Mortgage Term :: The sooner homeowners can burn their mortgages the better

Most mortgage term payments are made with after-tax dollars which makes the interest paid on a mortgage expensive.

Mortgage Term and the impact on your payments

Consider, a taxpayer paying income tax at a 50% rate with a mortgage payment of $1,000 per month. This person will have to earn $2,000 in order to have $1,000 of cash left over in order to make his or her monthly mortgage payment. In other words, at the highest personal tax rate, a $1,000 per month mortgage payment will require $24,000 of earnings after taking income tax into account.

The expense of a long mortgage term with small mortgage payments

At the risk of stating the obvious – mortgage debt is expensive debt. That’s why the sooner homeowners can burn their mortgages the better. Rather than simply trundling along, borrowers should step up to the plate and take control of the game. Consider the following:

1. I said it just a few short weeks ago but I’ll say it again – if you’re considering a new mortgage, don’t even consider a 25 year mortgage term. Stick with a maximum mortgage term of 20 years. Not only will you pay off your mortgage five years sooner, you’ll save five years worth of mortgage term payments that consist primarily of interest – the payoff here is huge.

2. When deciding on a mortgage term, go short. According to an article in Wednesday ‘s Vancouver Sun, since 1980 borrowers would have been better off 85% of the time by selecting a one-year mortgage term and renewing annually than opting for a five-year mortgage term. Yet more than half of those taking out mortgages will choose a four or five year mortgage term paying a premium in the process. Borrowers frequently site payment predictability and security as the reason for choosing a longer mortggage term but these comforts clearly come at a price. Going long is thinking grounded in the 1980s and not indicative of the relatively stable interest rate environment of the mid to late 1990s.

And while you’re at it, why not take it one step further? By going for a short mortgage term, your mortgage payment will be lower as a result of the lower interest rate. Rather than accepting the lower payment a better alternative is to go short on a mortgage term but set your payment equal to what you would’ve paid on a five-year mortgage term. The extra money you pay during the year goes straight to principal and the savings are all yours.

3. Increase the frequency of your mortgage payments. Monthly mortgage payments are passe. Bi-weekly or weekly payments are the way to go but you’d best pay close attention to how your lender calculates your payments if you really want to cash in on significant savings.

Mortgage Term Payments

Some lenders will simply take the total annual payments you’d make under a monthly arrangement and divide this by 26 to calculate your bi-weekly payment or 52 for a weekly payment. For example, a $1,000 a month mortgage payment would then become a $461.54 bi-weekly payment or a $230.77 weekly payment. Under this approach you’ll still be making the same total annual payments ($12,000 per year), only in smaller amounts on a more frequent basis. This method will undoubtedly save you interest but not as much as you might expect.

A better alternative is to take the monthly payment amount and divide it by two or four depending on whether you’re looking at a bi-weekly or weekly payment. Following this approach, your bi-weekly payment will become $500 and the weekly payment will be $250. Do the math and you’ll find that the total payments made during the year will amount to $13,000 per year. In effect, by following this approach you’ve managed to squeeze in one month of additional mortgage payments each year. There are big savings to be had here.

4. Remember that little things mean a lot especially for mortgages with a long mortgage term. Saving a loonie a day and making a lump-sum payment of $365 on each anniversary date will shave off 2.5 years and save over $15,000 in interest on a $100,000 loan at 8% amortized over 25 years. Doing the same thing with a toonie a day will knock off 4.5 years and save over $27,000 on the same mortgage.

5. Take a look around – do you have cash tied up somewhere that could be put to better use? How many times did you use the boat this summer? What about the motor home? Toys are great and I like them just as much as the next person but owning these things comes at a price that can go way beyond their original purchase price. In buying these things while still burdened with non-tax deductible debt, whether we know it or not, a choice is being made not to apply funds against our mortgage.

6. Consider restructuring existing debt. Over and over again I see situations where people have used their savings to build up investments when they still have non-tax deductible mortgage debt. A better approach is to apply savings against the mortgage term and finance the investments with debt. This alternative should yield tax-deductible debt which can reduce the tax bite on the earnings the investments yield.

Remember you don’t have to live with a mortgage for 20 or 25 years just because that’s the mortgage term your lender chose. If you take charge of your debt you’ll be burning that mortgage sooner than you might think.

Jim Maroney is a chartered accountant with Andrews Brown Maroney in Maple Ridge.