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15 Aug

Does a 85% Monthly Rate of Return Interest You?

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Posted by: Brad Lockey

Does a 90% Monthly Rate of Return Interest You?

If you are considering an Open Mortgage or are currently carrying a significant balance on a secured line of credit this post will be of value to you.

Interest only payments are great from a cash-flow perspective, but perhaps there is more to consider, read on.

Short Version

An Open Mortgage, or significant balance on a line of credit, only makes sense if you are paying in out in full inside a 6 month period.

Otherwise the interest rate premium of 1% (i.e. Opens are priced at 3.950% whereas closed variables are at 2.55% or better) will equal the expense of the three month interest penalty to break out of a closed variable mortgage early.

It almost never ever makes sense to take an Open Mortgage, or to carry a significant balance on a Secured  Credit Line as opposed to converting it to a closed variable rate mortgage.

Long Version

We will start with some clarity on a few terms that are routinely misunderstood as they apply to mortgages.

Definitions;

Open – A mortgage that can be paid out at any time without penalty.  A.K.A. ‘Secured Line of Credit’, HELOC, STEP, Homeline Plan, etc.

(The interest rate premium on these mortgage products makes them a questionable choice for many, we will detail)

Closed – A mortgage with some sort of penalty for early payment.  A closed variable is typically the absolute best option for minimal prepayment penalty, as well as minimal interest expense.

Fixed – This word refers to the interest rate component, i.e. the interest rate is fixed at 2.89% for 5 years.

Variable – This word refers to the interest rate component, i.e. the interest rate is set at a discount of .60% below Prime.  Prime is reviewed by the Bank of Canada 8 times per year at preset dates.  The BoC has not moved Prime in over four full years now.

***Variable rate mortgages are convertible to fixed without penalty at any point.  Lenders make it easy as you increase their profits and increase the penalty to break free when you convert to a fixed rate product.

Crossover Point – The point at which the interest expense of the premium paid on lines of credit and open mortgages equates to the prepayment penalty to payout in full a closed variable mortgage.  Typically 6 months, but on occasion as short as 60 days.

Have your Broker to the math for you.

The Math;

Open Mortgage, (Secured Line of Credit)

$100,000.00 at 3.95% (interest only)

Monthly interest expense $326.49 per month.

Minimum monthly payment is $326.49 – (increasing by $20.82 per 0.25% rate adjustment when Prime rises).

Closed Variable Mortgage

$100,000.00 at 2.55% (30yr Amortization)

Monthly interest expense $211.38 per month.

Minimum monthly payment is $397.02 – (A payment that will not increase when Prime finally rises, if placed with the correct lender)

This basic math, leads us to a more interesting question;

 If you were offered a return of $185.00 back on a monthly basis, for each $100.00 invested, is that an investment you would make? 

What if it were a major chartered financial institution offering you this investment opportunity?

An investment of $1,200.00 per year is effectively increasing your net worth by $1,027.68.  Arguably $2,227.68 if the payment increase represents a forced savings plan.

Does an 85% monthly rate of return interest you?

Admittedly cash-flow is negatively impacted to the tune of $100.00 per month per $100,000 of mortgage balance with the closed variable option, but it is very difficult to ignore the $185.00 monthly debt reduction.

There are few better places one could place a $100.00 bill each month.

While speaking of payment amounts, we must keep in mind that a secured line of credit is a variable rate product, and if Prime were to rise just 1.25% the payment (all interest) would then be $428.71 per 100K of mortgage balance.  Whereas with a certain choice of lender you will find that in a closed  variable rate mortgage can in fact have a FIXED payment amount for the entire mortgage term.

Creating certainty of cashflow with a Closed mortgage that is not possible with an Open product.

Let’s look at prepayment penalties.

In a closed variable rate mortgage (again with the correct lender) one will only ever be exposed to a 3 month interest penalty.  Currently that equates to ~$600.00 per 100K of mortgage money advanced.  Recall from above, there is a $100.00 per month interest premium being paid to sit in an Open mortgage product.

In other words the borrower that chooses an Open product pays the equivalent of a 3 months interest penalty every 6 months by way of the higher interest rate.

i.e. sitting in a Open for 18 months will cost triple what being in a Closed variable and paying the penalty would equal.

The lender did all this math for their own benefit when designing these products.  However it is unlikely that this math was spelled out clearly for clients who choose an Open mortgage.

Another Landmine Specific to Secured lines of Credit;

Interest only lines of credit (a.k.a. mortgages) are in fact demand loans.  If the lender gets uncomfortable with the borrower for any reason then said lender is within their rights to demand full repayment within 90 days.  This leads to the next point, the lender may demand repayment of the 3.95% line, but in turn offer a new 4.95% credit line to replace it.  (Revisit 2009 for examples of lenders that increased line of credit interest rates by one full percentage point overnight)

Clients were not impressed.  We humans, we rarely read the fine print.

To be clear I am not suggesting one not have a secured line of credit, quite the opposite as per our own personal mortgage.  Rather I am suggesting one not carry a significant balance on a line of credit for long, and ideally have a line of credit product that offers the ability to lock into a closed variable mortgage which not many lenders offer.

The bottom line;

Keep your options Open, but most likely your Mortgage Closed.

Thank you,

With inspiration from Dustan Woodhouse (Guest Blogger)