Last week, the Toronto Star’s Ellen Roseman wrote an article titled 40-year Mortgage Comes with Hidden Hazards. On Move Smartly, we often try to pick up where the main stream media left off. Instead of just telling readers the 40-year mortgage is bad for their pocket books, we try to give practical advice that addresses the needs of today's home buyers.
Let me start off by saying that a 40-year mortgage is not for everyone. Anyone who qualifies to buy a home with a 25-year mortgage but opts for a 40-year mortgage instead because it leaves them with a little more spending money in their wallets is downright foolish. If you want more spending money in your pocket, spend less on your home - don’t get a 40-year mortgage and pay more interest over the life of that mortgage.
Having said that, does this mean that a 40-year mortgage is wrong for all home buyers? Is a 40-year mortgage like long term renting? Not quite.
Unlike Roseman, many of today's first time buyers are not buying their first home with their partners and therefore don’t have the luxury of counting on a second income to help pay their mortgage. Last year, the Toronto Star reported that single women account for 20 per cent of Toronto's real estate market. Many of the home buyers who are turning to 40-year mortgages are single income buyers who can’t afford to buy a home with a 25-year amortization.
So what is a single (or similarly positioned) first time home buyer to do? Should they eschew buying a home today out of fear that they’ll be paying their mortgage well after they’ve retired, as Roseman suggests. This is definitely one option.
But if the single home buyer shouldn’t buy today, when should they buy? Should they wait another 5-10 years for their salary to increase enough for them to afford a home with a 25-year amortization? This strategy is also risky, since renting and delaying your purchase for 5-10 years also pushes your mortgage payments further into your retirement years.
For the home buyer who doesn’t want to wait another ten years to be able to afford a home with a 25-year mortgage, here are a couple of tips to help you beat the risks and costs of the 40-year mortgage.
Firstly, do not buy your house with zero down. Buying a house with no downpayment is foolish. Buying a house with no down payment and opting for a 40-year mortgage is doubly foolish. There are risks associated with buying a home which are not exclusive to the 40-year option - Realosophy’s Home Buyers Guide has some real life examples of things you should be aware of and Roseman’s article also covers some of the risks. Save up at least 5% for a down payment and at least 2% to cover the closing costs associated with buying your home.
But by waiting to save up for a down payment, aren't you just prolonging your home purchase which means you’ll be making mortgage payments later in life? Absolutely, but this is where I draw the line. I don’t advocate zero down mortgages because the costs and risks associated with them are just too high. So buckle down, save a small down payment and then look at buying your first home.
Secondly, memorize these words “Accelerated Bi-Weekly.” These are the most important words you’ll need to know when signing your mortgage documents. Say them out loud a few more times to make sure they stick.
Accelerated Bi-Weekly, Accelerated Bi-Weekly, Accelerated Bi-Weekly
When your mortgage broker prepares your mortgage documents, she is going to ask you whether you want your mortgage payments to come out monthly or bi-weekly. This is when you are going to have to recall today’s word(s) of the day: “Accelerated Bi-Weekly.” Don’t confuse this with just bi-weekly which is something very different as far as banks are concerned. Accelerated bi-weekly puts more money in your pocket, not the banks'. Let’s look at a real life example to see how this works.
Suppose you are about to sign up for a $250,000 mortgage. Your mortgage broker gives you the option of paying $1,312 monthly or accelerated bi-weekly, under which you would pay half of that amount, $656.11, every two weeks. What’s the difference? With monthly payments you would end up making 12 payments of $1,312 each year for a total of $15,744. Under accelerated bi-weekly you end up making 26 payments of $656.11for a total of $17,058. You’ll notice that the accelerated bi-weekly option results in you making the equivalent of one extra monthly payment of $1,312 each year. This one extra payment reduces the life of your mortgage from 40 years to 30.8 years. By choosing accelerated bi-weekly, you’ll have your mortgage paid off 9 years ahead of schedule and will have saved over $104,649 in interest payments.
Here’s a screen shot of the RBC mortgage calculator I used, which I was happy to see defaulted to accelerated bi-weekly payments.
The last tip is to increase your mortgage payments as your salary increases. Don’t count on making lump sum payments during the year. While many home owners intend on making additional payments to their mortgage, the reality is that few do because it’s hard to save up the cash. It’s easier to increase your mortgage payments as your salary increases because you don't miss the cash as much. The key with this tip is to do it regardless of how big or small your salary increase might be. If your salary increases by 2% each year, increase your mortgage payment by 2%. Even this small increase will cut years off of the life of your mortgage if you stick to it every single year.
A 40-year mortgage can be hazardous to your financial health if you don’t take the necessary steps to mitigate the risks and costs. But if you have a real need for one, follow the tips above and you’ll have a 40-year mortgage in name only. Your mortgage will actually be paid off years earlier.