Long-term amortization a short-sighted move

Jonathan Chevreau, Financial Post - Published: Saturday, May 03, 2008

It is amusing to see Canada's mortgage industry extol the virtues of 40-year mortgage amortization schedules. As Burlington-based mortgage consultant Ron Cirotto says, "the best mortgage is no mortgage at all." Homeowners should be thinking in terms of four-year amortizations, not 40 years.

Almost all the Baby Boomers I know, wealthy or not, made an early commitment to pay off their mortgages as soon as possible. They focused on reducing debt in a matter of years, not decades. To do so, they aggressively paid down principal, even if it meant foregoing a few things.

A home is typically the biggest financial commitment most will ever make. The longer the period over which a mortgage is amortized, the bigger the magnitude of that commitment. Even over a traditional 25-year period, homeowners will pay as much in interest as they will in principal. So, a $300,000 house may cost almost $600,000 once you include interest payments -- paid with aftertax dollars. In highly taxed Canada, to come up with that extra $300,000 in interest payments you would have to earn something like $450,000 in employment income (and pay income tax of about $150,000).

Two years ago, GE Money announced its 40-year amortization option in Canada, one of the first to do so. It was aimed at those who found it hard to qualify for traditional bank mortgages, such as recent immigrants who lack a credit history, the self-employed and those with less-than-perfect credit. And, as claimed by BCMortgage.ca, extending amortizations to 30, 35 or 40 years lets young homeowners "purchase a more expensive home."

But the price of this affordability is too high.  At the end of the day, the interest paid over the 40-year period of the mortgage is almost twice as much as that paid on a 25-year plan.

Of course, the U.S. subprime mortgage crisis, which ushered in a global financial meltdown, has revealed the ultimate effect of encouraging consumers to take on more home than they really need.

Cirotto's Web site, www.amortization.com, graphically illustrates how much more interest you'll shell out as amortizations are extended. It also shows how to reduce interest payments by bumping up the frequency and amount of mortgage payments: All the extra goes directly to paying down the principal, which has an amazing affect on lowering interest expense. Even so, Paul Bath, president of Newmarket, Ont.-based Centum Hewmac Mortgage Centre, encourages some homeowners to get a 40-year amortization "right away, so they can get the lowest payment possible. Once they do, they can always raise payments back to the level of a 25-year schedule."

That's worth considering, but it's more prudent to buy an affordable home in the first place. Too many couples starting out haven't grasped the basic fact that building wealth requires delaying instant gratification. Those who buy too much house in too upscale a neighbourhood end up not just with huge mortgages, but higher property taxes, bigger heating bills and the burden of keeping up with the expensive tastes of well-heeled neighbours. It is what Texans call, "big hat, no cattle."

To me, it's simple. If you can't afford a home, rent and save money for a down payment. As of 2009, the federal government's new Tax-Free Savings Accounts (TFSAs) will be the ideal way to do this. Any young couple will be able to stash $10,000 a year into these vehicles ($5,000 each). With well-chosen investments, the tax-free growth should allow them to save a 25% down payment on a home in a few years.

With lower prices, a decent down payment and a reasonable starter home in an appropriate part of town, you'll have a shot at being mortgage-free within 10 years.

Once you experience that freedom, then you can think of "moving up." But having tasted such financial freedom, my bet is you'll think twice about re-embracing debt to do so. Either way, you should be cured of the temptation to extend amortization periods.