Unlike our U.S. neighbours who have much higher mortgage indebtedness, the average Canadian family with a mortgage has attained approximately 50 per cent equity value in their home. This fact encourages many of us, when refinancing, to add tens of thousands of dollars to our renewal mortgage — for renovations, a new vehicle, to pay off debts, or for travel.
The temptation is understandable. More than 20 per cent of families renewing mortgages succumb to this lure, unfortunately reducing their equity by adding to mortgage debt. Often this also adds to their amortization period. Is it the smart thing to do? Very rarely.
Assume you have 15 years left on your $200,000 mortgage. You decide to add $50,000 to it when renewing for a five-year fixed term at today’s very attractive mortgage-broker rate of 3.65 per cent. You don’t feel comfortable with the extra $361 monthly cost. But by extending your amortization period from the present 15 years to 20, your payments are virtually unchanged. Why should you not jump at this chance?
The reasons are several. You are committing to the incremental debt for 20 years. The interest rate however is assured only for five of those years. Even at 3.65 per cent over the full 20 years, you would be repaying a shocking $92,000 on the extra $50,000 that you borrowed. It’s inevitable that rates will rise. Also inevitable will be the resulting increase in your monthly payments. Even at the low rates, do you really want to spend $92,000 of after-tax money to pay for a $50,000 renovation?
Compounding works hugely in our favour on investments. Unfortunately it has exactly the opposite effect with borrowed funds — even at relatively low rates, compound interest on debt always works against us.
You however, still want that $50,000 renovation. Is there a better way? Best and cheapest is always to first save the money, then do the renovation. If you can’t wait and must borrow the funds, check out the interest cost on a home-secured line of credit. You’ll likely find the rate to be attractive, with the added feature of monthly payment flexibility. With a little extra discipline you will be able to pay off the loan more quickly and cheaply than if embedded in a mortgage loan.
The smart Canadian will make every effort to pay off a mortgage as quickly as possible. Other than an emergency, when no other option exists, one should always resist adding to long-term mortgage debt.
Increasing a mortgage makes sense when necessity dictates upgrading one’s home to accommodate a growing family. Usually as the family grows, so too does family income. This should keep the incremental payments affordable.
The cost is high when homeowners use their mortgage like a personal ATM. It is precisely that tendency which resulted in so many U.S. homeowners finding themselves in an unsustainable financial whirlpool. Some 10 per cent ended up in either default or foreclosure. Canada’s foreclosure rate is about 0.4 per cent. Let’s be prudent with our borrowing, and continue to keep our foreclosure rate very low.
A retired corporate executive, Peter Dolezal is the author of three books. His most recent, The Smart Canadian Wealth-Builder, is now available at Tanner’s Books.