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Calculating How to Pay Your Mortgage Off Early
When you take out a mortgage in Canada, one of the choices that you have to make is between an open and a closed mortgage, in addition to fixed, variable, or adjustable. A closed mortgage has a lower interest rate, but if you pay it off early, or if you take off more of the scheduled part of the loan before the term ends, you end up paying a pre-payment penalty on the basis of the interest rate differential, 3 month interest penalty, or perhaps a tiered calculation depending on the year within the term paid out.
So why would you want to pay your mortgage off early? Well, take a look at the amortization table for the loan you’re considering. Even if your interest rate is 4 or 5 percent for the first mortgage, and even if you can keep that rate through renewal after renewal through the course of the 25 or 30 years over which the mortgage is amortized, you’re going to pay a lot more than the purchase price to actually own that house. A house that lists for $500,000 will likely cost you over $1 million over the life of the loan because of the cost of borrowing from the bank. So if you can knock off principal, you’re basically saving dollar for dollar, especially in the early years because that’s when you’re primarily paying interest rather than principal. That means that down the road, you can put that money you would have been paying to your lender into other investment vehicles, such as bolstering your retirement, helping your kids start a down payment fund for their own homes — or taking your spouse on that long-awaited cruise for your anniversary.
Of course, that flexibility also comes in handy if unpleasant things happen. If you lose your job and have to take a lower-paying position, you’ll have some cushion because you’ll only have to make minimum payments instead of making those extra payments until you get back into a position that pays what you were making before.
There are some advisors who argue against paying your mortgage ahead of time. Many of them suggest investing your extra money in something that pays a higher reward, such as the stock market or mutual funds. Some real estate experts familiar with the private lending market are advocates of investing in private mortgages. However, while you might make more money that way, you also don’t have any security in case you have a hit to your regular income. That might take place while the markets are down, and the money you invested isn’t available to you anymore. The better option is to work on paying your mortgage early after you’ve got an emergency savings fund (at least $1,000 if you’re single, and as high as $5,000 if you’re not) and then three to six months of living expenses in the bank.
You might be thinking that this sounds good so far, but you might be wondering how to make it a reality. The first step is to buy a house that costs less than the maximum that you can afford. That way, you’ll have an automatic cushion in your budget above what you need to make each month. Budget that cushion to go with your mortgage, though, so you’re used to sending it to the bank. Some people max out their purchase price and then end up struggling when things hit a rough patch financially. This way you’ll have the cushion in your budget — but if hard times hit you can use the cushion for emergency medical expenses or to make up the difference between the salary you’re making and what you’re having to live on while you look for a better job.
It’s also important to shop your mortgage around. Find lenders that have the smallest difference between their closed and open rates, so that the prepayment penalty will be smaller. Also confirm if the lender uses posted rates, discounted rates in their formula. If the first bank has a fairly large gap — and if they want to charge you a fee for making payments every two weeks instead of once a month (which allows you to sneak in a 13th “monthly” payment) — then tell the banker that you’re going to talk to another bank. Mortgage specialists are in sales, and they want your business. Remember that, and the application process will be less intimidating.
At first, it might be tempting to use that cushion for something fun. However, all that money you will have saved up at the end of your loan will allow you to have much more fun — and give you and your family security. Hopefully you’ll never need it, but in today’s economy nothing is certain. Paying off your mortgage as early as possible will make your family secure.