Rising interest rates are causing a lot of unhappiness among bond investors, heavily-indebted homeowners, real estate agents, and others who make their livings from home sales.  The exact nature of what is happening now was unpredictable, but the fact that interest rates would eventually rise was inevitable. Long-Term Bonds On the bond investing side, I was disappointed that so few prominent financial advisors saw the danger in long-term bonds back in 2020.  If all you do is follow historical bond returns, then the recent crash in long-term bonds looks like a black swan, a nasty surprise.  However, when 30-year Canadian government bond yields got down to 1.2%, it was obvious that they were a terrible investment if held to maturity. This made it inevitable that whoever was holding these hot potatoes when interest rates rose would get burned.  Owning long-term bonds at that time was crazy . One might ask whether we could say the same thing about holding stocks in 2020 ...

Many people have heard of the Smith Manoeuvre, which is a way to borrow against the equity in your home to invest and take a tax deduction for the interest on the borrowed money.  It was originally popularized by Fraser Smith , who passed away in Spetember 2011.  Now his son, Robinson Smith, has written the book Master Your Mortgage for Financial Freedom which covers the Smith Manoeuvre in detail for more modern times.  Smith Jr. explains the Manoeuvre and its subtleties well, but his characterization of its benefits is misleading in places. The Smith Manoeuvre In Canada, you can only deduct interest payments on your taxes if you invest the borrowed money in a way that has a reasonable expectation of earning income.  Buying a house does not have the expectation of earning income, so you can’t deduct the interest portion of your mortgage payments. However, if you have enough equity in your home that a lender is willing to let you borrow more money, you could invest t...

The internet is full of debates about whether to take a mortgage interest rate that is fixed or variable.  However, what gets less attention is whether the mortgage is open or closed.  The most common fixed-rate mortgages are closed, and this means you’d have to pay a penalty if you break your mortgage. I can already hear most people saying “but I’m not going to break my mortgage, so I don’t have to worry about penalties.”  However, the future can surprise us.  If breaking a mortgage cost us a finger, we’d think a lot more carefully about what might happen to make us break our mortgage: job loss, job moves to another city, divorce, health problems, bad neighbours, and more. Mortgage penalties aren’t as bad as losing a finger, but they can be bad enough.  Suppose you took out a 5-year mortgage at TD Bank 2 years ago, and it has a remaining balance of $300,000.  According to Ratehub’s mortgage penalty calculator , the cost to break your mortgage would be $16,...

COVID-19 has a lot of people hurting, personally and financially. The federal government has pushed a sensible measure onto the big banks: mortgage deferrals. Most people who take a deferral have little choice, but this doesn’t change the fact that these deferrals have a cost. Interest keeps building on a growing mortgage balance during the deferral. Let’s look at an example. Suppose you have 20 years left on a 3% mortgage whose current balance is $300,000. You’ve just made your monthly payment of $1661, and the bank grants a deferral on your next 6 payments. What effect does this have? To begin with, your mortgage balance will increase to $304,500 in 6 months. Banks may plan to have borrowers increase future payments to catch up, or they may just extend the amortization period with the same payments. Let’s assume the latter case. How many more payments will you have to make at the end of your mortgage to make up for the 6 deferred payments? The answer is just under 11. ...

“It is better to be vaguely right than exactly wrong.” ― Carveth Read. In a good example of how you should be careful where you go for financial advice on the internet, the blog Money After Graduation attempted to tackle a reader question about whether to save money or pay down a mortgage . The analysis and conclusion are not useful. Ordinarily I applaud those who pull out their math skills to answer questions, but in this case, crucial factors were missed. The article simplified the reader’s question by assuming that TFSA investments would provide a tax-free return of exactly 5% each year, that the mortgage interest rate would stay less than 3%, and that nothing bad would happen in the reader’s life. With these assumptions, there is no need for the article’s detailed calculations. We can see that 5% is more than 3%, so investing will beat paying down the mortgage. No need for any further analysis, unless there are problems with the assumptions, like the possibility of stock ...

We can try to justify taking on a huge mortgage by doing detailed projections of house price increases and accounting for various housing costs, but this isn’t the path to a useful answer. It’s unexpected factors that drive this decision. One factor that many don’t properly take into account is repair costs. We all know the furnace, roof, and other expensive items will need replacing, but we usually can’t predict when. This makes it easy to ignore such infrequent large costs in a budget. Some inexperienced homeowners may even forget about predictable costs like property taxes, house insurance, and condo fees. Another category of unexpected factors is reduced income. If you buy a house with a spouse right up to your joint affordability limit, any reduction in income can be devastating. We’ve all been told that we could lose our jobs, but in my experience, most people don’t think this will happen to them, even though it’s common. You may believe you could lose your job, but th...

For anyone who got their first mortgage more than a decade ago, the reality of getting into today’s housing market can be an eye-opener. In describing the effects of the latest new government mortgage regulations, Rate Spy writes “Today, someone with 10% down who makes $50,000 a year can qualify for a $300,000 home purchase. That hypothetical maximum mortgage amount will plunge 18% to $246,000.” Mortgage experts have become desensitized to such numbers, but to me they look like there must be a typo. Someone earning $50,000 per year can get a $300,000 home with only $30,000 down! That leaves a mortgage of about five and a half years of gross earnings. It seems crazy for someone to dig such a huge financial hole. Dropping this mortgage size to about four and a half years of gross earnings isn’t enough better. Rate Spy goes on to write “This one regulation alone could shut out more buyers from the market than possibly any of the prior rule changes.” Good. I’d be horrified to...

A fellow financial blogger asked my opinion about his upcoming mortgage renewal. He faces the same choice as many of us do: should you take a fixed-rate mortgage or go for the lower variable rate? The risk with the variable rate mortgage is that rates might rise. The answer requires surprisingly little math. If rates stay the same for 5 years, then the lower variable rate will save you money compared to a 5-year fixed-rate mortgage. If rates go down, you’re even further ahead. Averaged over all possibilities, the average outcome is that you save some interest on a variable-rate mortgage. The worry, though, is the possibility that rates go up. You can’t fully protect yourself against rising rates even with a 5-year fixed rate, because you’ll have to renew at a new interest rate after 5 years. But you might hope to get your balance down enough that you could absorb an interest rate increase in 5 years. The real test of what you should do comes with looking at a terrible outc...

The many arguments you can find online about whether it’s best to pay down your mortgage or invest tend to gloss over the most important considerations. The answer isn’t in detailed calculations of returns based on assumptions that are just guesses. The truth is that if your income remains stable, you’ll do fine with either approach. The real answer comes when considering problem scenarios. All investment choices should balance two needs: (1) capturing wonderful returns through good times, and (2) surviving bad times. If you just average out the good and bad times and project future returns based on some middle-of-the-road assumptions, you might be taking on too much risk. One possible future for you is that you will always have a job when you want one and enjoy ever-increasing pay until you choose to retire. Here is another possible scenario: – The stock market crashes and stays low for 5 years. – Shortly after the crash, you lose your job. – It takes you 6 months to fin...

One of the ways that pressure on home-buyers can drop over time is that inflation erodes the purchasing power of mortgage payments. However, this pressure valve is less effective with today’s low inflation. Imagine a young couple taking on a 25-year $250,000 mortgage. Today, they might pay a mortgage rate of 3.5% and expect 2% inflation. Imagine a 2% increase in both (5.5% mortgage rate and 4% inflation). How does that change the financial pressure on our couple? In the first scenario, the mortgage payment is $1244/month, and in the second scenario the payment is $1515/month. But this only tells part of the story. The following chart shows how these payments change over time when we adjust for inflation. In the first scenario, the purchasing power of the mortgage payments drops by 39% over 25 years. In the second scenario, the purchasing power of the mortgage payments drops by 62% over 25 years. While the first couple starts with lower payments, the pressure of these ...

Many financial advisors would say you shouldn’t defer saving for retirement to pay off your mortgage first. However, the truth is that paying off your mortgage first can be a perfectly sensible strategy as long as some important conditions are met. The main condition you need to meet is that you are saving for the long term in some form. This should be at least 10% of your take home pay directed to long-term savings, preferably more. Commissioned financial advisors can make money if your savings are in the form of RRSP or TFSA contributions, but making extra payments against your mortgage can work for you as well. Note that I said “extra” mortgage payments. It’s no good to save nothing in an RRSP or TFSA and just make your regular mortgage payments for 25 years. That’s just using your mortgage as an excuse to overspend right now. Suppose your family take-home pay is $70,000. Then if you’re going to defer making RRSP or TFSA contributions, you should be paying at least $7000...

I’ve got some good news. When you think in inflation-adjusted terms, you’re really paying more mortgage principal with each payment than you may think. The bad news is that home buyers these days have a punishing amount of principal to pay. When it comes to money, it’s important to think in inflation-adjusted terms . It’s easy to get lulled into the feeling that a dollar today is the same as a dollar was last year. But it isn’t the same. Dollars are leaky; it takes more of them to buy the necessities of life each year. The leak is slow enough that we don’t feel it every day. Fortunately, the leakiness of dollars works to a borrower’s advantage. Suppose that you’ve just taken on a $250,000 mortgage at 3% interest. Amortized over 25 years, the monthly payment is $1183. After the first payment, the balance owing drops by $562. When we think in nominal terms (as though dollars are constant), we would say that your first payment was split so that you paid $621 in interest an...

We’ve been treated to a long-running battle between Jim Flaherty and mortgage lenders over the length of mortgage amortization periods and low mortgage interest rates. I wonder why we can’t just have a market-based solution. I don’t mean this in the same way as some critics of Flaherty who call for him to leave markets alone. Mortgage lenders lay off much of their risk to the Canada Mortgage and Housing Corporation (CMHC), and CMHC charges mortgage loan insurance premiums that make no sense. As long as this situation persists, we can’t just let the lenders go crazy lending to anyone with a pulse. This brings up the question of why CMHC premiums make no sense. The rules for calculating the premium you have to pay with your mortgage fit on a short web page . The premium amounts don’t take into account important factors such as the current ratio of house prices to rents. This guarantees that the premium you pay has little relationship to the real risk of default. It wouldn’t b...

An RBC mortgage ad in a newspaper drew my attention. It offered a 3-year mortgage at 2.99% and a 7-year mortgage at 3.59%. However, what really caught my eye were some percentages in large font in the fine print. It turns out the advertised rates assume a $250 processing fee, and the actual rates when this fee is accounted for are higher than the advertised rates. The fine print says that the advertised rates are “based on a $200,000 mortgage and a mortgage processing fee of $250.” The fine print goes on to say that the 3-year 2.99% offer is really 3.04%, and the 7-year 3.59% offer is really 3.61%. To RBC’s credit, the real rates were in a huge font compared to the rest of the fine print. However, it would be better if they just advertise the real rates in the first place. Being a math guy I wondered how RBC came up with the real rates. I used a spreadsheet to try one method that matches RBC’s numbers, so it may be how they did it. For starters, I assumed a 25-year mortgage...

Much has been made of the fact that the family debt-to-income ratio has hit 164.6% . In a funny off-colour joke, Preet Banerjee made the point that this is an average and that young people tend to have a higher debt-to-income ratio than older people . Boomer and Echo made a similar point that young people tend to have large mortgages and that their debt-to-income ratio is misleading . I think there is truth in these arguments, but that young people need to be very careful using these arguments to justify taking on enormous debts. An important goal is to eliminate debt before retirement. Not everyone will succeed, but we can expect the debt-to-income ratio for retirees to be low. Young people buying a house tend to start with large mortgages and smaller incomes than they will have later in life. It’s normal to expect that debt-to-income ratios will be higher among the young than the old. So, young people whose ratio is higher than the national average can relax. But don’t rel...

Recently, Rob Carrick interviewed Rick Lunny from the Melrose Management Group to discuss mortgage defaults. Lunny explained that the main reason people default on their mortgage is not rising interest rates, but people losing their jobs. Lunny said that he had “been involved in studies that go back 30 years, and you see that unemployment is the number one reason for mortgage default.” Let’s take a look at the history of Canadian interest rates for the past 30 years: The trend of dropping interest rates should smack you in the face. How could Lunny’s study say much about whether rising interest rates lead to mortgage defaults? Apart from 1988 to 1990, Canadians haven’t had to face much in the way of rising interest rates in the past 30 years. Keep in mind that it’s not high interest rates that cause your payments to rise. After all, the bank takes into account current interest rates when they decide how much to lend to you. What causes your payments to go up is the inc...

Too many discussions of whether you should go for a fixed-rate or variable-rate mortgage center on trying to predict future interest rates. This is a waste of time. I don’t believe anyone can guess future rates better than the yield curve . Even if someone out there has a better prediction, I couldn’t distinguish him or her from all the other prophets who claim to see the future, but can’t. We should simply view fixed-rate mortgages as a kind of insurance. To make things a little more concrete, suppose you’re trying to choose between a variable-rate mortgage that starts at 2.75% and a 10-year fixed-rate mortgage at 4%. On a $250,000 mortgage in Canada amortized for 25 years, the monthly payments are $1151 and $1315, respectively. I think of the extra $164 per month (about $20,000 over 10 years) as a premium for insurance against rising interest rates. It’s tempting to try to guess which mortgage will be cheaper. After all, if interest rates rise to the point where your avera...

If you have a mortgage, inflation is your friend. Your future payments are in fixed dollars and inflation erodes the value of the money you will have to pay. This affects the riskiness of mortgages over time. Consider the case of a $250,000 mortgage over 25 years. In one scenario, the mortgage rate is 4% with 2% inflation, and in the other scenario, the mortgage rate is 7% with 5% inflation. Here are the monthly payments in each case along with the inflation-adjusted real value of the last payment: Scenario 1 : $250,000 mortgage, interest rate 4%, inflation 2% Monthly payment: $1315 Real value of last payment: $803 Scenario 2 : $250,000 mortgage, interest rate 7%, inflation 5% Monthly payment: $1751 Real value of last payment: $519 Initially, the scenario 1 payments are much more affordable. However, by the end of the mortgage, the scenario 2 payments are lower in real terms. In the low inflation case, people are enticed into larger mortgages with lower payments, and ...

How many times have you heard something like the following? “On a $250,000 mortgage at 3.5%, if you choose a 20-year amortization instead of 30 years, your payments will only be $328 more per month more and your savings over the life of the mortgage will be $55,675!” This is just well-meaning nonsense. If there were no such thing as inflation, the figures above would be accurate. But in what universe does is make sense to simply add 2012 dollars to dollars from the year 2042? Even if inflation is only 2.5%, the 2042 dollars will be worth less than half of present day dollars. To figure out the real savings, you have to take into account inflation. Suppose that over the life of the mortgage, inflation is 2.5%. Then we can take the present value of the 20 or 30 years of monthly payments to figure out the potential savings. 30-year case: Monthly payment: $1119.09 Present value: $284,281 20-year case:  Monthly payment: $1446.66 Present value: $273,713 The actual s...

Reader JP sent some questions about his leveraged investments and whether he should hold his mortgage in his RRSP. Here is an edited version of his questions: “Does it make sense to hold my residential mortgage in my RRSP? Given the size of my RRSP and the modest remaining size of my mortgage, I’m really torn about what steps to take. In addition to my RRSP I have after tax investments that I purchased using a secured line of credit, separate from the mortgage, and I claim the interest as investment costs. On one hand, I have enough that I could simply blow away the mortgage by cashing out the after tax investments. The after tax investments give a nice stream of dividends, but does it make sense to have them and still have the mortgage sitting there? Do RRSP contributions make any sense now that my wife and I are now both ‘employees’ rather than ‘contractors’ and we still have the mortgage sitting there?” To start with, I have nowhere near enough information to give JP any spe...