Elimination of 40-year mortgages
Don’t pay until 2048 has become a very attractive payment plan for Canadian homebuyers. But if that’s not enough incentive, the mortgage institutions have also introduced zero equity mortgages (no down payment) and interest-only loans. These options have become especially attractive for first-time homebuyers.
Recently, the Federal Government has announced new rules to eliminate 40-year mortgages and zero down mortgage options. By October 15th, you have to have a minimum down payment of 5% and the longest amortization will be 35 years.
Benefits of 40-years
The main reason anyone would choose a 40-year mortgage is for affordability. You can blame that on the rising Canadian housing market. Extending the amortization not only lowers your monthly payments but also allows you to get a bigger mortgage for the same monthly payment. Let’s look at a few simple numbers.
On a $100,000 mortgage at 6%, with what used to be a normal amortization of 25 years would mean monthly payments of $640. Extending the amortization to 40 years would lower the payment to $545. That means you can spend $95 on something other than your mortgage.
Another way to look at this is if you could afford the $640 per month payments but you extended the amortization to 40 years, you could now borrow $117,500 and get a more expensive house. Or what some people have done is spent the extra $17,500 for renovations.
At what price?
Although longer amortizations create greater affordability for housing, it comes at a big price. We live in a world where affordability is all about whether we can afford the payments. Lowering the monthly payments simply means we can go into more debt. More debt means more interest and less equity. These are two sure things to slow down your path to financial freedom.
With the 25-year amortization, after 25 years assuming the same 6% interest over the entire period, you will pay a total of $191,943 in payments. That means your $100,000 mortgage cost you $91,943 of interest over 25 years.
On a 40-year amortization, your total interest jumps over 75% to $161,643 of interest. You are paying more interest than the original borrowed amount. In many cases, you will pay more interest than the original price of the house you buy. That’s ridiculous! A 40-year amortization will save you $95 per month in payments but at a cost of an extra $70,000 of interest on a $100,000 mortgage.
35 years is not much better
There’s no question the government is doing the right thing in preventing people from extending the amortization periods too far. They obviously want to prevent the fiasco that is happening to the US housing market from occurring in Canada.
If you look at the numbers, moving from a 40-year mortgage to a 35-year mortgage will save you $24,238 in interest on the same $100,000 mortgage (at 6%). That’s great but with the 35-year mortgage, you will still pay $137,405 in interest, which is more interesting than the original borrowed amount.
My two cents
It used to be that buying a house was like a rite of passage. Before you could buy a house, you had to show that you had some financial discipline. Not only did you had to save a significant down payment but you also had to afford a 25-year amortization. Although some new home buyers will argue that rising house prices make it impossible to enter the housing market, remember that buying a home should be a result of some good initial habits. We live in a world that encourages debt, which is the biggest cancer to financial freedom.
Creating more access to debt may improve our perceived lifestyle but it also comes at a significant price. If you don’t believe me, just take a look at what too much debt has done to people south of the border.