that you, the borrower, are paying the maximum amount of interest on your mortgage loan. While this is good for the banks, this is terrible for the borrower. One of the few ways to pay less interest on your mortgage debt is to repay it as fast as possible. Paying your mortgage bi-weekly will allow you to do that.
There are other payment cycles. I’ve already mentioned monthly payments, but there are also weekly mortgage repayment plans. For my part, I’ve always paid bi-weekly on my personal residence. On my rental properties, the mortgage is paid monthly for two reasons. First, rent from my tenant pays down the mortgage. Second, the interest on the mortgage balance is tax-deductible, so it’s to my advantage that the mortgage balance is not paid down as fast as possible.
I’m not a fan of weekly mortgage payment schedules. This is because the amount of interest saved on a weekly payment schedule is only marginally less than the amount of interest saved on a bi-weekly payment schedule. To my mind, it’s hardly worth the added stress of insuring that the money is in the bank every 7 days. Play around with a few mortgage calculators on the web and come to your own conclusion. If you’re headset on paying as little interest as possible, then a weekly mortgage payment schedule might be for you.
c) Get Life Insurance instead of Mortgage Insurance
Most people don’t realize this but mortgage insurance is a rip-off. The insurance pays the bank the amount of the outstanding mortgage balance in case the borrower dies. However, the premium for mortgage insurance stays the same every single month. This is a problem because it means that the borrower is paying the same amount of money for a lower amount of coverage each month as the mortgage balance decreases.
Assume that the mortgage balance starts at $100,000, that the beneficiary of the mortgage insurance is the bank, and that the monthly premium on that mortgage is $5. Every month, the borrower will pay $5 to the bank to insure that the mortgage balance gets paid if the borrower dies before the mortgage is paid off. If the borrower dies the day after taking out the mortgage and the insurance, the policy will pay out $100,000 an the mortgage gets paid off. Ten years into the mortgage, the mortgage balance is now down to $81,000. The borrower is still paying $5 per month in premiums on that mortgage. If the borrower dies ten years into the mortgage, the insurance policy will only pay out $81,000 to the bank.
Do you see the problem? The premium stays the same but purchases less and less coverage each month. This is not a good deal for the borrower. The monthly mortgage insurance premium remains the same even though the remaining mortgage balance is decreasing as each mortgage payment is made.
Instead of taking out mortgage insurance through the bank, get a life insurance policy on the life of the borrower that is equivalent to the starting balance of the mortgage. If the borrower dies before the mortgage is paid off, the full amount of the life insurance policy is paid to the beneficiary. After paying the mortgage in full, the beneficiary can keep the rest of the life insurance proceeds. This is a much better deal all around and the mortgage balance still gets paid.
While I was on holidays, I received a very excited email from my friend. Her assistant and the fiance had put in an offer on a house! And a week after I got back to my office, the assistant came to me and told me that she was only a few days away from taking possession. Of course, I couldn’t resist giving her even more advice – get a locksmith to meet her at the house on the day of possession to have the locks changed immediately – but I was deeply happy that my words had helped them in making one of the biggest purchases of their lives.