MoneySense Magazine, Dec/Jan 2010
The solution to mortgage confusion
Rate-cappers, hybrids, all-in-ones. Today’s mortgages come in dozens of flavours. Here’s how to pick the right one for you.
This article was first published in the Dec/Jan 2010 issue of MoneySense.
I wanted to know my number. It was a few years ago and my honey and I about were about to purchase our first home. But like many first-time buyers, we were overwhelmed by the options. And I’m not just talking fixed versus variable. We were looking at capped mortgages, hybrid mortgages, even all-in-one mortgages like the Manulife One account. It was all so confusing—which one was right for us?
Desperate for guidance, I called Robert Abboud, an Ottawa-based financial planner and author of No Regrets: A Common Sense Guide to Achieving and Affording Your Life Goals. He showed us how to take these complicated mortgages and look under the hood, to see how they really worked. If you’ve been confused by all the different flavours that mortgages seem to come in these days, read on, and I’ll give you a guided tour.
Put a cap on it
Let’s start with capped-rate mortgages. With these loans, you get all the benefits of a variable mortgage, but if rates shoot up, your rate won’t. Once you reach the predetermined cap on your rate, your mortgage automatically converts to a fixed-rate mortgage. (Some varieties, called convertibles, require you to choose when to switch.) The advantage is that you can start with ultra-low variable rates, but you’re protected if rates start to creep up.
Unfortunately, there’s one big drawback, says Robert McLister, editor of CanadianMortgageTrends.com. According to his rate simulations, a rate-capper only makes sense if the prime rate jets up to 6% or more in the next two years. That’s because the initial rate on a rate-capper mortgage is higher than what you’d get if you negotiated the best possible rate on a stand-alone variable mortgage, and if rates zoom up, your cap will be higher than what you could have originally negotiated on a stand-alone fixed mortgage. In short, says McLister, you’re paying a premium for safety.
A bit of both
An alternative approach is to use a hybrid mortgage. With these mortgages, rather than starting with variable and converting to fixed, you start out with both, right from the beginning. Typically offered on a five-year term, hybrid mortgages split the principal into two portions—half in a variable rate and half in a fixed rate. (Both the terms and portions can be negotiated.)
The advantage is that if rates shoot up, the fixed portion will offer some protection. And the best part is, the premium you pay for that protection is usually lower than the premium you pay with a rate-capper.
“This is actually not a bad option if you’re getting the best rates on both products,” says Andy MacDonald, founder of MortgagesInCanada.com. For example, your $200,000 mortgage could be split into two mortgages, each worth $100,000. If you negotiated the best rates available right now for each part, you would only pay about $60 more per month for the hybrid option. This advantage, however, is destroyed if you can’t get the best available rates, says MacDonald. You will also need to make sure you get the same terms for both parts, he says, “because if different portions of your mortgage mature at different times, this reduces your flexibility, and ties you to your current lender.”
All in one
One of the most innovative mortgage models out there is the all-in-one mortgage, such as the Manulife One or National Bank’s All-in-One. With these accounts you consolidate all of your debt and savings into one, low-interest, variable-rate account. That means when you make a big deposit into your chequing account, for instance, that money is counted towards your mortgage, at least for as long as the money is in there.
“The key is interest-offsetting,” says McLister. If every month you deposit your $5,000 paycheque and leave that money in the account for 15 days before withdrawing the funds to pay bills, you reduce your overall debt—and the amount of interest you pay. Do this religiously and you can shave 5 to 10 basis points off the interest you pay over the life of your loan, he says.
As you might expect, you’ll benefit the most from this set-up if you have a lot of money saved relative to the amount you borrow. If you have almost no savings at all, you might be better off with a traditional mortgage. That’s because all-in-one accounts calculate your interest on a daily basis—they have to, as the amounts in your savings account could be constantly changing. But as a rule, you’ll pay less interest on a mortgage if your interest is compounded less frequently.
As well, you should stay away from all-in-ones if you don’t trust yourself with a big line of credit. All such accounts have some kind of easy-access borrowing built in, a bit like the overdraft option on some chequing accounts. Unless you have a lot of discipline, it might be best not to face the temptation.
The simple way out
Most of the products above could perform well for you if you’re in the right situation. But what if you’re the type of person who craves simplicity and stability? In the end, my partner and I discovered that was us—so we ended up settling for a regular five-year fixed mortgage. We knew we wouldn’t save as much on interest, but as first-time home buyers, we did have peace of mind and a good night’s sleep.
MoneySense Magazine, Dec/Jan 2010