Back in the summer of 2008 I bought my house and went with a variable rate mortgage at prime – 0.50. When I picked my mortgage I did not expect seeing the subsequent economic events unfolding. I did not think I would go through 50 bps rate cuts and end up with a rate as low as 1.75%. It was all in hindsight, no claim to fame in this post.
I chose a variable rate at the time because I perceived the economy to be somewhat exhausted. I never tried to predict where the rates would be in the long run, I simply said to myself that for the short term, there was a good chance rates would not be moving higher. I also knew that I can always switch to a fixed rate mortgage if I started losing sleep over interest rate increases. My initial variable rate in July of 2008 was 4.25% and I was willing to wait until it broke my psychological risk level of 5.00% before fixing it.
Did you notice that I had my risk level identified? I also acted on my perception of the economy at the time by keeping a close eye on economic data while ignoring any outstanding predictions. Finally, my ace in this game was to be my lump sum payments every year for the first few years which would help me get ahead if interest rates were to rise in the future.
Fast forward to 2010, Canada’s growth is being revised downwards and the US economic recovery has stalled. A hold in interest rate hikes is justified in the short term in my opinion. This makes my decision to stick permanently with a variable rate mortgage more feasible with a low risk since there is still a lot of margin before rates hit 5% again.
The lump sum strategy
My mortgage started at 200k in 2008 and should reach about 130k by the end of 2010. Every year I pay a lump sum of 20k, 10% of my mortgage which is the maximum my bank allows me to pay.
You see every dollar you inject in your mortgage immediately gets to work for you by reducing your principle and saving you interest. You will save time because you just shaved years off of your mortgage time-line and money from the all the interest you would have paid.
Let’s use the average Montreal mortgage for our case study:
Average Montreal Mortgage:
Average Applicant Income: $65,529.00
Average Co-Applicant Income: $44,763.00
Average Loan: $222,582.00 (rounded to $222,000 for our example)
Using the following mortgage calculator, we will take a look at 3 cases for 3 amortization periods (25, 30 and 35 years) assuming a fixed interest rate at 4%.
Case 1: No lump sum payments
Interest paid over 25 years: $128,330
Interest paid over 30 years: $158,035
Interest paid over 35 years: $189,003
Case 2: 10% lump sum paid in the first 2 years ($22,000 in year 1 and $22,000 in year 2)
Interest saved over 25 years: $53,156 + you finish 6 years and 11 months earlier
Interest saved over 30 years: $69,529 + you finish 9 years earlier
Interest saved over 35 years: $87,911 + you finish 11 years and 3 months earlier
Case 3: $10,000 lump sum paid in the first 2 years ($10,000 in year 1 and $10,000 in year 2)
Interest saved over 25 years: $27,486 + you finish 3 years and 5 months earlier
Interest saved over 30 years: $36,627 + you finish 4 years and 6 months earlier
Interest saved over 35 years: $47,273 + you finish 5 years and 9 months earlier
I have linked to the calculator above if you wish to run your own numbers. Those amongst you with bigger mortgages or higher rates will be even more surprised at the results.
Mortgage over Investing
I choose to invest my lump sums in my mortgage before anything else. Even if the return is as low as 2.5% it is risk free return. Higher returns require bigger risks, just look at my portfolio for an example.
The one return that is priceless is the peace of mind once the mortgage is reduced to an insignificant amount or completely paid off. My lifestyle security is above any other return since the household runs on 1 income.
The 2.5% I mentioned is my current mortgage rate, but what I will end up saving is much more than that compared to current fixed rates and especially if the rate increases dramatically during subsequent years that I will avoid paying due to finishing earlier or to having a much lower amount outstanding.
Donating to Banks
Amongst the things I hate the most is giving my money to banks for free. When you don’t make any effort to accelerate payments on your mortgage, you are essentially benevolently giving a lot of your after tax money to the bank in interest payments.
In the scenario above, interest paid over the amortization period is between 2x and 3x the average applicant’s income. Investing a little bit of effort into budgeting would go a long way in saving you the equivalent of a year’s salary pre-tax. Imagine how much money you could recover from the government if the interest you saved is invested in an IRA or an RRSP.
You can do it too
Many amongst you have mortgages; don’t let the lump sum numbers scare you. You can put together a lump sum by the end of each year without sacrificing your family’s lifestyle. Play around with the numbers as it will give you a good idea for a plan and work on it. Any amount of money you decide to put on your mortgage produces a winning scenario in the end whether your mortgage’s interest rate is fixed or variable.
What did you pick for your money? Investing over paying off the mortgage or paying off the mortgage over investing and why?