I recently did an analysis on my mortgage to see if it was worthwhile to refinance it. According to my original analysis, it wasn’t since I would be more or less breaking even. If I did end up making any money it would have been because of a good call on interest rates rather than the refi itself. As an interesting side note – we found out the termination fee from both the mortgage company and our mortgage broker. The mortgage broker’s termination fee was $300 higher which I guess would be their commission for ‘brokering’ the new mortgage. Always check with the mortgage company for the details.

Mr. Cheap referred me to one of his earlier posts where suggested that a cheaper way to refinance was to make use of any pre-payment room to lower the termination fee. He points out that you can borrow the money, pay down the mortgage and then get a new mortgage for the original amount and use the cash difference to pay off the loan. Since the loan would be very short term, the interest should be minimal.

Let’s look at a simple example:

Joe has a mortgage for $150k at 5% interest, 5 year term and he is 2 years into the mortgage. He owes $100k on the mortgage at this point in time. His mortgage broker calls and offers a deal – for a $4,000 breakage fee he can get a new mortgage for 4%.

Joe does the math (without prepaying) and concludes that he would break even so it is not worthwhile. Then he gets a call from Mr. Cheap explaining how to lower the termination costs by borrowing some short term money. Joe can prepay $30k so he can lower the termination fee by $1200 to $2800. Even if he pays $100 in loan interest then his profit is still $1100.

Needless to say Joe is pretty excited and goes ahead with the deal.

However that night Joe gets another phone call from someone named Mike who points out that he left out an important number from his original calculation. Joe (and Mike) didn’t add the termination fee to the amount of the new mortgage. Adding $2800 to the mortgage will increase his interest costs by $336 (for 3 years) which lowers his profit to $760. Not bad, but it’s debatable whether it is worthwhile or not.

Blend and extend

“Blend and extend” sounds like a good recipe for a fancy drink. It’s hard not to be positive about a smooth sounding marketing line especially when there are no termination fees to worry about. But is it too good to be true?
A commenter on my blog gave some details about his ‘blend and extend’

In our case we were 2 years into a 5 year fixed at 5.09%. By blending and extending we brought our rate down to 4.81% (for 5 yrs)
…
and it cost us a mere $75 to take that option and the paperwork was 1 page or 2. No legal fees or termination fees required in blending and extending.

As I interpret this – the ‘penalty’ is that he just got a 5 yr mortgage with a well-above market rate interest rate. Right now you can get a 5 yr mortgage for just under 4% so the extra ~0.8% is the penalty. This is not to say that ‘blend and extend’ is a bad deal, but rather that it’s probably not any better than a normal refinance where you pay the penalty and get a lower rate.

Switch to variable?

Another strategy is to pay the termination fee on your long-term mortage and then go for a variable rate or 1-year deal. The rates are so low that this is very tempting. However, if you do this you are really just making a play on interest rates. If you guess right then you might save a lot of dough, if you are wrong then you might be better just leaving things well enough alone.

What’s your story? Have you refinanced lately? Share ALL the details and why you think you are saving money.

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• This and That
• Carnival of Debt Reduction # 31
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Canadian Mortgage Trends reported just the other day that BMO has lowered its variable rate to prime and other banks may follow suit. With a spread of 1.75% between a FRM and VRM and the Bank of Canada saying it intends to keep rates level until 2Q-2010, VRMs may once again be poised to deliver savings over FRMs. The usual caveats apply: mortgagees opting for VRM take on the risk of a spike in interest rates in return for the potential to save interest on their mortgage.

Related Reading:

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Time to opt for a variable-rate mortgage again? is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Should you go with a fixed-rate mortgage (FRM) or a variable-rate mortgage (VRM)? One thing is clear about questions of this nature: nothing is ever clear. In the same way that RRSP vs. mortgage vs. TFSA can never be answered definitively for all cases, the decision on whether to take a variable or fixed mortgage interest rate can also never be resolved in cookie-cutter fashion.

To paint broad strokes, banks charge a premium on FRM’s to accept the risk that money will not be so cheap in years to come – by accepting a VRM, and hence the risk, you stand to save money, historically, and on average.

Widely-reported Dr. Moshe Milevsky of York University authored a study in 2001, with a subsequent update summarized nicely here, where 90.1% of the time over 1950-2007 it was better to have chosen a VRM over a FRM (down to 77.1% if you have good negotiation skills and credit, and can secure a discounted rate). As discussed in the comments there, it would be nice to know what conditions existed in those minority of times when it was better to have a FRM, ie. historically, given that prime rate was x%, what was the probability that fixed would fare better than variable over the next finite time period?

Given that mortgage interest rates are currently at an all time low, one has to wonder whether historical studies have the same relevance when brought to bear on current market conditions. The spread between VRM and FRM is extremely slender at the moment – on a standard 5-year term closed mortgage, the best discounted VRM today is just north of 3% and the best discounted FRM is about 4%. The narrower this gap, the better one’s probability of doing better with a FRM.

Some have argued that when rates do begin to go up, as they almost certainly will in time, the increases will be modest at first and at that point early in the rise one can lock in to a fixed rate. However, it is a certainty that by the time the average Joe realizes it’s time to lock into a fixed rate, the banks will have raised the fixed rate higher than he could have gotten today. This becomes a case of pay less today on your VRM, pay more tomorrow on your FRM.

In a recent discussion, Dr. Milevsky states generally that people with a lot of assets and therefore increased ability to deal with risk should still consider a VRM. Dr. Milevsky offers that those with small home equity, or low or unstable income, may want to consider a FRM.

Historical studies aside, there are some elephants in the room these days. Job stability is at generational lows, house prices are in steady decline, the future of North American automakers hangs in the balance, and governments are pumping trillions into the financial system with uncertain results. These are uncharted waters.

Ultimately with mortgage rate choices, as with all other aspects of personal finance, it comes down to risk management. If we pull out all the stops in efforts to maximize the slice of pie at retirement, we run the risk of burning the pie, or finding we’ve arrived at the dinner table without a plate and fork. If we don’t take the occasional calculated risk, however, we may find that there’s not enough pie to eat on Tuesdays.

And as always, more important than the decision you make on VRM vs. FRM is the decision you make in your day-to-day life to control your expenses, increase your income, and direct the net savings toward paying off the mortgage and maximizing registered and non-registered investments.

[Update: You may want to check out this post on Canadian Mortgage Trends on the same topic.]

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While there is no question that the tax issues involved in implementing the Smith Manoeuvre are complicated and potentially require the services of a tax accountant to make sure that everything is set up right, it is worth asking if the warning isn’t a little self serving. If a homeowner simply builds equity in their home, no trailer fees or sales commissions are generated for the advisor. But, the home owner implementing the manoeuvre with actively managed funds, while compensating her advisor handsomely, faces long odds of making any profit.

How so? There is a striking consensus among pundits that future equity returns are going to be rather modest and real returns from stocks can be expected to be in the neighbourhood of 4% to 5%. We’ll split the difference and say that the risk premium — i.e. the extra return obtained when you invest in stocks instead of T-bills — is 4.5%. Let’s further assume that the real return on risk-free assets such as T-bills is going to be 0% (a very conservative assumption but we’ll give the Manoeuvre all the benefit it can get).

From the 4.5% excess return that stocks can be expected to provide, we’ll have to deduct the costs of the SM. First, there is the line of credit provided by our friendly bank at a 1.75% premium over the risk-free rate. That leaves us with a 2.5% premium of implementing the SM, which may not be too bad if a homeowner can handle the risk and negative behaviours that come with leveraged investing, especially when the portfolio grows to a significant size.

But, sadly, there is more. The average mutual fund in Canada has a MER of 2.5%. It is a good bet that the average mutual fund will produce, well, average gross returns. Net out the MER and the intrepid investor implementing the Smith Manoeuvre using an average mutual fund sold through an advisor will be left with a return of — drum roll, please — 0%.

It’s true that we haven’t accounted for the tax arbitrage between the deduction from income of interest paid and the capital gains tax rate on investment income. However, consider that (a) part of the investment income comes from dividends, which is taxed on an ongoing basis (b) mutual funds generate turnover that results in a tax bill and (c) capital gains tax is levied on the nominal, not real, gains. Does the tiny return justify the extra risk assumed in implementing the Smith Manoeuvre? I’d argue that there are less risky, old-fashioned alternatives such as simply paying down the mortgage.

So, who benefits from the Smith Manoeuvre? The bank made money on the loan. The advisor made money on commissions and trailers. The homeowner? Well, I suppose, as the old saw goes, two out of three ain’t so bad.

Related Reading:

• DIY Smith Manoeuvre, Part 4
• Smith Manoeuvre Warning
• DIY Smith Manoeuvre, Part 1
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It is much easier to figure out whether contributing to a RRSP is better than a TFSA because it largely depends on just two variables – the tax rate at which contributions are made and the tax rate during the withdrawal phase. If the two tax rates are identical, the TFSA is better option because it is more flexible and withdrawals do not affect income-tested benefits.

I suspect that a lot of people (your humble correspondent included) will fall in the category where their tax rates in the accumulation phase are higher because they are in their peak earning years and are paying the highest tax rates of their working life. Presumably, when they are retired they will be paying much lower taxes. Since their contribution tax rate is much higher than the withdrawal tax rate, a RRSP contribution is likely to be the better option. For the few Canadians who pay a higher rate in their withdrawal years than in their contribution years, a TFSA is probably the superior option.

The RRSP/TFSA versus mortgage paydown is a much harder debate because the right answer depends on so many assumptions made about the future. At first glance, it seems like a no-brainer because investments within a RRSP or TFSA need to earn higher after-tax returns than the low interest rate on mortgages today. However, this is easier said than done. Many experts believe we are in an era of low returns for all asset classes (say 7% for stocks and 4% for bonds) that a 5% guaranteed after-tax return that can be obtained by paying down the mortgage starts to sound very good. Also, while markets have provided generous returns in the past, the average investor has lagged the market returns badly due to chasing performance and not controlling expenses.

Unfortunately, if you have X amount of dollars, it is hard to say which option would be the most profitable pick. But, picking any of the three options would be a good move because the bottom line is you are saving money. In an era where the national savings rate is close to zero, that’s a wise move.

Let the flogging begin!

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RRSP versus TFSA versus Mortgage Paydown is brought to you by Canadian Capitalist -- Helping you to invest & prosper.

Personally, we have a fixed-rate, 5-year mortgage that allows us to increase our monthly payment by 25% and make a total annual prepayment of 20% of the original loan value without any penalty. A lump sum prepayment of any amount (as long as the total annual prepayments stay within the 20% limit) can be made at the same time as the regular mortgage payment. Even though we pay down our mortgage aggressively, I find it difficult to make the maximum prepayment every year. I wonder if the open nature of the One-and-Only account, albeit at a higher rate, will appeal to many mainstream customers.

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In theory, the one account is a great idea. In practice though, there is one large problem: the interest rate on these combined accounts is at prime, whereas typically you can easily get a 0.90% discount to prime with a traditional variable rate mortgage. On a $200,000 mortgage, the traditional variety starts out with roughly a $1,800 per year advantage. Now, let’s imagine that your household net income is $5,000 that is paid into your account on the first of the month and everything is spent or saved by the end of the month. So, by keeping $5,000 in your account for roughly the entire year, you are saving $300 in interest costs with a combined account. In this scenario, your “savings” from a combined account does not make up for the cost of not opting for a traditional mortgage. You can check out different scenarios using the nifty calculator on the Canadian Tire website.

Call me skeptical but until these accounts start offering a discount to prime, the basic math just doesn’t work out. Still, the One-and-Only account is a significant new competitor to the Manulife One account (review by Million Dollar Journey) because there are no monthly fees.

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The planner’s client (let’s call him Joe) owns a house appraised at $350K and has a $260K mortgage on it. His monthly mortgage payment is $1,520. To implement the SM, the planner takes out a secured investment loan of $55K and invests the proceeds (less expenses) in segregated funds. To service the investment loan, Joe pays an interest of $275 per month.

To make an apples-to-apples comparison, I am going to assume that Joe can make an extra payment of $275 towards his mortgage principal. If Joe can find an extra $275 savings for the SM, he can find a similar amount for a mortgage pre-payment.

After five years, let’s assume that Joe’s home is still worth $350K (the home’s value doesn’t affect the outcome). If he had opted for an accelerated mortgage pay down, he would have a mortgage balance of $211K and he has a net worth of $139K. If Joe had implemented the SM instead, after five years, he would own the $350K home, an investment portfolio of $99K and a loan of $321K, leaving him with a net worth of $128K.

What about after 10 years? With mortgage pre-payments, Joe’s net worth would be (Home:$350K – Mortgage:$149K) $201K. The SM would leave him with (Home:$350K + Investments: $160K – Loan:$321K) $189K. Even after 15 years, Joe would be better off with a mortgage pre-payment (net worth of $280K) than the SM (net worth of $270K).

Now, surely over 20 years Joe would have come out ahead, right? Not really. With pre-payment Joe now owns his home free and clear. The SM also results in a mortgage-free home, but Joe now has a portfolio of $346K and an investment loan of $321K and a net worth of $375K. But, the key difference is that Joe hasn’t made a mortgage payment for 17 months, which if he had saved would have added an extra $31K to his net worth.

The point of this exercise is not to show that the SM doesn’t work but that it entails taking a small risk, not any risk at all as many planners claim. You should also note that this particular SM example involves a higher leverage and would become risky if a severe real estate downturn should occur. Also, while segregated funds may give you peace of mind, it also comes with a higher price tag. If you are earning 8% in the markets and giving up 3% in expenses, you would probably just break even with the SM. I’ll close with a comment made by David Trahair, author of Smoke and Mirrors, in a recent Toronto Star column: “It’s a high-risk strategy because you’re betting the farm that some investment adviser can do better than you can. You have a guaranteed return from getting rid of the mortgage.”

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• Book Review: The Smith Manoeuvre
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As of mid-2006, the total amount of outstanding mortgages was worth roughly $660 billion, with about $80 billion of that representing new mortgages and the rest representing existing mortgages. Of that $580 billion or so in existing mortgages, about one-third ($193.3 billion) was up for renewal during the year. Given the rather immense amount of money being renewed each year, it is a surprise to hear from our former mortgage insider how many people sign and send back the mortgage renewal form sent to them by their banks, even though the rate being offered is not discounted at all. “If I told you how many people do this, you’d be floored,” the insider said. “It’s close to 30 percent.”

Consider me floored.

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