With fixed rates on mortgages rising, and variable rate mortgages seemingly falling, consumers are often wondering what the best course of action is.

The media has pounded it into people that “variable rates always save you money.” If this was true, why would any stooge be foolish enough to take a fixed term? The answer is that variable rate mortgages OFTEN save you money, but only in times of stable or declining rates. In times of rising rates, variable rate mortgages often cost clients far more.

While interest rates are stable or falling, variable rate mortgages (typically pegged to prime rate) allow clients to ride the downward trend. However, when rates start to rise, so too does their rate.

With prime rate held down to what is, effectively, zero in the eyes of the banks, variable rate mortgages only have one way to go from here: up.

People taking fixed rates are, today, able to lock in these historically low “emergency” mortgage rates for 5 to 10 years, and take on absolutely NO risk of upward rate movement. People taking variable rate mortgages are doing so at historically high premiums. Historically, variable rate mortgages were offered at or below prime rate. With prime so low, and profit margins eroded, banks are now offering variable rates at prime PLUS some amount. A client taking a variable rate today will get lower rates in the short term, but when rates begin to rise (and if and when variable rates start to be offered at or below prime again) the variable client will be paying far more than anyone else for their variable money.

If we imagine that prime returned to a more “natural” 5% in the next two years, that means that varaible clients would be paying 5.4% when new clients may be able to get below 5%.

Now, many proponets of variable mortgages cite the “transferrability” option as the saving grace: that you can transfer to a fixed term at any point in the term. While this is great in theory, human nature being what it is, people often fail to transfer when they should and miss the boat.

For example, if prime rate is 2.25% and you have a prime + 0.40% rate (5 year term) for a net rate of 2.65% and the best fixed 5 year rate is 4.04% then you may thing that the 2.65% is a great deal! Fast foward a year and a half and you hear that prime rate is going up. You call your broker, and ask for the best 5 year rate and are shocked to hear that the best rate is 4.75%!

How could this happen? Because fixed rates and prime rate are not tied, and are, in fact, based on entirely different market forces. Fixed rates can (and have just recently) risen while variable rates have remained stable.

Bottom line: unless you follow interest rates and financial news on a daily basis, you likely aren’t going to be well enough informed to know when to lock in, or what the rates are at any given point. You can’t count on your bank or lender to advise you either, as they are ultimately only in this for the profit. If upward moving rates and higher payments scare you, if your budget is tight, or if you don’t follow financial news very often, take a fixed rate. If you none of those apply, then you can roll the dice on a variable.

However, my personal feeling is that taking a variable today is like buying Nortel at $200 per share and thinking that it would go higher and higher and higher still. It, like rates today, only had one way to go…

It’s happened 3 times in the last week, another lender halting the issuance of pre-approvals. The most recent culprit: TD Canada Trust.

This comes on the heels of ING Direct, Vancity, Firstline Mortgages, and a whole host of other peripheral lenders who have also stopped issuing pre-approvals.

So the first question everyone asks is, “Why?”

Two reasons:

1. Hedging costs
2. Unusual, historically high volume of real deals

We’ll come back to these later, but first, some preliminaries:

Let’s define what a pre-approval is, as there is a lot of misunderstanding in the media and amongst the public. When you submit an application to a broker, or lender, and they issue a pre-approval, most clients think they can rely on it. They can’t. When a bank issues a pre-approval it is always, “subject to satisfactory verification of income,” and, “subject to satisfactory confirmation of down payment,” and many other things. Even if you get your income confirmation and other documents together, the lender doesn’t look at them.

This means that a pre-approval is just a “rate hold” and is the lender’s way of saying, “assuming the information you put on the application lines up with what is on your documentation, then we will approve you for X, Y, or Z amount.”

It does NOT mean that you can write an offer without subjects for financing. It does NOT mean that the lender has verified your income, underwritten the file, and signed off on it. All that it is, is a rate hold for 90 or 120 days (depending on the institution).

Why don’t the banks verify income and all that? Because probably 8 out of 10 pre-approvals never become “live” or “real” deals. It would be a collossal waste of time to spend the hours working on files that only have a 20% chance, approximately, of closing. Lenders are dramatically over-worked in the current market, and they aren’t going to take their valuable man hours off of real deals to put them on pre-approvals which have a low probability of converting.

My job, as a mortgage broker, is to get you a pre-approval (if that is what you are looking for) and provide a list of documentation that the lenders will ask for to support the application. Then I, the broker, review the documents the same way as a bank would and can let you know if your pre-approval will “hold up under fire,” or, in other words, hold up when you write offer.

As a broker, I CANNOT guarantee that the financing will be approved because I am not the lender: I am just the middle man and the lender won’t underwrite (fully review) a pre-approval. I CAN tell you the probability of the banks approving your mortgage and can get you to collect additional information if it is warranted.

So, let’s get back to the resaon banks are cancelling pre-approvals all over the place. I’ll give you the first two reasons, and then my own personal opinion on reason #3.

HEDGING COSTS:

When a bank issues a pre-approval at, say, 4.29% on a 5 year mortgage, they are taking a risk that the rates could rise and they could be left holding the bag and getting you to pay only 4.29% when they could be lending it out at, say, 4.49% if they hadn’t issued a pre-approval. This is an element of time risk that is inherent in the practice of issuing pre-approvals.

To mitigate this risk, the banks “hedge” against this happening by buying derivatives or bonds in the open market to offset this risk. There is an inherent cost to doing this (transactional costs) that my only run a few hundred dollars per pre-approval, but add that up over $100,000,000 of pre-approvals and only 20% of them funding and that cost gets very high. (These numbers are just an example, but you get the idea).

UNUSUAL, HISTORICALLY HIGH VOLUME OF REAL DEALS

The number of transactions going on in the market today is incredible. After an absolutely dead winter period, there was a lot of pent up demand and with rates falling, and prices falling, the market exploded in late March and hasn’t looked back since. The lenders are so busy that we are getting 14 day turnaround from submission of a deal to an answer at a few lenders, and longer in other cases. There are a few lenders that are able to meet usual deadlines, but their rates are often a little offside (high) and this accounts for their lower volumes.

MY PERSONAL OPINION

My own personal opinion is a bit more revolutionary that the above conventional explanations, so here goes:

I believe the banks are dead certain that rates are going up, and they don’t want to offer clients pre-approval rate holds in the event that rates rise dramatically and they are stuck offering the old lower rates. My evidence for this claim? Look at the current 1 and 2 year mortgage rates which are 2.75% on a 1 year and 2.85% on a 2 year. If banks can entice a client to take a shorter term, they will face (likely) much higher rates at renewal and the banks will extract their profit at that time. Think about it: if the rates were going to go up, wouldn’t it make sense for the bank to offer great short term rates in the hopes of making a far greater return in the future once rates have risen? For a bank, long term thinking always pays off.

So, will pre-approvals dissappear all together? I have my doubts. They represent a solid method for lenders to solidify client business, and many home buyers expect to have some idea of what they can afford, in writing, before wasting a realtor’s time running around looking at properties. That said, the market has changed fundamentally, and don’t be surprised if you start getting pre-approvals from lenders you haven’t heard of as most of the big banks have stopped issuing them in the interim.

Until next time…

This is common question: do you pay more interest on a 35 year mortgage than with a 25 year mortgage?

Also common: are there any additional costs to a 35 year mortgage than a 25 year mortgage?

The answers are “yes and no” to both, so we have to clarify where it applies.

There is a lot of concern that if you take a 35 year mortgage you are paying more interest. The answer is that if all you do is make the minimum payments for 35 years or 25 years, then absolutely you will pay more interest. However, let’s look at an amortization schedule as see where the interest occurs over the 1st 5 payments of a 25 year and 35 year mortgage.

You will have to pardon the formatting as this bloody Wordpress system doesn’t allow for tab stops on which I rely heavily…

Assumption:
$1,000 mortgage payment
4.29% interest rate

25 YEAR MORTGAGE:
PAYMENT               INTEREST                PRINCIPLE
#1                              $653.95                     $346.06
#2                              $652.72                    $347.29
#3                              $651.49                     $348.52
#4                              $650.26                    $349.75
#5                              $649.02                    $350.99

35 YEAR MORTGAGE:
PAYMENT               INTEREST                PRINCIPLE
#1                              $653.95                     $191.34
#2                              $652.72                    $192.02
#3                              $651.49                     $192.70
#4                              $650.26                    $193.39
#5                              $649.02                    $194.07

So the first thing that jumps out at you should be that the INTEREST is the same in both cases, no matter the amortization.

Why?

Think about this: if the interest paid was higher, then it wouldn’t be the same interest rate, would it?

This is an important concept to grasp. The longer amortization doesn’t result in more interest paid every month, but the am0unt of money that goes towards principle is greatly reduced meaning that the mortgage is in effect far longer. So, you pay more interest over the 35 years than the 25 years, but only if you take the full 35 years to pa it off! (Highly unlikely).

So yes, if you only pay the minimum, then you will pay more interest over the entire 35 years. However, on a month to month basis, you don’t pay any more (give or take a penny or so).

SO WHY DOESN’T EVERYONE TAKE A 35 YEAR MORTGAGE?

Largely it’s due to myopic thinking and wanting to pay it off sooner. You can pay a 35 year mortgage off in 25 years by taking advantage of standard pre-payment privileges. Usually, you can ramp up your payment by 20% extra per year. When you do the math, taking a 35 year payment and increasing it by 20% makes it slightly more than a 25 year mortgage. However, if you take a 35 year mortgage you can always go back to the lower 35 year payments if you face financial hardship, job loss, layoff, injury, etc… and for this reason I recommend most people to take a longer amortization period and simply pay it off as fast as they can. This allows them to reset to the longer lower payment if needed (at no cost) but also gives them flexibility to pay off the mortgage faster than 35 years.

THE HIGHER COST OF 35 YEAR MORTGAGES:

“There must be a cost!” many clients exclaim. If you have 20% or more down payment, (thus avoiding CMHC fees) then there is NO incremental cost to taking a 35 year (0r 30 year) mortgage over a 25 year. However, the wateres get muddied when you have less than 20% down payment and have to pay CMHC fees.

If you have less than 20% down (in Canada) you have to pay CMHC fees which is “Mortgage Default Insurance.” You are paying for insurance so that if you cannot afford to make the payments, the bank gets paid out and protected from any losses. I will go into more detail as to what these insurance premiums are in the next blog post.

However, the point here is that if you have a 30 year mortgage your insurance premium will be 0.20% higher than if you have a 25 year mortgage. If you have a 35 year mortgage, your premium will be 0.40% higher. This amount is based on mortgage amount. So, if you put 5% down on a $100,000 purchase that would result in a  $95,000 mortgage.

If you took a 25 year mortgage, your premium (added to mortgage) would be $2,612.50
If you took a 35 year mortgage, your premium (added to mortgage) would be $2,992.50

So the only additional cost that may arise is when you put less than 20% down you will face a higher CMHC premium. That’s it. No higher rate of interest. No higher penalties. No extra interest. Just the additional CMHC premium, and if you have 20% down payment (or more) this cost doesn’t apply to you.

Some people may argue that encouraging 35 year mortgages is a bad idea for the aggregate market, but I disagree. The market’s health is directly related to affordability and cashflow, and by optimizing cashflow and putting the buyer in the driver seat of their pre-payment or lack thereof, I think everyone is better off.

Until next time, happy investing!

I get a lot of questions from clients that run along a similar vein:

“How do I pay my mortgage off faster? Should I do bi-weekly? Weekly? Semi-monthly? or Monthly payments?”

First, let me define what these terms mean:

Weekly is one payment every 7 days
Bi-weekly is every 14 days such that you pay the same amount as the monthly amount over the year
Bi-weekly accelerated is the monthly payment, divided by two, every 14 days
Semi-Monthly is either 1st and 15th or 15th and 30th (depending on the bank)
Monthly is one payment every month on the same date

Let’s provide a numerical example to what these mean. Suppose that your mortgage has minimum payments of $1,000 per month and is amortized over 35 years. How long does it take to pay it off using the following structures.

MONTHLY
This one is fairly obvious: $1,000 per month.

Time to payoff: 35 years.

WEEKLY
Calculated and paid as follows:

$1,000 x 12 = $12,000 per year in payments
$12,000 / 52 = $230.77 per week

Time to payoff: 35 years.

BI-WEEKLY (Normal)
$1,000 x 12 = $12,000 per year in payments
$12,000 / 26 = $461.54 every 14 days

There are 26 bi-weekly periods in a year (52 weeks divided by 2). This payment scheme results in EXACTLY the same payoff period as a monthly payment. In other words, just doing bi-weekly doesn’t pay it off any faster. You have to use bi-weekly accelerated (described next).

Time to paoff: 35 years.

BI-WEEKLY (Accelerated)
$1,000 / 2 = $500 every 14 days

Notice that this payment scheme results in:
26 x $500 = $13,000 in payments per year

This means that $1,000 extra is paid throughout the year (1 full extra monthly payment) compared to weekly, bi-weekly normal, or monthly payments, and THIS is the reason that bi-weekly payments result in a faster mortgage payoff period. It isn’t some special scheme of paying interest off faster, or anything like that. It is simply paying more.

Time to payoff: 29.45 years.

SEMI-MONTHLY
$1,000 / 2 = $500 on the 1st and 15th or 15th and 30th.

Note that this is still only $12,000 a year paid towards the mortgage, and therefore still is only paying it off as fast as monthly.

Time to payoff: 35 years.

THE MORAL OF THE STORY

There is no panacea or “magic pill” or technique to out-smart the banks. The only way to pay your mortgage off faster is to do just that: pay it off faster (i.e. put more money against it sooner than required).

Many people get confused and say, “but I heard that bi-weekly pays it off faster.” Dead nuts wrong. “Bi-weekly accelerated” pays it off faster.

Look at this this way: if you are only paying $12,000 per year ($1,000 per month is the minimum) then you will only pay it off in 35 years no matter how you slice it. That makes sense, doesn’t it? If you want to pay it off sooner, you have to put extra cash out of pocket. It’s the only way.

Before anyone jumps on me about the “truth in equity” style of pre-payment (a line of credit used as your operating account), let me point out that this system only works by paying extra against the principle. If you want the details, go to www.truthinequity.com and if you pay attention you will notice that it is only by making extra payments that the system works. It DOES work, but it DOES require extra cashflow or extra money to be put towards the mortgage (or line of credit).

Bottom line: if you want it paid off soon then PAY IT OFF SOONER!

With massive delays at the banks on purchases and refinances, I felt it was time to put out an article to my readers as to what the delays are caused by, why they happening, and what you as a buyer (or refinancer) should do to avoid stress and problems.

To the client, in a perfect service delivery, the broker is able to submit the mortgage into the lender, and act as a “filter” between the lender and client: passing on information as required, but not involving the client in the day to day back-and-forth question and answer process that invariably occurs. In essence, the client should apply, get approved, get a list of required paperwork, supply it, and get a mortgage. End of list.

The reality is that in today’s marketplace, the service process has been far worse, and far slower than borrowers (and brokers) are used to.

With so many people flocking into the banks and brokers to refinance and try and lock in lower rates we are seeing massive delays on getting files underwritten (looked at an approved) and even longer delays in getting paperwork reviewed. Many lenders are 5 business days, or more, behind. In fact, one of the biggest lenders in the country disclosed to me in confidence that they are working on June 3rd deals today the 18th!!!

Traditionally, you could get an approval in 1-2 days with document review in another 1-2 meaning that 5 business days for subject removal was a reasonable time frame. However, if you want the broker to have adequate time to shop the market for the best rate, 5 days is the bare bare minimum. I suggest 10 business days. The lenders that have the best rates, not surprisingly, have the worst turnaround times.

Now, before you (or your realtor) go, “no seller will accept 10 business days for financing subject removal!” think again. I am seeing two week subject removals, or 7-8 days, on almost EVERY deal that I see come across my desk (largely due to me coaching the realtor ahead of time). My point is, sellers want to sell, and a solid offer is a solid offer. If 4-5 more days of subject removal is a make-or-break condition, they need to give their head a shake.

Furthermore, as 80% of the mortgages lenders are working on are refinances or equity take outs, count on even longer delays as lenders (rightly) prioritize purchases with subject removal deadlines ahead of refinances. If you are refinancing, count on lengthy delays.

If you are dealing with a mortgage in excess of $1.5 Million, you can expect even lengthier delays as the lenders have to get approval from head office, and this can take anywhere from 1 day to 2 weeks depending on the lender and their level of due diligence. Combine a large mortgage, as a refinance, with a self employed borrower, and you have a recipe for a 4 week approval process.

SO WHAT CAUSED THIS:

First, the low rates have everyone wanting to save money. This isn’t unusual, but the volume that the lenders are seeing is unusual.

Second, in the slow later part of 2008 and the DEAD period of November 2008 – March 2009 lenders cut back on staffing, laid people off, and reduced the size of their workforce. Combine this fact with the highest historical volume ever, and you have a lending business that is wildly over worked, under staffed, and behind on everything from expectations to servicing attitude.

Tips if you are applying for a mortgage:

1. If you are applying for a property that is hotly desired and you need to remove subjects quickly, keep the above points in mind.

2. If you are very focused on getting the best rate above all else, be aware that delays will be longer and give your broker several days notice when writing an offer so they can get going

3. If you want a pre-approval, many lenders are cancelling them and offer a “rate hold” instead, but you may have to wait 5-10 days to see it in writing (if at all)

4. Get your job letter, paystub, proof of down payment (or existing mortgage statement) ready ASAP as it will take the banks days to review and approve these items

The bottom line is this: expect delays. Plan for them. It’s the reality of the market – love it or hate it – and it will change at some point (likely very soon as rates have started upwards making refinancing less attractive.

Happy investing!

On every mortgage application, one of the first questions we hear from the lender is: can you send me their credit score. More and more borrowers are becoming aware that the manner in which they have handled their bills, over the past 5 years, has a material impact on their terms and rates on mortgage financing today. Just because a debt that went bad due to a divorce was ultimately paid, the effect can be long lasting, embarassing, and detrimental to future credit applications.

A nice breakdown of how credit scores are calculated came across my desk today and I wanted to post it so that people can see how their score is establisehed (or harmed):

FACTORS                                    WEIGHT          POINTS
Past Payment History               35%                   315
Credit Utilization                        30%                   270
Length of Credit History           15%                   135
Types of Credit in Use              10%                    90

Inquiries                                        10%                   90
TOTAL                                          100%                 900

In Canada we refer to this as your “Beacon Score” but in the USA it is more common to hear it referred to as a “FICO Score”

So, what does this all mean?

Past Payment History: Well, this one is obvious. If you miss a payment, it will show up on your credit and will have a VERY detrimental effect. However, in order to qualify as a “missed” payment, you needn’t be a day or week late. You must be really late. You have be one full payment cycle late before it shows up. So, if your bill is due on the 15th of June, and you forget and don’t pay it until the end of June, it is likely not going to show up on your credit bureau. However, if you miss the June 15th payment, and then miss the next one on July 15th, it absolutely will show up!

Credit Utilization: This the percentage of available credit being used. However, the credit score is calculated by a dumb computer so it doesn’t really do this calculation well. For example, if you owe $450 on a visa with a $500 limit then to the computer that does the scoring, that means you are utilizing 90% of your available credit. This is a very high percentage, and your score will suffer for it. However, if you owe a $450 on a $5,000 visa, it will have a positive effect on your score as the computer will see you are using less than 10% of available credit (even though the amount owing is the same). So, how you allocate your debt is important. It is far better to spread it out over several accounts, than load up one card. Then again, if you pay it off every month in full, you never have to worry about this.

Length of Credit History: The longest that an item remains on your credit is 72 months or 6 years. Each “Trade Line” or account reports the number of months reporting, and the longer the better. This can be important because people may have a Sears card they forget about that has 72 months reporting of good usage (even though they never ues it) and they always say, “should I cancel it?” I wouldn’t. That long lasting, but still current, account has a very positive impact on your score that can help mitigate other areas you may not score as well on.

Types of Credit in Use: Certain types of credit are worse than others. For example, finance companies (Wells Fargo, Citibank, etc…) score low, whereas visa cards and revolving credit facilities score high. Also, the number of recently opened accounts has an impact.

Inquires: This is the most misunderstood portion of the bureau, but one that people guard jealously. The more “inquiries” (companies looking at your credit score) the lower your score. However, you can see this accounts for only 10% of the score. Also, the folks operating the credit bureau don’t want to hamper you from shopping around, so all applications done within a 7 day period (for a similar type of account – mortgage versus finance company, for example) count as 1. More will show up, but the impact on your score is minimal. Also, you are allowed to have inquiries! Just because an inquiry was on there, doesn’t mean your score is low. However, if you apply at TD for a visa, RBC for a loan, a finance company for a secured card, and then Hydro pulls your bureau as well, you can expect it to drop. How much? Even then, it might be a few points. If you score well in other areas, you shouldn’t even be given this a thought. However, if you are re-building your score, you should monitor this carefully.

SCORES AND INTERPRETATION:

Minimum = 300
(Lowest I’ve ever seen is 393)

Maximum = 900
(Highest I’ve ever seen is 826)

Average = 660
(More likely 660-680)

A good score = 680+

A great score = 700+

So that should give you a good primer on what scores mean, how it is calculated, and what you can do to preserve yours.

Your credit is like your reputation: it takes years to build, and only a couple stupid moves to tear it all down…

I have been taking a pile of calls from existing clients wanting an “open mortgage,” but when I ask them what about an open mortgage seems so attractive, they often aren’t entirely clear what it is they are asking for. The purpose of this post will be to clarify what an open mortgage versus a closed mortgage is, and to explain why most mortgages are NOT open.

WHAT IS AN OPEN MORTGAGE?

An open mortgage is one that can be paid off (or paid down) at any point in time, with no penalty. That’s it.

WHAT IS A CLOSED MORTGAGE?

A closed mortgage is one that, in exchange for a deeper discount, or fixed rate regardless of the economic conditions, requires a penalty to be paid off (or substantially down).

WHY DOESN’T EVERYONE GET AN OPEN MORTGAGE?

This is a little more complicated, but I’m going to refer to something called the “Contractor’s Triangle” to make my long winded point.

In the world of renovations, home upgrades, and contracting, there are three elements to any transaction. You are only allowed to get any TWO of the three. They are:

1. Fast
2. Cheap
3. Good

You can get fast and cheap, but it likely won’t be very good. You can get good and fast, but it likely won’t be very cheap. You can get cheap and good, but don’t count on it getting done very fast. Anyone that knows anything about home construction can relate to this simple metaphor.

In the mortgage world, the perfect mortgage (enjoyed by our cousins to the South in the US) is a FIXED rate mortgage that is OPEN. In Canada, this product does exist, but the rate isn’t great. Usually it is 7%+ wherease 4% (ish) is available at ths time for a fixed closed mortgage. Unless you plan on selling the property in very short order for a profit, the fixed variable makes no sense.

The only open product that is available in Canada is a “Variable Open” and right now, the best rate is Prime + 0.80% with prime rate being 2.25% presently. This is a net rate of 3.05% on a 5 year variable open. So why doesn’t everyone that takes a variable take a variable open instead of a variable closed?

The answer is a combination of: “it’s not as good a deal as the closed,” and “it’s harder to qualify for.” Some banks make qualification for an open mortgage more difficult as they really don’t want them on the books. Also, you can get a better deal on a variable closed (Prime + 0.40% versus Prime + 0.80%). Not surprisingly, if you do the math, you’ll save roughly the same amount over 5 years by taking a 5 year variable closed as you would if you bailed out of the variable open 1 year into the term.

So, you can’t have you cake and eat it too… There is no fixed open product that you can enjoy the best of both worlds with rate security and no penalty. Anyone that tells you they got one from their bank is either wrong, lying, or part of a VERY limited group of people that had such offers extended to them in the past. In this current market environment, they don’t exist.