Saturday, September 8, 2007

A life sentence to the poorhouse

A while back I received a request to give my opinion on 40 year mortgages on the local CBC radio station. I was on the road at the time and planned to do a story here about the 40 year mortgage and my thoughts but as things tend to go life got in the way and I never got around to writing down my thoughts. Until tonight.

The National Post ran this story today: 40 Years of Debt. Here are some highlights, emphasis mine:
Benjamin Tal, a senior economist with CIBC World Markets, says the change in the way Canadians pay off their mortgage is the most significant innovation to hit the industry in almost three decades.

Mr. Tal, who is the process of compiling a report on how the new products have changed the market, says interest-only and zero-equity loans are probably less than 1% of new business. It's the long-term amortization that has caught everybody's fancy.

"They were available in the early '80s and nobody was interested. The attitude toward debt is totally different now," says Mr. Tal, who adds his study will show a "significant" amount of new money is geared toward that 2047 mortgage-burning party.

The Canadian Real Estate Association says the average sale price of a home was $311,495 in July. If you bought that house with 0% down and a 25-year amortization, the total interest would end up being $277,993 over 25 years, based on monthly payments and an interest rate of 5.85%, a typical discounted rate today. Extend the amortization period 40 years under the same terms and you end up paying $488,116 in interest --more than the price of the house.

[Mr. Cirotto,] laughs at the suggestion the 40-year amortization is giving Canadians more flexibility when it comes to making lower monthly payments. "I'm not sure you can call it an advantage to pay interest for another 15 years," says Mr. Cirotto. "To me it's bullshit. The best way to save money is not to have any mortgage."

Much of what is happening in Canada has been lender-driven, agree many in the industry.

"The 40-year amortization is the only way to get people qualified."
Want to know how much that 40 year amortization "saves" you every month? I'll do up the numbers on an arbitrary $300,000 mortgage. Doesn't matter what you put down or what your home is worth, the mortgage is $300K regardless. Interest rate is 5.85%.

$300K over 25 years = $1892/month and $267,732 in interest

$300K over 30 years = $1756/month ($136 lower than above) and $332,188 in interest

$300K over 35 years = $1666/month ($90 lower than above) and $399,754 in interest

$300K over 40 years = $1604/month ($62 lower than above) and $470,112 in interest

So by amortizing over 40 years you'd "save" yourself $288 dollars a month. In order to save yourself $288 dollars a month it will cost you $202,380.

Look at those numbers again. Notice how the big jump in monthly payment "savings" is between 25 and 30 years? Every five year period tacks an additional $70K in interest, roughly. But the payment doesn't lower proportionately. In fact, the "savings" shrink drastically the longer you amortize. There are some even more interesting numbers at work here behind the scenes. They have to do with income.

If you want to amortize $300,000 you need a household income of approximately $83,000 annually--that's assuming 0% down and no other household debt. What happens when you amortize over 30 years? Income need drops to $77,500. Over 35 years? $74,000. Over 40 years? $72,000.

Rather than close with my own advice for you, I'll quote someone far more knowledgeable than I:
[Mr. Cirotto] has an answer for the people who say the only way they can buy a house is with a 40-year amortization: Don't buy a house! "There a lot of people buying a house who shouldn't be buying the house they're buying. They need to buy a smaller house. People turn down their nose at smaller houses. They need to lower their expectations."
I know this article is leading, but I believe that readers of this here blog are smart enough to see through my opinion and form their own. So I give you another poll. Comments, as always, are welcome.


Anonymous said...

The only way that I would use a 40 year mortgage is if I were using the money in my RRSP to give myself a mortgage. Then the interest accrued is injected back into my RRSP. In otherwords, I am making the interest(tax sheltered) - not the bank.

If your in your 20's. Don't think about buying a home until your in your mid thirties. Build up that RRSP first - you will have far more options later in life.


vg said...

The Tal guy seems to have it ass backwards,the whole idea of having a mortgage is to pay it off as soon as possible and lower your amortization not raise it. It is why the whole banking system in the 80's went to the bi weekly and weekly payment options,you want to be mortgage free in 15 years not 40,thats insanity. I always had 15 year and biweekly and it was affordbale making average incomesback then,only costed me an extra $100 or so a month.

The problem now is that in an overvalued market it is not doable for most on an average wage and why a real estate crash will be the best thing that could happen for everyone.

Anonymous said...

vg -

greg said...

vg -

I agree completely. When people are contemplating dropping $400,000 + on a fixer upper then spending tens of thousands more on updating - that is not a healthy market for FTBs.

Anonymous said...

anyone notice that the Oak Bay house where the recent murder suicide took place had a $685k mortgage on it?? This was quoted in the TC, as well that the monthly payment would have been around $5000!!!! This is a classic example of where this ridiculous bubble has taken us. I will continue to wait it out.

Aleks said...

I would consider a 40 year mortgage if there were no restrictions on extra payments. That way I can pay it off in 20 years or less, but if I lose my job the required payments are lower.

However, if you're talking about buying a house that's so expensive I can barely afford the payments on a 40 year amortization, no f'ing way.

Traciatim said...

I recently purchased a home using a 5 year term and 35 year amoritization. I think it's a great idea. I can borrow money at 5%, keep my minimum payment low. My spouse at the time was in school changing professions. Once she's back to work full time we'll be able to pay more.

What happens if one of us loses our job and we amortized over 15 or 25 years? We could probably lose our house. What happens over 35 years? One income pays for it all.

With 25% payment increases and 20% lump sum amounts every year allowed, who the heck has a mortgage for their whole amortization schedule these days anyway.

I look at it more like we chose a low minimum payment that we can fall back on in case. Then each year my bonus from work, if we get it, and other windfalls just reduces our time. I'll never know the true cost of the mortgage until the very last payment, but who cares? It's far better than renting and having ignorant people stuck to your walls. When my kids run around in the back yard and spin in circles instead of playing video games because they have no yard . . . I'll suck up the extra $100K any day.

Anonymous said...

hmm - fair play to you for your choice, but you can rent houses with yards. We rent 2.3 acres...