John in Money, HomeBuying, Real Insight, In the News
Ed note. Real Insight is a periodic feature decoding some of the many mysteries surrounding HomeBuying.
Last weekend’s National Post featured an article which questioned whether or not 40-year amortizations for mortgages are good for consumers. The key argument against long amortizations was that consumers end up paying significantly more in interest over the life of a mortgage. But is this increase in interest payments enough of a reason to put off your home purchase? The bottom line is not as simple as some media headlines would have us believe.
How has the 40-year amortization helped HomeBuyers?
While there is no doubt that longer amortizations are costlier overall, the 40-year amortization mortgage has helped first-time HomeBuyers jump onto the property ladder in the first place. The longer amortization means that HomeBuyers have more time to pay off their mortgage and, as a result, can afford to spend more. To see this in action, consider this example: a family earning $60,000 a year with a $20K down payment would be able to afford a $236,000 home with a 25-year amortization. Bump the amortization up to 40 years and the same family can now afford a home worth $273,000. Housing options in the $236,000 range are scarce in the City of Toronto, but with a budget of $273,000, the door of opportunity widens slightly.
How much more are you actually paying in interest?
According to the Canadian Real Estate Association, the average sale price for a home in July 2007 was $311,495. With no down payment and a 25-year amortization, you would pay $226,202 in interest over the life of the mortgage. This is assuming an interest rate of 5.85% and accelerated bi-weekly (every two weeks) mortgage payments. Increasing the amortization to 40 years increases your interest payments to $351,134 over the 40-year life of the mortgage, a difference of $124,932.
A similar example in the National Post article shows that HomeOwners make significantly higher interest payments over the 40-year period. This discrepancy is due to the Post's assumption that HomeOwners will make monthly mortgage payments instead of accelerated bi-weekly payments. In this example, interest payments went from $277,993 for a 25-year mortgage to $488,116 for a 40-year equivalent, a difference of $210,123. While it is interesting to note that the Post's example illustrates the most extreme difference that may exist between the two amortizations, the more important lesson for HomeBuyers to take away is that you would save $136,982 in interest payments by simply switching your mortgage payment plan from a monthly schedule to an accelerated bi-weekly one, even if you do choose to go with the costlier 40-year option. (Going bi-weekly means that you will make approximately 2-3 more mortgage payments a year, but these little extras add up to big savings, so dig deep.)
Do you need a 40-year amortization mortgage?
Some HomeBuyers are using the longer amortization as a way to super-size their home purchase. But just because the banks says you can spend more on a home, it doesn’t mean you should. HomeBuyers who are willing to spend less on a home and decrease the amortization period on their mortgage stand to gain in the long-term. Not only will you be debt-free faster, but a greater portion of your mortgage payment is going into your pocket – as principal payments or home equity – instead of your bank's. Which means that if you decide to sell your home 5-10 years after purchasing it, you will have more money invested in your current home which could then be used as a down payment towards your next home.
What if a 40-year amortization is your only option?
But if a 40-year amortization mortgage is the only way you can get onto the property ladder, should you still buy? To answer this question, let’s look at two different scenarios.
HomeBuyers who plan on living in their home for the long term (e.g., anywhere from 15 to 40 years), have little to worry about because they are less likely to be affected by short term dips in real estate prices. The long-term HomeOwner only needs to worry about making their mortgage payments on time and in full. One way for you to pay off your mortgage earlier and cut down on interest payments is to increase your mortgage payments as your salary increases (one rule of thumb is to make payments according to a set formula, such as putting 30% of your income towards your mortgage, regardless of the actual amount you earn). But irrespective of whether you decide to increase your payments, you can rest well knowing that the appreciation in the value of your home will likely exceed any interest you have paid over the 40 years of their mortgage. For example, a quick look at Toronto home values since 1973 shows that average home prices have increased 800% over the past 34 years.
HomeBuyers who are purchasing for the shorter-term (e.g., 5-10 years) with little or no down payment, however, have to be concerned about short-term dips in real estate prices. Buyers with a 40-year amortization are more vulnerable than other buyers because less of their mortgage payment is going towards their principal. Looking at our previous example, the HomeBuyer who uses a 25-year mortgage to pay for their $311,495 home (just below Toronto's average home price) will have contributed $44,076 towards their mortgage after five years versus the $21,589 contributed by those with a 40-year equivalent. This means that if you have a 40-year mortgage, you will have less equity saved up in your home to protect you from a drop in real estate prices. Our HomeBuyers guide has a Real Life scenario outlining some of the things short-term HomeBuyers should think long and hard about before purchasing.
One thing shorter-term buyers can do to minimize their risk is to buy a home that they can grow into over time instead of buying one they are going to have to sell in several years. Now, by "growing into," I don’t mean buying a bigger home - this isn't and shouldn't always be an option. But if a 2-bedroom home is all you can afford, try to find a home that has room for an addition or can be renovated in some other way. If real estate prices drop, you might find it more economical to add an extra bedroom to your existing home than to move homes.
For all consumers, buying real estate involves some degree of risk and HomeBuyers need to be aware of these risks before jumping in. Decide on what a home means to you. What price are you willing to pay to ensure that you and your family live in a home or a condo? Can you commit to staying in your home for as long as necessary? If your decision is based more on 'like to have' rather than 'need to have,' how much are you willing to pay for a feeling?
Take time to decide on what makes the most sense to you, but set a time-limit: wait too long and rising home prices may become a fast-moving target. Before you buy, commit yourself to sticking to the most disciplined mortgage repayment plan you and your family can manage. Be honest about your financial habits and agree to every decision together. Above all, remember that no matter what you decide, your plan is only as good as your follow-through.
John is a sales associate at Prudential Properties Plus in Toronto and a founder of Realosophy. Email John
Hi John, Great analysis. I'd just note that inflation sometimes offsets a lot of price appreciation (in most Canadian markets anyway). Therefore, in the early years of a mortgage, that lessens the amount by which interest can be offset by appreciation. Cheers, Melanie
Posted by: Toronto Mortgage Broker | November 08, 2007 at 02:10 AM