Month: November 2018

Rising Mortgage Rates & the Stress Test

Recently, people near and dear to my heart bought a new home. I was more than thrilled for them since their new place is lovely and will be a perfect nest for their growing family. And as they disclosed their numbers to me, I started to think about the impact that the rising mortgage rates will have on them when they go to renew their mortgage in 5 years. I’m fervently hoping that they are not underwater on their mortgage when it comes time for them to renew. The new reality in Canada is that if homeowners are underwater on their mortgages at renewal time, then there is precious little incentive for their lender to give them a preferential renewal rate.

 

What does it mean to be underwater on your mortgage?

 

You are underwater on your mortgage if the mortgage debt outstanding is higher than the market value of your home.

 

For example, if you owe $250,000 on your mortgage and the market value of your home is $200,000, then your mortgage is underwater by $50,000.

 

What is the stress test?

 

The Canadian government introduced a mortgage stress test to assist borrowers to determine if they could afford their mortgage if rates were to increase 2% above the posted 5-year rate. If the posted rate is 3.49%, then the person seeking a mortgage has to demonstrate she can still service the mortgage at rate of 5.49% (= 3.49% + 2%).

 

If you want to read the nitty-gritty details, here is the link as of the time of writing: How the Stress Test Works.

 

The short and sweet of it is this: if you cannot show that your finances could not support a mortgage at a rate 2% higher than the bank’s posted rate, then you cannot get the mortgage amount that you want.

 

Why does it matter if you’re underwater on your mortgage?

 

Being underwater matters when it comes time to renew your mortgage. Banks and other mortgage lenders are not keen to renew mortgages where the underlying asset, i.e. the property, is worth less than the debt. They reasonably and rightly understand that there is less incentive for a homeowner to pay the full price of the debt ($250,000) for something that is worth less than the debt ($200,000).

 

However, let’s assume that you want to stay in your home even though you’re underwater on the mortgage. The lender may not offer you the best rate since there’s less chance that you’re going to switch to another mortgage holder. Before the lender releases title on your property to another lender, you as the homeowner have to pay off the mortgage. But you’re underwater by $50,000 (= $250,000 – $200,000).

 

Another lender is not going to give you a mortgage of $250,000 on a property that is worth $200,000.  Secondly, lenders want homeowner to have some skin in the game so they generally want to see homeowners put down 20% of the value of the home. In this case, the next lender would only advance a mortgage of $160,000 (= 20% x $200,000).

 

As the homeowner, you would have to come up with $90,000 to get a mortgage from another lender. That $90,000 would cover the difference between the debt owed to your current lender, again $250,000, and the amount of money that your next lender would give you, $160,000, on your home which now has a market value of $200,000. Another way of looking at is that you’d have to come up with $50,000 to pay off your old lender and another $40,000 as a 20% equity stake in order to get financing from your new lender.

 

If your current lender is aware that you don’t have $90,000 kicking around, then your current lender has no incentive to offer you a rate that is lower than the posted 5-month rate. In other words, they’ve got you by the short and curlies. Why on Earth would your lender offer you a lower rate if they don’t have to? The only reason that your lender offers you “their best rate” is because they don’t want you to get a mortgage with one of their competitors.  If there’s no chance of you leaving, due to that pesky problem of not having an extra $90,000 lying around, then your lender has no motive to charge you less interest on your mortgage.

 

The second reason to not be underwater on your mortgage is that the new lender is going to subject you to the stress test. Not only do you have to come up with the down payment amount of $40,000 and another $50,000 to satisfy the deficiency between your mortgage debt and the market value of your home, you have to demonstrate to the new lender that you can afford the new $160,000 mortgage at rate that is 2% higher than the posted rate. If you can’t pass the stress test, then the new lender is not going to issue you a mortgage and you’re stuck with your current lender.

 

How to obtain good options for renewal time

 

You want to be in the position of having good options come renewal time. When it comes to mortgages, one of those good options is knowing that you can switch lenders if you need to. Once your current lender is convinced that you have the ability to take your mortgage business to their competitor, they will again be incentivized to give you a discounted mortgage rate, which is simply a mortgage rate that is less than the posted one.

 

In short, the discounted rate is a sweetener that is offered so that you have a good reason to stay with them. They know that it is easier to keep a current customer than it is to find a new one.

 

The main way for you to become a customer that they want to keep is by ensuring that you are making all of your mortgage payments on time and that your mortgage debt remains lower than the market value of your home. You cannot control what the residential market does, but you can control how much money you put towards your mortgage every time you make a payment. Using mortgage prepayment options means that you are eliminating your mortgage debt as quickly as possible.

 

I firmly predict that as mortgage rates continue to rise over the next 5 years, there will be many people who will not be in a position to move their mortgage to another lender due to being underwater on their mortgages, becuase they cannot pass the stress test, or both. The end result will be that these mortgage holders will not be offered discounted mortgage rates by their current lenders. In turn, this means that they will be required to make higher mortgage payments after renewal or else face foreclosure by the bank.

 

Do what you can right now to pay down your mortgage as quickly as possible so that you maintain the desirable position of not being underwater on your mortgage and ensuring that you will be offered the option of being offered a discounted mortgage rate when it comes time to renew your mortgage.

Bi-Weekly Payments vs. Semi-Monthly Paycheques

One of the easiest ways to cut down the amortization of a mortgage is by making bi-weekly payments. A bi-weekly payment is one where, every two weeks, your mortgage lender makes a withdrawal from your bank account for the purpose of paying your mortgage.

 

If you’re paid on a bi-weekly schedule, then there’s absolutely no issue with having your mortgage payment come out of your bank account the day after you’re paid. Money comes in – mortgage goes out. Easy-peasy for all concerned!

 

However, there are those folks who don’t get paid on a bi-weekly schedule. They might be paid monthly, with a mid-month advance. Perhaps they receive a mid-month advance and the bulk of their paycheque is paid at month end. For these people, a  bi-weekly payment plan has to be structured a little bit differently so that they can still save interest on their mortgage debt by decreasing the amortization period.

 

1. Open a second chequing account at Simplii or Tangerine. This will become your mortgage account. 

 

These are online bank accounts that are free.

 

If you are paid monthly and that you receive a mid-month advance, (or even if you’re only paid once a month), arrange to have your mortgage payment deducted from your mortgage account instead of from your current bank account.

 

Since there are 52 weeks in a year, the bi-weekly plan means that 26 payments are made to your mortgage every year. There will be two months in the year where the mortgage payment will be debited three times in the month. However, you will not be paid three time in that month since your employer only pays you twice a month.

 

You’ll need the mortgage account so that your current account isn’t debited unexpectedly, which will mess up the rest of your finances. At this point, you may be wondering how your finances might get messed up with the bi-weekly mortgage payment.

 

Bi-weekly mortgage payments will not always coincide with the days on which you get paid. If you decide to implement my suggestion, the mortgage account will always have a buffer of 2 (hopefully more!) mortgage payments sitting in it. So long as you automatically transfer money into your mortgage account from your mid-month advance and from the remainder of your monthly paycheque, the mortgage balance will be paid down every two weeks without fail because your lender will simply withdraw your mortgage payment from your mortgage account.

 

Do not use your mortgage account for anything else, except your annual property taxes and house insurance. Set up an automatic transfer from your chequing account to your mortgage account to cover the costs of taxes and insurance. This way, the money’s in place when you need it and you won’t have to touch the 2-month buffer of mortgage payments.

 

2. Do not use the lender’s bank account unless it’s free for life.

 

If you’re getting a mortgabe through a bank instead of a mortgage company, the bank will want you to use their bank products. They might even tempt you with one or two years of a free chequing account. My suggestion is to not take their offer. After the first year or two of free banking, you’ll have to go back to paying banking fees unless you’re wiling have $1500 or more held ransom for the privilege of free banking. What I call a ransom is what banks calls a “minimum monthly balance.”

 

I strongly suggest opening your mortgage account at one of the free online banks, Simplii or Tangerine. You don’t have to pay any bank service fees for any of their accounts, which means you don’t have to keep a minimum balance in your accounts to avoid bank fees. (I am not getting paid for this recommendation.)

 

And if you’re already banking with Simplii or Tangerine, then so much the better!

 

3. Figure out how much your mortgage payments will be.

 

You can figure out your anticipated mortgage payment with an online calculator. I say “anticipated” because the actual mortgage payment amount will be finalized on the day that you sign your mortgage documents.

 

BMO has a pretty useful calculator: https://www.bmo.com/main/personal/mortgages/calculators/payment/  (Again, I’m not receiving any compensation from BMO for recommending this calculator.)

 

When using this calculator, be sure to choose the option for determining the accelerated bi-weekly mortgage payment amount. This bi-weekly amount will come out of your mortgage account every 2 weeks once your mortgage is up and running. Take that bi-weekly amount and multiply it by 26, to get the annual total amount of your mortgage payment. Then divide the annual total amount by 24, since you receive your paycheque in 24 instalments over the year. This new amount, i.e. 1/24th of the annual total amount, is the amount that you should be automatically transferring to your mortgage account each time you get paid.

 

You can also pro-rate the transfers if it’s easier on your budget. If you receive 1/3 of your monthly pay at mid-month, the transfer 1/3 of the new amount on the 15th of the month. The remaining 2/3 of the new amount can be transferred at month-end or at the beginning of the month, whenever you get the bulk of your paycheque.

 

The sooner you start automatically transferring money to your mortgage account prior to taking possession of your new home, the bigger a cash cushion you’ll create.

 

Ideally, you start funding your mortgage account via automatic transfers from your current bank account before you even get your mortgage.

 

Why? It’s best to have a buffer of atleast 2 mortgage payments sitting in your mortgage account before the mortgage starts. Taking this step will allow you to adjust the rest of your budget to accommodate your mortgage payments. You’ll have had, at a minimum, 2-3 months to adjust to the impact that your mortgage payments will have on the rest of your financial goals.

 

4. The reason for this suggestion.

 

Why am I suggesting this method of payment? And why am I suggesting that you start now?

 

Again, it’s because your bi-weekly mortgage payments will not always coincide with the days on which you get paid. The mortgage account will always have a buffer of 2, or more, mortgage payments sitting in it. So long as you automatically transfer money into your mortgage account, the mortgage balance will be paid down every two weeks without fail.

 

I want you to pay the least amount of interest possible on your mortgage. To do that, you need to be paying down your mortgage every two weeks. (There’s also a weekly option but I don’t really like that one.) Every time you make a mortgage payment, you’re reducing the principal balance of your mortgage. Every dollar of principal that is paid off is a dollar on which you will never again pay interest.

 

Shaving years off your mortgage means less interest going to the bank because that money stays in your pocket!

Money is a Tool

A little while back, I read something online that said that some older women believe that they need not learn about money because it falls into the realm of things-that-men-know-about. These women believe that men are the only ones who need to understand money and that they will be fine so long as they have a man around.

 

I was literally blown away and couldn’t get to my computer fast enough to start writing this post! This is one of the most ridiculous concepts I have ever heard in my life. I had to ask myself – Why is this idea so foreign to me? Why am I having such a visceral negative reaction to this worldview?

 

The answer is as follows – money is a tool, much like a knife. If you’re smart enough to learn how to use a knife, then you’re smart enough to learn how to use money. A tool is a tool and its functionality doesn’t change based on the gender of the person who wields it. A butter knife is a butter knife whether held in the hand of a woman or a man. Similarly, money’s functionality doesn’t change – it purchases options for both women and men. Body parts have absolutely nothing to do with it!!!

 

I realize that many households run on a division of labor, and perhaps handling money is one of those items that falls along gender lines in some households. However, a division of labor is not the same thing as saying that one person cannot learn how to use a tool simply because their private bits are on the inside while someone else’s bits hang on the outside.

 

All people come into this world naked – no one is born knowing how to use any of the tools that have been invented by everyone who came before us. Adults don’t expect babies to know how to do very much beyond cry, poop, and sleep. For the first few months, we get a pass so long as we’re doing these things on a sufficiently normal schedule. However, there does come a point where we have to start learning how to use the tools that are available to us so that we can be fully functioning adults.

 

Money is one of those tools. My fervent hope is that the idea that only men need to know how to use this tool is one that will be extinguished forever. Every one needs to know how to use this tool in order to live a life that is truly reflective of their personal goals, dreams, desires and priorities. Parents teach all children how to use tools that are necessary to their offspring’s survival because parents want what is best for their children. It is perplexing to me that parents would purposefully limit their daughters’ armamentarium of tools by failing to teach them about money, which is so vitally important to achieving the financial goals that their daughters may have for their futures. The more money there is, the more options there are.

 

(And while we’re on the subject, washing machines and clothes dryers are tools too. There’s nothing intrinsically female about these machines. Both will start and operate properly whether they are loaded and unloaded by a man or by a woman. Yet it never ceases to amaze me how many older men – with wives or without – never consider doing their own laundry.)

 

Thankfully, dinosaur-esque attitudes about what topics are suitable for men and what topics are suitable for women are dying. Money is a tool that benefits all people because it affords them the ability to exercise financial agency over their own lives. Knowing how to use money as a tool is vitally important for everyone, regardless of their gender. Trusting someone else to take care of you for your whole life is a huge gamble. Even if you’re married to the most loyal, ethical and wonderful person in the whole world, someone who could never dream of harming a single hair on your head, there’s no guarantee that this magnificent person will always be around. There are things such as accidents, kidnappings, unemployment, comas, and death which can all work to prevent Magnificent Person from taking care of you every single day for the rest of your life.

 

This is why it’s imperative that you learn how to operate the tool called money. You have to know more than how to pay the bills. You need to know that part of every dollar that crosses your palm needs to be set aside in an emergency fund, and that your emergency fund needs to be worth atleast 3 months of income. You need to know that paying interest on credit card debt is the equivalent of setting money on fire. You need to know that it’s generally best to pay off your home before you retire so that you can rely on its equity if you need to pay for nursing home care. You need to know that from the smallest acorns do the mighty oaks grow – the same is true of your money. Steady contributions to your investment portfolio will yield a nice, fat cash cushion for you in the future.

 

There are many lessons about money that take a lifetime to learn, and you bear a responsibility to yourself and to your loved ones to learn how to manage the money that comes into your life. And it’s also your duty to teach the young people in your life how to properly manage their money, how to stay out of debt, and how to invest for their futures.

 

So many of us in the FIRE-sphere think about the financial independence that money will bring to us. Some of us dream about retiring early. However, there’s insufficient emphasis on the nuts and bolts of money that are just as vitally important to those who don’t live and breathe FIRE. Money is a tool – everyone needs to know how to use this tool so that they can pursue their own dreams and goals.

 

 

There’s no need to pay interest on your credit cards!

I want you to know that I use credit cards. Frankly, I love the convenience of them. When I don’t have time to run to the bank machine to grab some cash, it’s very comforting to know that I can slide my credit card out of my wallet and still buy whatever it that I need at the moment. Credit cards are a seductively easy way to replace cash when it comes to paying for everything legally available under the sun. There’s no annual fee to worry about and I even earn rewards for using my card. The cherry on my sundae is that I earn points towards free groceries – score!

 

The only negative that I’ve been able to associate with credit cards is the manner in which they facilitate debt problems. In other words, they make it ever-so-easy to get caught in the debt trap. See, when the bank issues you a credit card, the bank sets a limit on how much you can spend. And when you get close to that limit, the banks will increase limit so that you can continue to buy-buy-buy. From what I’ve observed with my own credit cards and the credit lines of others in my circle, the limit that is assigned to your card is completely and utterly divorced from the amount of disposable income that you have each month with which to pay off your credit card balance when the bill comes due. I used to have a $9,000 limit on one of my cards! I can assure you that I do have $9,000 each month that can be put towards my credit card.

 

Credit cards are here to stay. Let’s face it – society is not moving en masse back towards cash. There are the diehards who only use cash, and their numbers are dwindling. The last time I was at the airport, I noticed that passengers must use a credit or debit card to pay for their baggage fees. Excuse me? How is it possible that the words “Legal Tender” don’t apply at the airport?

 

The cornucopia of credit cards is not going to disappear anytime soon, but that doesn’t mean that you have to pay interest for the privilege of using them. Use your credit card as much as you want, but ensure that it is paid off in full by the due date. There are multiple ways to do this.

 

There’s the Traditional Method: the statement arrives, you see the balance, you pay the balance in full. This method is old-school. It’s incredibly effective. I don’t know of a single person who has been charged a penny in interest by paying their credit card balance in full before the due date. The banks lend you money via your credit card, then they ask to be re-paid if you use it. When the bill comes in, you repay the bank their money. Everyone’s happy and you get to do it again the following month. The Traditional Method works like a charm.

 

There’s my Obsessive Compulsive Method. I use my card. I check my account online. When the charge is posted, then I know that I will get the points for my purchase. I then go to my bank account and make an online payment for the charge in full. This method ensures that my credit card statement shows a balance of $0.00 by the time it’s sent to me. The OCM is a bit more time-consuming but it ensures that I don’t forget to pay my bill due to other stuff going on in my life. I have the satisfaction of knowing that all of my charges are paid off before the statement is issued – there are no debts hanging over my head.

 

Very recently, I learned about a third method – the Disposable Income Method. It involves pre-determining how much money from your paycheque to allocate to your credit card each time you are paid. You then tell your credit card company to set your credit card limit at this amount. You also tell them to freeze your credit limit, which means that they cannot raise your limit unless you ask them to. Then you use your card in the normal course and you pay off your credit card in full from each paycheque.  For example, if you know that you can pay $1000 to your credit card account from your paycheque, then you arrange for the limit on your card to be $1000. When you get paid, you pay $1000 to your credit card. You credit card bill gets paid in full and you never carry a balance, which means that you’re not paying interest to your credit card company.

 

This third method has many benefits.

 

One – You never spend more than you can pay off in one paycheque. I will venture to say that most people with five-figure credit limits are not in a position to pay off their five-figure balances in full each month. This is why they carry a credit card balance and why they pay interest on their credit card balances.

 

Two – You will build your credit history quickly. There will be a solid record of you borrowing money on your credit card and paying it back promptly.

 

Three – You can still collect point or airmiles or free food, or whatever benefit it is that you card offers. You can still spend money however you want to, just like you did before. However, you’ve taken the very adult step of ensuring that you’ve prevented yourself from spending more money than your budget can handle.

 

Four – If your credit card is used fraudulently, then the damage that is inflicted is limited to a relatively small amount of money, i.e. the pre-determined amount that you can pay from your paycheque. The criminals cannot go hog wild with your card.

 

And if you’re already in debt, the answer is to stop using your cards. With rates pushing 30%, there’s no way that you can get yourself out of debt while still accruing interest charges on your credit cards. And if you’re paying 30%, then you might as well light your money on fire for all the good that it’s doing you. Paying interest is giving money away to the bank. That money should be in your pocket, not theirs!

 

You’ll need to go on a cash diet, while making payments to your credit card. Pick an amount – higher is better – and pay that amount to your credit card every single month until your card is paid off. Do not make any charges on your card! This means, you stop all auto-pays on your credit card. Why? Auto-pays are new charges, against which interest will be charged until you’ve paid off your debt. You will pay for your life with cash until you get out of debt. And if you have more than one credit card, you will continue this process until all of them have balances of zero. Check out the Snowball Method for detailed instructions on how to get out of credit card debt.

 

Once you’re out of debt, you won’t be paying interest to the bank anymore. You can use your credit cards again, but only if you are committed to one of the three payment methods.

 

All three of these methods work to keep you from paying interest on your credit cards. Pick one of the three methods outline above – all equally effective – to ensure that you don’t pay any interest to the banks. You can even combine them if you’d like. By following any or all of these three methods, you’ll pay for what you’ve purchase and not a penny more!