With the prime rate in Canada at 4.70%, mortgage interest rates are rising, making home ownership unaffordable for many Canadians. So it’s no surprise that rate hikes have sparked a desire among some homeowners to pay off their mortgages sooner to reduce the impact of this cost.
As with any financial decision, it’s important to take the heat out of the debate and think about a strategy that will serve you best in the short and long term. Paying more than your monthly amount can help. This reduces the total interest payable and can reduce the amortization period to a few years. But while paying off your biggest debt may seem like the best way to ease your anxiety during tough times, it’s not necessarily the best use of your hard-earned money.
Are prepayments the right strategy for paying off a mortgage? Here are some things to consider:
Understand the terms of your mortgage
If you plan to make additional payments monthly or annually, it’s important to understand the terms of your mortgage. For example, is there a penalty for repaying more than the monthly amount? Is your mortgage open or closed? Open mortgages have an option for additional payments, and closed mortgages sometimes do not, except under certain conditions. If you have the option of making additional payments, is it flexible or only at predefined intervals such as the end of each year of your term? Is there a limit to the amount you can prepay? Before creating a prepayment plan, carefully review your mortgage terms to avoid penalties.
Opportunity cost of prepayments
Homes are expensive and with rising interest rates your portion of the debt becomes more expensive. If you’re lucky enough to have more money for your mortgage, it’s important to evaluate your alternatives first to make sure you’re getting the most for your money. Paying back principal and reducing interest is helpful, but what if your money is earning more elsewhere?
For example, if you have three years left until the end of your term and you want to set aside $10,000 to pay off your mortgage, you could save about $600 in interest (a year at a 2% fixed rate if you had blocked your mortgage before then). Now, consider a 4% GIC (not uncommon these days): your return almost doubles to $1,200. An alternative strategy is to put your money into a three-year GIC and use the proceeds as a lump sum payment after the renewal of your mortgage.
There are plenty of other ways to get more out of your money, such as paying off high-interest debt like credit card debt or finding tax shelters like an RRSP or TFSA. Although there are no guarantees, bear markets can be the perfect time to buy “discounted” stocks.
While it may seem obvious, it’s also worth noting that sinking every last penny into your mortgage may not leave you with enough money to meet other obligations. For example, do you have money to cover emergencies? Are you on track to meet your retirement goals? Do you have big expenses in mind, like travel or health expenses? It is important to consider your short-term goals or expenses before making advance payments.
When interest rates rise, the goals to be achieved seem further away. But it’s important to take a step back. Real estate is only one piece of the financial puzzle, and because of its sheer size (both physical and financial), it tends to overwhelm other investment avenues that should be considered. We will look into it. As with any major financial decision, do your research, talk to experts, and make the decision that best fits your financial goals.