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Monday, February 23, 2009

Understanding Mortgages

For most people, a mortgage is the largest debt incurred in a lifetime and as well their largest single asset. As a result, the impact of a mortgage on financial planning strategies needs to be considered carefully.

A mortgage is a secured advance of funds for the purchase of an asset such as a home. Mortgages originated as a way to circumvent onerous laws against borrowing. The debt is secured with title to the asset. Mortgages allow the borrower to spread the acquisition of a major asset, such as a home, over a period of 20 years or so.

For most people, a mortgage is the largest debt incurred in a lifetime. At the same time, a home purchased with a mortgage may be the largest single asset. As a result, the impact of a mortgage on financial planning strategies needs to be considered carefully. Different mortgage payment options to provide liquidity and flexibility should be considered, as they permit the mortgage to be more customized to an individual’s requirements. Mortgages were once relatively generic with few or limited options, but today there are many types of mortgages and options available.

Mortgage Term and Amortization

The mortgage term is the length of time for which a mortgage is extended to the borrower. Normally, the term for a homeowner’s mortgage ranges from about 6 months to 10 years, which permits the interest rate and associated payments to be fixed for up to 10 years. At the end of the mortgage’s term (the maturity date), the borrower must either repay the mortgage or renegotiate it.Many mortgage borrowers choose to lock in their mortgage term for 5 years, the most popular mortgage term.

The total cost of the mortgage and the time that it takes to repay it are impacted by the mortgage amortization period. A longer amortization period will provide lower monthly payments. However, with the mortgage amount outstanding for a longer period of time, the total interest paid, and therefore the total price paid for the home, is higher. Even with a long amortization period, prepayments speed the repayment of the mortgage and reduce the remaining amortization period. Finally, given the long amortization period, small changes in the mortgage interest rate are magnified result in substantial changes in the total cost of borrowing.

Mortgage rates reflect current interest rate conditions. The relationship between short term, medium term, and long term interest rates is encapsulated in the yield curve. Since a typical yield curve exhibits higher interest rates for longer terms to maturity, a mortgage with a 5 year term typically has a higher interest rate than a 1 year term. In addition, open mortgages have a higher interest rate than closed mortgages given the same term. The advantage of a fixed interest rate is that the homeowner knows what the mortgage payments will be for the term of the mortgage.

The amortization period of the mortgage is the number of years during which payments occur. All else being equal, the longer the amortization period, the lower the monthly payments and the higher the cost of the mortgage. Although 25 year amortization periods are common, many homeowners choose shorter amortization periods to lessen the interest expense. There are likely to be several mortgage term renewals during the amortization period.

There are several mortgage payment options available that impact the total cost of the mortgage and the time that it takes to repay it. The higher the amortization period, the lower the loan payments, all else equal. In addition, the more payments made per year, the faster the mortgage can be repaid, all else equal. Finally, the lower the interest rate, the lower the total cost of borrowing. Since most mortgages amortize payments over 20 years or more, small changes in any of these variables are magnified and can impact the total cost or term of a mortgage substantially.

Mortgage Features

A mortgage is a major commitment, and any features that are available and that improve its attractiveness to the borrower should be sought. Some of the features available to a borrower when obtaining or renewing a mortgage include assumability, portability, and a selection of prepayment privileges.

Assumability is the ability to have a new purchaser assume the mortgage if the borrower needs to sell the property in the future. This feature can make it easier to sell in a weak property market. Although the buyer may still need to be qualified by the bank or mortgage lender in order to assume the mortgage, it may be an attractive feature. This feature is particularly attractive as a real estate selling tool if the mortgage rate is less than current mortgage rates.

Portability is the ability to use an existing mortgage to finance a borrower’s new home if the original home is sold. This is an alternative to allowing a buyer to assume an attractive mortgage, by allowing the borrower to maintain the existing mortgage. If additional funds are required to purchase the new property, the new payments will be a blended amount of the existing mortgage with the new mortgage.

The ability to prepay a mortgage is one of the most important features to a mortgage buyer in the current interest rate environment. At one time, mortgages permitted prepayments on the anniversary of the mortgage only, and borrowers who could not take advantage of that window had no recourse. Mortgages are available as closed, partially closed, and open. Closed mortgages have no prepayment privileges, or only allow pre-payment with a stated penalty. Partially closed or partially open mortgages allow prepayments at specific dates to a maximum amount of the principal. These are the most commonly found mortgages today. Open mortgages permit prepayment at any time and in any amount by the borrower. In reality, many mortgages today that are called closed mortgages do, in fact, permit some prepayment, often up to 10% of the mortgage principal each year.

Another popular method for mortgage prepayment is with “accelerated” weekly or bi-weekly payments. By increasing the total annual payments slightly each year, and by paying the mortgage more frequently than monthly, borrowers can shave years off their mortgage amortization.

The interest savings as a result of prepayment privileges are a tremendous incentive to individuals, and mortgage prepayment should be considered an important part of the overall financial plan. Since most mortgage interest is non-deductible, it should be retired once no further high-interest debt remains ahead of it.

Sources of Mortgage Funds

Mortgage funds are available from a variety of lenders. Most commonly, mortgages are obtained from financial institutions such as banks, credit unions, caisses populaires, or trust companies. The mortgage market is relatively competitive, since financial institutions realize that borrowers often bring other fee-generating requirements with them, such as registered retirement savings plans and mutual fund portfolios.

Mortgage funds may also be obtained from private lenders through the use of a professional mortgage broker. A mortgage broker arranges lenders for mortgage borrowers, collecting fee income for doing so. Mortgage brokers are often used when the subject property does not meet the standards for a conventional mortgage, or when the borrower does not have adequate financial resources to meet the lender’s criteria.

Funding from family members is often used for first home purchases. A private mortgage can then be made available for an individual who might not otherwise qualify for a mortgage from a traditional source. In addition, many sellers who own their homes free of mortgage are often willing to take a mortgage from the buyer. Known as a vendor take back (VTB) mortgage, a private mortgage can be an attractive selling feature to buyers with weak or limited credit ratings. The financial advisor should ensure that a good real estate lawyer and agent be involved in arranging non-traditional sources of mortgage funds.

Another source of funds for new home buyers are mortgages arranged by builders of homes, condominiums and townhouse developments. Although buyers must still be approved by the sponsoring financial institution, developers may negotiate special terms to help buyers put together financing for purchasing their homes. Prospective buyers will want to check the terms of financing carefully to ensure that they are as attractive as they appear to be. Sometimes, the advertised “low monthly payments” or “lower than rent” payments are obtained with a substantial ($100,000 or more) down payment and a long amortization period of 30 years.

For a discussion of how first-time buyers can use Registered Retirement Savings Plan (RRSP) funds to finance a downpayment of up to $20,000, see the section on the Home Buyers’ Plan (HBP) at http://www.professionalreferrals.ca/article-376.html

Conventional and Non-Conventional Mortgages

Conventional mortgages are those where the lender provides no more than 75% of the pre-purchase appraised value of a property or the purchase price, whichever is less. In addition to the limit on the mortgage amount, individual lenders determine what form of property is acceptable for a conventional mortgage. For example, a home without a poured concrete foundation, or a very small home, may not meet the lender’s criteria for a conventional mortgage, even if the borrower needs to finance less than 75% of its value.

A non-conventional, or high ratio, mortgage exists where the borrower makes a down payment of less than 25%, so that the mortgage amount provided by the lender is more than 75% of the property’s appraised value or its purchase price, whichever is less. Borrowers who do not have sufficient assets to make the necessary down payment on a home need to find another source of funds or apply for a high ratio mortgage. In Canada, high ratio mortgages are insured by Canada Mortgage and Housing Corporation (CMHC). Since the chances of default are greater for mortgages of a high value relative to the value of the home, borrowers are required to purchase CMHC insurance, which adds to the cost of the mortgage. The cost of the insurance increases as the percentage to be financed increases, up to about 3.75% of the mortgage amount.

For borrowers who choose a high ratio mortgage, the CMHC insurance is an additional cost that must be paid. Many mortgage lenders arrange to have the insurance premiums added to the mortgage and amortized over the life of the mortgage, rolling the insurance premiums and mortgage payments into one convenient monthly payment. However, this adds greatly to the interest costs, since the amount paid for the premium is substantially higher when amortized over 20 or 25 years. The borrower may decide to pay the CMHC insurance fee up front, saving thousands in interest costs.

Alternatively, borrowers without the necessary 25% down payment may use a personal loan for the difference between the available down payment and the requisite 25%. Provided that the borrower has sufficient income to assume a personal loan and meets the credit criteria, the benefits are twofold. First, the mortgage insurance is saved, a cost which is never recovered by the borrower. Second, a personal loan will amortize the remainder of the required down payment over a relatively short period of time, such as 3 or 5 years. This will save thousands of dollars in interest, even on a relatively small mortgage, as the debt is repaid over a shorter amortization period than if it had been part of the mortgage.

Of course, the disadvantage of using a personal loan is the increased level of personal indebtedness. Since the purchase of a home entails often unexpected expenses and cash outlays, the additional debt burden may be prohibitive. If this is the case, the financial planner should not overlook private sources of funds, such as parents, single siblings, or other family members.

Some employers provide home relocation loans to employees who are required to move as a result of their jobs. The CCRA provides some relief to the tax consequences associated with these loans, and this may be an interesting alternative for individuals moving as a result of employment. A low interest or zero interest relocation loan should always be requested as part of the compensation package when an employee is asked to move to another location for work.

Fixed and Variable Rate Mortgages

Both conventional and non-conventional mortgages are available as either fixed or variable interest rate mortgages. The choice between a fixed or variable rate mortgage is an individual one, often based on the financial stability and risk tolerance of the borrower. Borrowers who choose a fixed rate mortgage are assured of the interest rate for a predetermined period of time. A two year fixed mortgage has a fixed interest rate in effect for the two years of the mortgage. When the mortgage is due at the end of the term, it must be renewed at then-prevailing mortgage interest rates.

Borrowers who choose a variable rate mortgage have an interest rate that varies with market interest rates. Some financial planners suggest using variable rate mortgages if interest rates are high when the mortgage is initiated and interest rates are expected to fall. However, this theory presupposes that an individual borrower has the ability to predict interest rates better than the professionals who make a living attempting to do so.

The greatest risk with a variable rate mortgage is that interest rates actually rise, and that the borrower is no longer able to make the higher mortgage payments. Many variable rate mortgages allow the borrower to convert it to a fixed rate mortgage anytime or at a predetermined time. The interest rates applicable to a variable rate mortgage depend on the flexibility features of the mortgage available to the borrower, but they are usually lower than those of fixed rate mortgages.

Borrowers considering variable rate mortgages should consider both interest rates and their own financial situation carefully to determine that there is sufficient advantage to a variable rate mortgage to justify the increased risk.

Refinancing

Refinancing a home can be used for many purposes, some of which have nothing to do with home ownership. Homeowners may need funds for a variety of purposes, from furthering an education to home renovations or travel. In addition, homeowners may wish to access the equity in their homes for investing in financial assets.

Funds borrowed to purchase a home are not normally tax deductible, but loans undertaken for the purchase of an investment are tax deductible. Therefore, investors with a mortgage-free home sometimes use the equity in their home to invest, refinancing the home with a loan or mortgage for investment purposes. As with any debt, care should be taken that the refinancing does not produce too high a debt ratio which could jeopardize the equity in the home or the home itself.

Second and Third Mortgages

A mortgage secured by the title to a dwelling is usually a first mortgage. This means the lender will lay claim to the property in the event of default by the borrower. Second and third mortgages are financing agreements that are secondary or tertiary to the first mortgage holder. From the lender’s perspective, it is far less favourable to be a second mortgage holder than a first mortgage holder. In the event of a default, there may be little or nothing left for the second mortgage holder. Clearly, the least attractive lending position is the third mortgage holder, which is relatively infrequent.

In the past, second mortgages were considered for individuals who could not afford an adequate down payment. This was more common when real estate prices were rising rapidly and second mortgage holders stood a better likelihood of being repaid if the borrower was unable to make payments. However, they are also often used by individuals with a sudden need for funds, resulting from a loss of employment, for example, as a means to access some of the equity in the home. A second mortgage on a home should be discouraged by the financial advisor if there are alternatives, since it may result in a level of indebtedness that is difficult to reduce and impossible to support. It may be more prudent to consider a reduction in living expenses by selling the home and purchasing a less expensive one (or renting) rather than engage in multiple mortgages on the same property.

Home Equity

Home equity, or simply equity, is the portion of a home’s value that is no longer covered by a mortgage. For example, a couple who own a home with a $200,000 market value and a $75,000 mortgage outstanding against it are said to have $125,000 in home equity. This equity can often be tapped in an emergency using a home equity line of credit or to refinance the home.
All else being equal, the greater the equity in the home, the greater the financial strength of a potential borrower. A strong home equity position may entitle a borrower to obtain lines of credit for investment or other purposes. Any new debt will require assessment of the ability of the borrower to pay, as discussed earlier. Most homeowners strive to be debt-free, so that all of the home’s value is equity.

If the value of a home declines past the amount of mortgage outstanding, the home is said to have negative equity. As a result, the home owners will have to continue to pay for an asset that is worth less than the outstanding mortgage. Negative equity is most likely when buyers make a very small down payment such as 5% and during severe financial downturns. With a mortgage equivalent to 95% of the value of a home, a small decline in market real estate values will result in negative equity.
Needless to say, it is in the best interest of financial institutions to encourage buyers to have a down payment that is larger than 5%. The more equity a home buyer has, the greater the chance that the home buyer will do whatever is necessary to make the monthly (or weekly) mortgage payments. From the bank’s perspective, buyers with 5% down have less equity in their home, and therefore less stake in the obligation.

Reverse Mortgages

Reverse mortgages are offered by some financial institutions in Canada. Aimed at retired home owners with a lot of equity in their home, reverse mortgages, or reverse income mortgages, allow a financial institution to take a claim (often 10 to 40%) in exchange for a regular payment to the owners. This may be in the form of a reverse annuity mortgage or a reverse mortgage line of credit.

Commonly, a reverse mortgage consists of an individual taking out a mortgage on his or her house and buying an annuity with the proceeds. The mortgage continues to grow until the individual dies (or, if the individual is married, when the individual and his or her spouse have died) or the mortgage term ends. Typically, the house is then sold and the proceeds used to pay off the mortgage. Conveniently, the annuity income from a reverse mortgage is received tax free since it is, in effect, a loan to the taxpayer.

Reverse mortgages can be relatively complex, and their use should be considered carefully by the planner in conjunction with other options available to the client. In addition, if the value of the home is not increasing substantially, it is possible that a surprising amount of its value will be absorbed by the interest on the reverse mortgage. In addition, there may be substantial interest penalties to exit from the strategy if the home owner decides not to continue with it.
Reverse mortgages should be examined carefully only if other options do not exist.