## Tuesday, May 17, 2011

### Cash-Back Mortgage Question

A reader who is a mortgage broker had a question about a recent post on this blog analyzing cash-back mortgages:

“My client is interested in either a p-.90% rate or the p-.50% CIBC 3% cashback mortgage. I’ve used your spreadsheet and (if I used it correctly) it says the equivalent of the cashback product is basically p-1.18%.

How would I calculate what the equivalent rate is if the client immediately invests the cashback into the mortgage as a prepayment?”

First, a little background. With cash-back mortgages the bank gives you some extra cash (3% of the mortgage amount in this case) when you sign up for the mortgage. They also charge a higher interest rate to make your payments higher so that they get their money back during the term of your mortgage. I created a spreadsheet to figure out the effective interest rate you’re paying with one of these mortgages.

After using the spreadsheet, it seems that the reader’s numbers are consistent with a 5-year term. If this is right then I think he used the spreadsheet correctly.

If the client makes prepayments on the mortgage, the equivalent rate gets even lower. How much lower depends on the amount of prepayment. We can see this by looking at an extreme case. Suppose that the client takes out the mortgage, accepts the cash-back, and then immediately pays off the entire mortgage. In this case, the client gets to pocket the entire cash-back amount.

Obviously the bank would not permit this. I’m suspicious that the bank may even not permit the modest 3% prepayment. If the reader can determine what prepayments are permitted by the bank on this type of mortgage, I can make a version of the spreadsheet that computes the effective rate for prepayment cases.

1. I find it amazing the cash-back mortgage comes in at a lower variable rate than the plain variable mortgage. Like you say, there are probably a lot of restrictions on pre-payments, but this would be a good option for someone not intending to do any pre-payments anyway.

2. @Gene: I was surprised that the cash-back mortgage turnout to be better as well. One possibility is that people who opt for cash-back mortgages are more profitable than other customers because they tend to maintain lines of credit and fail to make any prepayments on their mortgages.

3. I've been trying to google some info on cash back mortgages for Rental Properties but couldn't find any, so I thought I'll post here and hope that you or one of your readers has experience with this.

Cash back mortgage seems like a great tool to me for one of my rental properties coming up for renewal. I am trying to choose between a low rate or a cash back.

Low rate would give me more positive cash flow than what I am getting right now. However, this will be taxed.

If I go with a cash back:
Benefits include:
1. Lower rate than what I am paying now!(yes my current rate is 4.99!)
2. Cash up front which is supposedly not taxed as it is considered new debt
3. Works out better as the Net income will be ofset by the higher interest rate (lower than my current but more than the lowest market rate)

Did I explain myself ok?

If you can help, that would be awesome.

Thanks,
Micky

1. @Mickey M: I understand the ideas. However, I'm not expert enough in tax rules for rental properties to be able to help much. Good luck.