Mortgages: Go long

The recent creation of 40-year and longer mortgages has given rise to criticisms that such financing options merely encourage people to throw away more money on interest payments. Here is the sort of example used to demonstrate this essentially silly proposition.

Consider a $300,000 home financed completely by a 7% mortgage with a 25-year amortization period. The total $330,374 worth of interest paid over 25 years would exceed the purchase price of the house. Spread over 40 years, the mort-gage interest paid would be $584,426, almost twice the price of the house.

Critics reason that more interest is worse than less interest, hence stretched-term mortgages are bad.

But let's look at the logical conclusion that flows from such an argument. Considering the above $300,000, 7% mortgage, apparently a 10-year amortization term is superior to 25 years, since the interest paid would be only $161,138, rather than $330,374. A one-year mortgage is better still, since the interest paid would be only $11,330. In fact, the best way to finance a home is one that requires no interest payments at all. All homes should be purchased with cash!

Since the least-interest-is-best principle leads to such an unacceptable conclusion, there must be something wrong with the logic. The error is that critics who employ such reasoning do not consider the time value of money. That is to say, such critics treat a $1 today as the same thing as $1 a year from now, 25 years from now, or even 40 years from now.

Suppose you could earn 7% on your savings. If I were to borrow a dollar from you today, would you not consider my repayment of $1.07 a year from now as being just equivalent to the dollar you are lending me today (not a penny more or less)? What if instead you were the borrower? Suppose you wished to buy something today, but had to take out a one-year loan to finance it. Say the best interest rate you could get was 7%, and that you were willing to borrow at this rate. Would you not consider each $1.07 that you must repay a year from now as perfectly satisfactory with respect to, and in fact equivalent to, each dollar you are able, via the loan, to get your hands on today?

At a 7% interest rate, $1.07 to be paid a year from today is not the same as (is not equivalent to) $1.07 today. The $1.07 a year from now is exactly equivalent to $1 today. That is, the equivalent value today (or, using finance lingo, the present value) of monies paid or received at future points in time is arrived at by simply knocking off the interest. If someone obtains a$300,000 mortgage today at 5%, 7% or any other interest rate, and for any period, whether one year, 20 or 40 years, the equivalent value today of the total mortgage payments to be made in the future (principal and interest) is precisely $300,000, the amount of borrowed principal.

Since simply adding up the dollar amount of payments to be made on a mortgage without regard for each dollar's

different present value is plain silly and cannot be used to say anything useful about mortgages, how then should people approach the issue of interest and mortgage amortization?

With respect to interest costs and paying down consumer and mortgage debt, there are two important points to remember.

First, accumulated saving, otherwise referred to as investment or equity, is the difference between one's assets and debts. New saving or, synonymously, new investment or increases in equity thus may be formed either by increasing assets or by reducing debt.

Second, since Canadians cannot deduct mortgage or consumer-loan interest for tax purposes, paying off consumer or mortgage debt is typically the best risk-free investment a Canadian borrower can make. Paying down debt is a risk-free investment because such action increases one's equity with certainty by precisely the amount of the debt repayment. And, unlike risky investments, there is no doubt with respect to the rate of return or interest rate saved (earned) in the process. For example, for a person, say, in a 43% tax bracket, paying down principal on a 7% mortgage debt is equivalent to earning a risk-free interest investment return of 12.3% before taxes. Naturally, the fastest way to increase one's equity is to pay down higher interest-rate debt first (for example, credit-card debt) before seeking to pay off mortgage principal.

With the above two points in mind, one should employ the following steps when approaching the issue of home purchase and mortgage finance:

If the home purchaser has high interest-rate consumer debt, any savings currently invested in risk-free instruments (bank deposits, GICs, etc.), over and above that required for a rainy day reserve, should be used to pay down such debt. If no such debt exists, then use all available risk-free savings above the rainy day reserve as down payment, thus lowering the required mortgage principal and saving more risk-free interest after tax than could be earned elsewhere.

Given the mortgage interest rate, the mortgage amortization period (whether it is 10, 20 or 40 years) should be that consistent with the desired maximum monthly payment that will not interfere with other higher-priority spending or investment. If there is no term long enough to bring the monthly payment down to the above comfort-level amount, the particular home and associated mortgage are not affordable.

Even though some people may wish to place some of their savings in risky investments (for example, vehicles like stocks or exchange-traded funds), since paying down mortgage principal is typically the best risk-free investment Canadians can make, one should try and obtain a mortgage that will allow extra principal repayments at little or no cost.

(prepared by Alex Macmillan/Financial Post)


Touch base with Salmon Arm mortgage experts:

VIC HAMILTON
Bayfield Mortgage
250.833.9183
1.866.252.4526
vic@sunwave.net

SUE FOUBERT
TD Canada Trust
250.833.8790

CORINE HILD
Tekemar
250.832.8766
1.800.658.2345
child@sunwave.net