Mortgage payments made with After Tax CashMore Canadians are becoming aware that, since mortgage interest is not tax-deductible in Canada, (as it is in the US), you are making mortgage payments of both principal and interest with money that you've already paid tax on - "after tax dollars". This makes it even more important to eliminate the drainage of disposable income as soon as possible!
Prepayments give great Return on InvestmentIf you pay an average of 6.5% in mortgage interest, for each $1,000 by which you reduce your mortgage principal you will save $65 in after tax cash every year. If you are paying taxes at a marginal rate of 40%, you have to earn $108.33 each year to pay the interest on every $1,000 of principal outstanding...a heavy burden, but also a tremendous implied benefit to reducing this balance. In fact, the example shows that the "return on investment" for making prepayments on your mortgage is 10.833% before tax and 6.5% after tax - far better than most fixed return investments (bonds, GIC's etc.), which currently average about 5.0% before tax and about 3.0% after tax for the same individual.
- Increase your payment annually to the most you can afford. The upside is that most lenders will allow you to reduce it again to the previous level if it turns out to be too great a burden, or your circumstances change.
- Use your RRSP-driven tax rebate religiously as a mortgage prepayment method. Even if you can only prepay annually, make sure these funds are set aside for that purpose. Many Canadians will borrow (at prime) to buy an RRSP to ensure the maximum rebate. When applied to the mortgage principal, this refund is a "gift that keeps on giving". Combining the refund with the tax-free interest earned on the RRSP over the subsequent years will quickly outpace the short-term interest costs of the RRSP loan.
- Make accelerated bi-weekly payments to get a "free" principal reduction equivalent to one full mortgage payment every year - painlessly. Unless you are paid weekly it makes little sense to make weekly payments. All you'd be doing is making a smaller payment, and deferring the difference for a week.
- Make use of double-up privileges wherever possible, telling yourself that you will "skip-a-payment" whenever necessary...then skip only when you absolutely must.
- This discipline has allowed many people to shorten their mortgage life by years within a very short period.
How the Mortgage Market Works
In Canada, mortgage rates are set by the major financial institutions, in a "follow-the-leader" manner, with one of them, usually a major bank, taking the "leader" role. All major financial institutions earn a large part of their income on the "spread", which is the difference between loan/ mortgage rates they charge to borrowers and the rates they pay to depositors/ investors for an equivalent term.
In this section, the basic "cause and effect" factors behind these mortgage rate movements are discussed in greater depth.
How the Bond Market Affects Mortgage Rates
The bond market, which is a part of the worldwide "wholesale money market" is the great leveler. It is affected by monetary and fiscal policies and economic and political changes in all the major nations of the world.
How Market Changes can Affect Mortgage Decisions
Financial markets can vary greatly, and individual mortgage borrowers' most effective strategies can vary along with these conditions.
How the Bond Market Affects Mortgage Rates
The Government of Canada, and all major nations, finance their activities and accumulated deficits, by issuing "bonds". In the US they are known as "Treasuries" and in the UK "Gilts". The duration and interest rate paid on new issues of these bonds depends upon the financial strategy of the Government in power. The accumulated outstanding amounts of these bond issues, past and present, is known as "the National Debt". New issues are constantly required either to refinance maturing issues or finance current Government deficits, and a bond (say in $100,000 denominations) is considered a "commodity" by the market. Like every other commodity, its price can go up or down.
A new bond issue may set a "coupon" rate of interest at current market, say $100 million at 5.8% for an issue of 5-year duration. If this issue is made coincident with an economic or political event which drives down its value (say an unexpected "Yes" vote in a Quebec referendum), the effect on interest rates is immediate. The individual $100,000 denomination bond may fall in value to $95,000, thus yielding a significantly higher return for the buyer at the lower price. The combined "yield" of interest and capital gains sets the new base market rate for wholesale funds. Any financial institution seeking funds from these same investors, for example to correct an imbalance in deposit and loan commitments, will have to pay this yield plus a small "premium over Canada's" to secure them.
Investors who buy and sell these Government securities in large quantities, such as multinational corporations, pension funds and the like, weigh many factors, including the currency value and economic prospects of Canadian and other competing nations' issues. They then determine what price they'll pay for Government of Canada Bonds. The price they'll pay immediately defines the base market rate for wholesale funds. Every day, trends in this rate are watched closely by all Financial Institutions, in order to be in a position to adjust their rates on deposits and loans if required.
All Canadian mortgage lenders are acutely aware that their current or potential retail depositors can choose to put their money into none of the financial institutions GIC's in a rising rate market, and instead buy other "fixed income securities" such as bonds, which yield a higher rate because they adjust immediately to market changes. They can even switch their funds into the stock market if this is performing relatively better.
Therefore, in the truest sense of the word, the mortgage lending institutions are competing with other markets for the investor's money. If a bank doesn't attract enough depositors to fund all the mortgages, they'll have to go where their depositors go - the money market - to make up the difference....and there, they pay the going rate!
How Market Changes can Affect Mortgage DecisionsThe single biggest dilemma for Canadian mortgage borrowers since 1992 has been whether or not to lock in to a long term mortgage or stay 'short'. History has shown that, overall, it might have been better to stick with a short term or variable rate mortgage. That, however, is 20/20 hindsight, and many who locked in their mortgage at 6.75% in March of 1994 and then watched as rates zoomed through the roof when constitutional discord ravaged the Canadian dollar, would argue that they got the better of the deal. It remains to be seen what the next decade will hold. Let's consider a few of the dynamics directly affecting rates, and then see how personal mortgage decisions might be affected.
As described in the previous section on Bond Markets, it is clear to see that accuracy in interest rate prediction can only be judged after all the world's political and economic events have worked their way through the bond market over a period of time. One of the brightest analysts in Canada predicted a cataclysmic National Debt for Canada by the turn of the century, even suggesting that the International Monetary Fund (IMF) would have to place controls over the Canadian currency and foreign borrowings in order to stabilize the situation. Interest rates were confidently predicted by some to be heading back to double digits by the year 2000.
And yet, following severe damage control by the Bank of Canada in the late 1980's and early 90's, through draconian monetary policies, combined with fiscal restraint and heavy cutbacks by the Federal Government, Canada's financial house appears to be in order, paving the way for stable growth with a well controlled interest rate market.
In Canada, the threat of Quebec separation continues to be the 'wild card' which could tip the balance in terms of whether the Canadian dollar once again undergoes a prolonged attack. This would force the Bank of Canada to once again defend the dollar by driving up short-term rates and causing Canadian Bonds to be heavily discounted in the market. This would in turn drive up long term rates as explained in the previous section.
This leads us to the conclusion that there are three basic strategies that Canadians could follow given the current state of the market. Each is represented by a "risk tolerance" on the part of borrowers:
- Stay 'short' with a 6 month convertible or variable rate mortgage, watching for indications that a long lasting upheaval warrants either a long-term lock-in or a 'hedging' strategy. This approach is for the 'risk-taker', or the borrower who can easily absorb significant rate hikes and is prepared to live with a reasonable average over the long haul.
- 'Hedge' your bets by either taking a protected variable rate mortgage with a ceiling at the current, 3 year posted rates; or a split-term mortgage with terms varying from 6 months to 5 years, in amounts which suit your risk tolerance level. This strategy is the best for those that are cautious, and possibly vulnerable to significant rate increases in the near term...or simply partners with different risk tolerances!
- Lock in now, after negotiating your best long term rate - as long as 10 years from some lenders. This dispels all concerns about the direction of the market, and gives the risk- averse borrower an opportunity to reduce their mortgage balance significantly before they are once again exposed to interest rate risk.
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