The Frugal Canadian

A frugal spender seeks to find new ways to save money and increase her net worth.

Tuesday, January 02, 2007

To Prepay or Not to Prepay?

We've started to look at entering the housing market and my husband and I are both torn on the idea of prepaying our mortgage and the size of our down payment.

With respect to our down payment, we are definitely putting down 25% to avoid mortgage insurance. We are questioning however, whether it's better to put a larger down payment such as 30-35% down. The opportunity cost of the larger down payment are forgone returns from investing. For example, on a house price of $300,000, we could put down $100,000 and benefit from lower monthly carrying costs or put down $75,000 and invest the additional $25,000 in the markets.

We've been pre-approved for a five year, fixed rate mortgage of 5%. From an investment standpoint, as long as we net 7.7% pre-tax, we'll have a better return on our investment with a smaller down payment. The extra down payment would leave us with monthly carrying costs of roughly $150/month, which is not a huge amount to us. Given that the S&P returned approx 15% in 2006 as well as strong historical equity returns, it seems silly to even be pondering a larger down payment. Yet, we are both debt averse, even though I consider the mortgage to be good debt. The idea of having a larger debt hanging over our heads is a bit unnerving.

Then there is the issue of prepaying a mortgage. We have always discussed prepaying a mortgage, being keen on the the idea that if we are aggressive, we could be mortgage free in 8 to 10 years. While this is hugely appealing from an emotional standpoint, we question whether it is in fact a smart financial move given the opportunity for larger equity returns.

The biggest risk I think most people fall into is that without prepaying the mortgage, people just aren't saving and end up spending the money. As long as we "pay ourselves" first, I see little financial benefit in prepaying a mortgage.

We are probably at least a few months away from purchasing a home, so we have some more time to think about it. What are your thoughts?

20 Comments:

At 9:45 PM, Anonymous Anonymous said...

I'm no financial wiz, but I think you'd need to earn 7.7% POST tax to gain the advantage that prepaying your mortgage offers. This site is the basis for my comment:
http://www.centa.com/CEN-TAPEDE/2003/expert/expert119-01.html

If you are really interested in investing excess cash, you may find the Smith Manoeuvre an interesting option. Se www.smithman.net for info on this option.

David

 
At 10:33 PM, Blogger The Frugal Canadian said...

I don't see why you would need a 7.7% POST tax return. If I earned a pre-tax return of 7.7%, at a tax rate of 35%, I'm left with an after tax rate of return of 5%. This allows us to break even with our pre-approval rate of 5%. While this won't hold true in a higher interest rate period, i think this is correct for our current situation.


While the Smith Manouevre is attractive from an interest deductibility standpoint, it's also likely to come at a higher interest rate, which would increase our required rate of return.

 
At 10:53 PM, Anonymous Alex Harford said...

There is an argument that says you shouldn't hold any fixed income investments in your investment portfolio if you have a mortgage to pay off. If you have any fixed income in a non-registered account, how much are you earning POST tax return on that?

 
At 11:40 PM, Anonymous Canadian Capitalist said...

FC: I think this is a question with no right or wrong answer because it depends so much on what the future holds which is unknown at this point.

However, I use an estimate of 6%-8% long-term pre-tax returns from a diversified portfolio because many pundits think that we are in a period of low returns especially in the equity markets. If you use the lower estimate, then saving 5% interest on the mortgage sounds like a good deal to me. Even 8% pre-tax returns isn't such a good deal if you are in a high tax bracket.

FWIW, my strategy is maximizing RRSP contributions followed by mortgage pay downs. I'll probably post my thoughts in a future post.

 
At 6:11 PM, Blogger Jay said...

Howdy. Found your blog while looking for info on e*Trade's Cash Optimizer Account.

We're in a relatively similar situation where we would like to buy a place, have a nice sum saved up that would give us a 25-35% down payment, but would kind of dread trading in our investments for a 25%+ down payment.

We've looked at the Smith Maneuver. It seems intriguing but we haven't fully analyzed it. In some basic discussion with our bank, we could get pre-approved for about prime -75. However, mortgage dollars converted for investment would be just over prime. I’m sure we could have tweaked the numbers more if we were a little more serious.

The Smith Maneuver in general seems to be a pretty decent idea to consider if you want to have your house and investments. However, everything seems so unclear nowadays (housing bubble?, US recession?, direction of interest rates?, etc) I’m not sure if I’d be ready to accept the burden of a house and invoke the Smith Maneuver at this point.

 
At 2:57 PM, Blogger GIV said...

This may be a newbie quesiton but...what does "prepaying" a mortgage mean?

-GIV

 
At 8:47 PM, Blogger The Frugal Canadian said...

GIV: Prepaying a mortgage, means paying down the mortgage debt faster than the bank requires you to. As an example, many mortgages have an amortization schedule of 25 years, meaning that if you stick the schedule, you'd make payments for 25 years. Many lenders allow you to make extra payments on your mortgage, so that you reduce the debt on your mortgage. This means you end up paying less interest over the life of the mortgage.

 
At 8:19 AM, Anonymous Anonymous said...

We've done a combination of maximizing our RRSP contributions and prepaying a small sum ($100 on each biweekly payment) for the mortgage.

I've done the math, and making this extra payment plus using accellerated biweekly payments (instead of monthly) means that we'll have our "25 year" mortgage paid off in 16 years, sooner if we increase the prepayments.

To me, the extra payments make the "light at the end of the tunnel" that much closer to us. We both have good pensions at work (aside from our RRSPs), so we're not as worried about maximizing investment returns. I think the question of prepaying really requires that people analyze their individual situations to figure out the best option.

 
At 8:20 AM, Anonymous Anonymous said...

We've done a combination of maximizing our RRSP contributions and prepaying a small sum ($100 on each biweekly payment) for the mortgage.

I've done the math, and making this extra payment plus using accellerated biweekly payments (instead of monthly) means that we'll have our "25 year" mortgage paid off in 16 years, sooner if we increase the prepayments.

To me, the extra payments make the "light at the end of the tunnel" that much closer to us. We both have good pensions at work (aside from our RRSPs), so we're not as worried about maximizing investment returns. I think the question of prepaying really requires that people analyze their individual situations to figure out the best option.

 
At 2:48 PM, Blogger Nhan said...

FC: if you can invest for a return greater than the cost of borrowing consistently over time you are better of investing than paying down the mortgage. Your house will appreciated overtime, by the time you sell your house hopefully you can sell it for a profit. The profit is tax free so this will offset part of the cost of borrowing. Say a 25 years mortage @5% for $300K house will cost you ~$224K in interests. 25 years from now if your house worth 500K. You net $200k ... this offset the interests you paid over the years. You gotta to remember too that unless you sell your investment every year you don't have to pay tax on it until the year you sell your investment so you only pay tax when you sell your investment. Some studies proved that investment out side RRSP sometime has greater benefit than investment inside an RRSP. Government can't force you to sell your investment but they do make you cash out your RRSP when you retire.

 
At 4:18 PM, Anonymous MillionDollarJourney.com said...

Ms. Frugal Canadian,

First time visitor, great site!

Anyways, about your mortgage situation. If you pay down your mortgage, you are getting a GUARANTEED pre-tax return of 7.7%. Pretty difficult to guarantee a pretax return of 7.7% on the market.

Frugal Trader
http://www.MillionDollarJourney.com

 
At 10:53 PM, Blogger The Money Bomb said...

I'm not trying to push the Smith Maneuver on you, but it seems particularly appropriate for you based on a couple of things you mentioned in your post, so I'd suggest doing some further research on it if you haven't already. You'd also have to change your basis of comparison if you implemented the SM; since you'd have both investments as well as a larger down payment, it comes down to a comparison of the deductible and non-deductible interest costs in SM and non-SM scenarios, as you've pointed out.

SM works especially well in cases like yours, where there is a 25% down payment and extra capital for investments. It's commonly implemented with readvanceable mortgages available at similar rates to standard mortgage products. In other words, you shouldn't have to go with a separate or more expensive loan to implement it. I won't shill for particular banks or products, but I'd suggest googling for common mortgage products that the SM is implemented with, and then checking the rates on them. You should find they're competitive.

Moreover, SM seems to be in line with your objective to pay down the mortgage as quickly. You wouldn't be paying it down as much as converting it to a tax-deductible loan, but these deductions would accelerate the conversion process by helping you pay down the mortgage quicker - in a similar timeframe as you describe, in fact. As you say, you're not comfortable with debt, but SM would allow you to maintain a comfortable portfolio of investments and market exposure for the duration of your mortgage period. Once the non-deductible mortgage is paid off, you could liquidate the portfolio to eliminate your debt, if you wanted to. In essence, you'd have your cake and eat it too.

 
At 4:00 PM, Anonymous Anonymous said...

Remember you are comparing 7.7%
risk free against uncertain investment returns.

Note also that if you have the option of ad hoc borrowing (line of credit) in your mortgage it may meet any need for maintaining an emergency fund.

Mike

 
At 6:49 PM, Blogger everydayinvestor said...

To echo Mike's comments below, the 5% mortgage prepayment is both after tax and risk-free

Anyways, I'm in a similar situation as well. Another point to consider is whether or not you think rates will be significantly higher when it come time to renew the mortgage

 
At 11:12 PM, Blogger NFtoBC said...

Have you decided yet? Here's some numbers:

If you pay the extra $25,000 on your mortgage, at 5% you will save $1250 per year in interest costs in perpetuity, as it is money you never have to find. If You chose not to increase your downpayment and you were in the 40% tax bracket, you would have to earn about $2083 before taxes to have $1250 after taxes to pay the mortgage. Thus your investment would need to return $2083 to equal the return of pre-paying your mortgage. This equals a required return of about 8.3% after taxes are paid.

Remember, money you never have to earn is untaxed.

 
At 7:39 PM, Blogger orange said...

In BC, you can be charged a 1% property transfer tax if this is not your first property AND your down payment exceeds 30%, which negates some of the interest savings of maximizing your down payment. You are best off putting less than 30% down, but more than 25% to avoid mortgage insurance.

 
At 9:47 AM, Anonymous Lisa Kane said...

I just came upon your blog while seaching for comments on the Federal budget 2007.
We have just paid off our mortgate in under 10 years . We are a modest one income family with 3 children. We have been extemely aggressive in paying it off. We have always increased our payments with any raise my husband received. We always told the bank what we were willing to spend per week and they would adjust the amortization accordingly. It was always a challenge for them since their calculators only worked in one direction.
I should mention that when we needed money for renos we waited for the raise and borrowed against ourselves but always increased the payments so our amortization never went longer; sometimes it shortened it!! The thing that struck me in your post was that being mortgage free would be emotional appealing to you. I can't tell you how good it feels to be free of such an enormous debt. I consider it my raise as a stay-at-home mother and a reward for all our frugal ways.
Personally I would only put down the 25%. I would hold onto your 5-10% and put it in a PC financial account. You may want to use it for the house and any work you would like to do. Investing in your house that way is something you will enjoy immediately. If you want to increase your payments on your anniversary date or if you want to double up your payments the money is there for you. I would see how you manage with your payments for a while and adjust it later. I am sure you will do fine based on your
frugal lifestyle. Good luck.

 
At 12:01 PM, Anonymous Anonymous said...

You got a rate of 5%. That's good. Did you use a mortgage broker or did you just use your bank?

 
At 7:12 PM, Blogger The Frugal Canadian said...

We didn't use a mortgage broker. We visited a couple of banks and played them off one each other vying for business. We also have a very good credit rating. It is not uncommon for banks to grant a rate below their posted rates.

 
At 12:08 PM, Blogger Luctor et Emergo said...

Remember to use time discounting, not absolute/relative dollars.

 

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