How to Build Your Mortgage Bunker (while you still can…) – Part 1

Apologies in advance to our banking regulator (OSFI) and the Bank of Canada (BoC) for the advice I am about to give you.

While OSFI and the BoC are tasked with setting policies to maintain the overall stability of our financial system, my goal is to help you design a mortgage that will give you maximum flexibility and protection no matter what the economic weather.

While OSFI and the BoC have to worry about marginal borrowers over borrowing and doing harm to our economy, my focus is on the majority of Canadian borrowers who use debt responsibly.

In today’s post I will explain one tweak that borrowers who have at least 20% equity in their property can make to their mortgage, at no cost, to significantly enhance its flexibility. Then, on Wednesday of next week, I’ll follow up with a second suggestion.

The only catch (because isn’t there always a catch?) is that the window of opportunity for making these tweaks has been closing rapidly. The stewards of our financial system are making mortgage flexibility harder to come by because they are worried that marginal borrowers, if left unchecked, have the potential to poison the punch bowl.

Tweak #1: Cash-flow Buffering

I have always advised my clients to take the longest amortization period they can qualify for. While high-ratio borrowers (who are making down payments of less than 20%) are now limited to a maximum amortization of 25 years, conventional borrowers still have more flexibility (for now).

I don’t suggest this tweak because I want my clients to take longer to pay off their mortgage (quite the contrary). I recommend it because it enables them to set their minimum contractual mortgage payments at the lowest possible level. Remember, this is the amount you are required to pay come hell or high water.

What uninitiated borrowers don’t normally factor into their planning is that most lenders have generous prepayment terms. This means that you can make extra payments on your mortgage and even set up automatic additional prepayments that are taken each time that your regular payment is made.

Let’s use an example to highlight how this approach works:

Assume you want to borrow $300,000 at a five-year fixed rate of 3% and that you are comfortable with a 25-year amortization period. Your monthly minimum required payment would be $1,420.

Now, assume you borrow that same amount using a 30-year amortization. Your minimum required payment drops to $1,262 but if you want to achieve an effective amortization of 25 years, you just call your lender the day your mortgage funds and say “every time you take my regular mortgage payment, please take an extra $158 until further notice”.

Once you set that up, you will still be paying $1,420/month. The only difference is that your bank statement will show two withdrawals (one for $1,262 and the other for $158) instead of one withdrawal of $1,420.

The beauty of setting your mortgage up this way is that at any point in the future you can opt to suspend that extra payment and save yourself  $158/month in cash flow. And you don’t have to ask the lender for special permission – it’s entirely within your discretion to do this.

Setting your mortgage up this way will give you a cash-flow buffer which acts as a kind of financial shock absorber should you ever need it – and it doesn’t cost you anything extra.

Two additional points to consider:

1. Most lenders allow annual prepayment of at least 15% of your original mortgage balance each year. In the example above, that gives the borrower an annual prepayment allowance of $45,000/year ($300,000 x .15 = $45,000). Using the strategy above requires a monthly prepayment of $158/month or $1,896/year, which still leaves this borrower with $43,104 remaining in their annual prepayment allowance.
2. Borrowers who are putting down at least 20% of the value of their property can still find lenders who offer a 35-year amortization period which widens your potential cash-flow buffer further. Using the example above, a 35-year amortization would lower our borrower’s minimum payment to $1,151 (again, at no additional cost) and expands the cash-flow buffer on this mortgage to $269/month.

While advising borrowers to take the longest amortization period available to them might make BoC Governor Mark Carney cringe, on the contrary, I think it’s prudent advice for the vast majority of mortgagors who borrow responsibly. Structuring a mortgage in this way gives people more flexibility and makes them better able to withstand any future shocks or fluctuations in their income and budget requirements.

Despite this, maximum amortization periods have repeatedly been cut back by federal Finance Minister Flaherty as part of his changes to the rules for high-ratio mortgage insurance (most recently in July of this year). Several lenders have also cut back the maximum amortization periods they offer on conventional loans as well (where borrowers have more than 20% equity in the property), and as such, there is no guarantee that amortization periods beyond 25 years will be available indefinitely.

Check back next Wednesday when I’ll offer you my second recommended tweak for building your mortgage bunker…