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Challenging Financial Norms – How to Save for Retirement

Do you feel like you have a strong grasp of your finances and know how to make wise financial decisions? Let's put that to the test and see if you are making the right decisions for your long-term planning. Is 25 or 30 year amortization better? 5% or 10% down? There are many different strategies you can employ but let's pit a few against one another.

We all carry misconceptions about finances. Are biweekly payments better than monthly? Should we take a 25 or 30 year mortgage? Is it better to put 5% down and pay mortgage insurance or put 20% down? Money is not intuitive, I’ll show you why (and help you save hundreds of thousands along the way)

Testing Financial Intuition

To get started, a quick test for your intuition.

If you needed to buy a $100,000 car would you be better off to buy it in cash or to finance the car at 6% for 6 years and invest the $100,000 into a Guaranteed Income Certificate (GIC) yielding 4% inside your TFSA?

Let’s break it down.

If we buy the car in cash our cost is limited to $100,000 but we lose out on the opportunity to invest the $100,000 and own a depreciating asset instead.

If we decide to finance the car and invest the money instead we have to consider taxes, risk(s) and payments on the debt. We are assuming we invest in something guaranteed (GIC) and hold the investment inside our Tax Free Savings Account (TFSA), which means no taxes!

The financing on the car would cost $1649/m with a total interest cost over six years of $18,731.

If we invest the $100,000 at 4% for six years we will end up with $126,531.9

I share this example because it feels counter intuitive that borrowing at 6% interest to invest at 4% could lead to a $7800 profit.

The key here is visualizing the debt vs the investments. 

The debt starts off at a higher cost but due to the balance rapidly declining the investments come out ahead.

In other words the average balance of the debt over six years is drastically smaller than the average balance of the investment over the same time period. (debt is getting smaller each year whereas the investment is getting larger)

We need to question the financial assumptions we are making because with the way the world is going it doesn’t feel like getting ahead is getting easier.

Comparing Financial Strategies

25 Year VS 30 Year Amortization

Let’s look at the story of Jack and Jill.

Next month they are each purchasing a home for $625,000 and will be neighbours. Jack, a self proclaimed financial expert, takes every chance he can get to tell others how smart he is… but that is all about to change.

During their first site visit to see their homes being built Jack and Jill start chatting.

They both plan on putting 20% down to avoid mortgage insurance but are debating over 25 and 30 year mortgages.

Jack quickly informed Jill that she was being irresponsible if she took a 30 year mortgage.

Jack, certain of his financial expertise and intuition, eagerly shouted off reason after reason on why Jill was a fool to not listen to him.

With a 25 year mortgage she would…

“You get a lower rate!”

“You pay off the mortgage faster!”

“You pay way less interest!”

With Jack red in the face and out of breath Jill thought on what he had said.

If Jack borrows $500,000 on a mortgage at 5% paid off over 25 years he saves $99,927 compared to Jill taking a 30 year mortgage at 5.1% (generally there is a 0.1% premium for a 30 year mortgage amortization).

(5% at 500k = $373,246 total interest vs 30 year at 5.1 = $473,173)

Jill knew conventional wisdom taught that the best course of action is to be like Jack and to pay off our debts faster. Many would agree that the 25 year mortgage is the better choice…

But Jill was not “most Canadian’s” and instead of following the pack she decided to look at the math to decide what is best.

Jill let Jack know she would think about it which only irked him more. He knew he was right… why wasn’t she listening to him?

25 vs 30 Year Mortgage Over 25 years

That night Jill begins to think about the situation…

If Jack takes a 25 year mortgage his monthly payments are $2910.82. If Jill takes the 30 year mortgage her monthly payments are $2703.26 or $207.56 lower.

At the surface level Jack is paying an extra $62,268 (207.56 X 25 years) to avoid paying $162,180 (2703 X 5 years).

Sounds like a pretty good choice but she thinks there may be a way to have her money work harder.

If Jill takes the 30 year mortgage she could invest the $207.56 into her Tax Free Savings Account (TFSA) each month.

She pulls out her calculator, pen and paper and begins to crunch the math…
Here is what Jill would end with based on her potential investment returns over 25 years.

Annual ReturnBalance Year 25
4.5% $                                        110,699.98
5% $                                        118,554.11
6% $                                        136,283.45
8% $                                        181,595.15
10% $                                        244,294.10

Keeping in mind that Jill’s mortgage would have a balance of $142,900.48 after 25 years she would need to earn at least 6.3% to break even and a return of 7%+ would put her ahead.

If she could average 10% per year she would be $142,656.16 ahead (after paying off her mortgage balance).

An extra $142,000 could help Jill retire sooner, pay for her kids tuition or help them buy their first home… ok with the way things are going micro condo… but it could help!

An extra $142,000 is great but this article is about challenging the financial assumptions we make and we have made a big assumption… we are paying off the mortgage after 25 years.

Can We do Better?

Jill shows Jack her idea of investing the difference in payments each month and proudly declares herself more financially savvy than Jack.

Jack storms off and thinks about everything Jill has said. He stays up all night thinking about how he can do better than Jill.

If Jack pays off his mortgage over 25 years he will be mortgage free. He could then invest his full mortgage payment ($2910.82) each month for the last five years! Eureka he’s done it. He’s certain he can do better than Jill

Meanwhile Jill stays up all night thinking on how she could do better. She decides she’s not going to pay off her mortgage early and instead will save her $207.56 every month for 30 years.

Which Mortgage and Financial Strategy is Better?

The next morning Jack and Jill end up on a call to see who is financially savvier.

Who will have more money? Jack paying off his mortgage in 25 years and then investing $2910.82 each month for 5 years or Jill paying off her mortgage over 30 years and investing $207.56 each month?

Here is what they would have based on potential returns after 30 years.

 Balance year 30Balance year 30
Annual Return$2910.82 x 60 (Jack)$207.56 X 360 (Jill)
4.5% $                          191,037.18 $           139,314.99
5% $                          192,955.04 $           165,034.10
6% $                          196,847.29 $           196,380.53
8% $                          204,861.71 $           281,395.50
10% $                          213,190.09 $           408,603.15

You should have seen Jack’s face! Bested a second time… he was furious.

As long as Jill earned over 6% she would come out ahead of Jack.

If Jill averaged 10% (Keep in mind the largest US stock index, the S and P 500 has averaged 10.757% over the last 50 years) she would have $195,413 more than Jack (assuming he also averaged 10%)

$195,000 could be life changing, while it’s not enough for financial freedom on its own, I doubt we could find many retiree’s right now who wouldn’t benefit from some extra money in the bank!

What would you do with the extra money? I have always wanted to travel but retiring sooner might be tempting!

While an extra $195,000 is great we are still making some big assumptions. We have broken down the merits between 25 and 30 year mortgages and there appears to be a clear winner.

Does that mean that 30 year mortgages are always better than 25 year mortgages? Well remember the very first example I shared with the car… often the “best” financial choice can be counter intuitive.

 

Should you Put 20% Down?

Jack and Jill both made an assumption that putting 20% down was a better choice than putting 5% down and paying a 4% mortgage insurance premium (essentially having 1% equity day one)

I would be a hypocrite if I got lazy and didn’t dig into that math for you as well!

Three weeks before closing Jill had been savoring her triumph over Jack but at the back of her mind she kept wondering if she could do even better. You know, really ruffle Jack’s feathers.

She made some calls and realized that she could put 6% down (the minimum is 5% of the first $500,000, 10% of the balance above).

She knew it was a silly question but what if she put the minimum down and paid the mortgage insurance. She would have higher payments, a bigger mortgage, a dreaded 25 year amortization and her net worth would be lower day one.(due to the 4% mortgage insurance cost)The silver lining would be an interest rate 0.25% lower and having the remainder of her down payment to invest right away but would it be enough to help her retirement?

If Jill puts the minimum down ($37,500) she will have an extra $87,500 to invest and her new mortgage payment would be $3,336.

To be fair we should consider the two 20% down scenarios (25 and 30 year) and assume the difference in payments is invested each month.

A) Jack will take a 25 year mortgage, investing the difference in payments ($425.31) for those 25 years. Once his mortgage is paid off he will invest $3,336 until year 30.

B)  Jill could put 20% down and take a 30 year mortgage. She would invest the difference in payments ($632.97) each month for 30 years.

C) Jill would invest $87,500 into her TFSA day one and make no further investments until her mortgage is paid off year 25. Once her mortgage is paid off she will invest $3,336 until year 30.

Take a moment and think about what we have discovered so far. Which scenario do you think will do best?

Scenario

A) Jack

B) Jill

C) Jill

Annual Return

20% at 25 years + 60*3336 

20% at 30 years 

6% down at 25 years + 60*3336 

4.5%

$                                  502,239

$                  462,678

$                546,719

5%

$                                  531,859

$                  503,872

$                599,372

6%

$                                  600,112

$                  599,577

$                728,220

8%

$                                  782,676

$                  859,140

$             1,115,334

10%

$                               1,052,183

$              1,247,553

$             1,771,222

The worst of the three options is putting 20% down and taking a 25 year mortgage, which may be surprising for some. The main reason this option performs poorly is due to its smaller investment potential. Essentially your ability to save for retirement is being neglected in order to have a larger down payment and to pay off the mortgage faster.

The middle option is putting 20% down and taking a 30 year mortgage. As we learned earlier it can be financially beneficial to pay a little more interest if we can make consistent contributions to our investments earlier in life.

Putting the minimum down payment and investing the difference performs the best in most circumstances. With a worst case benefit of roughly $45,000 and a best case benefit of $332,658 it could be a real game changer for many Canadians trying to optimize their planning.

I personally was quite surprised to see the minimum down payment scenario do the best. I expected the higher payments and $23,500 in mortgage insurance premiums to really hurt the scenario.

Even more Benefits?

Another perspective to consider is how likely each scenario would be able to deal with job loss, repairs etc.

Scenarios A and B (putting 20% down) have put all of their savings towards their down payment. While they have lower mortgage payments it would take their payment differences 17 years (25 year mortgage) or 11.5 years (30 year mortgage) to rebuild the $87,500 reserve fund scenario C (6% down) has.

We could shorten that time to rebuild a reserve fund by factoring in investment returns but even a “best” case scenario would still take around 8 years (10% return, $632.97 invested monthly).

In the same timeline the 6% down scenario (C) would have built up $187,500.

Overall putting the minimum down payment and maximizing TFSA’s appears to be the most financially effective scenario we have analyzed so far. It provides the greatest long term financial benefit as well as a most robust position for a home owner (larger financial reserves).

If you have any questions, feedback or thoughts on this concept let me know. The goal is to help families make better and more aware financial decisions. I welcome your views even if they disagree with mine! Together we can make this better so please reach out!

As I am sure you can imagine Jill was on top of the world. She had repeatedly bested Jack and improved the future of her family.

Her head hurt a little as the journey had been a challenging one… every time she thought she had the best answer she learned she was wrong. She quickly came to realise that she could not make generalisations or “rules”.

At the most basic level a 25 year mortgage was better than a 30 year mortgage as it saved interest and paid off the mortgage faster.

If she thought a little more a 30 year mortgage could outperform a 25 year mortgage by having lower payments and investing the difference. If she used this strategy to build investments and to pay off the mortgage year 25 she could have a great benefit. If she left the debt alone and kept investing for 30 years she could have an even better benefit.

By challenging her financial assumptions she quickly learned that this was not the best option either. She had assumed putting 20% down to avoid mortgage insurance was a far better choice than putting the minimum down payment.

After crunching the numbers she had discovered that putting the minimum down and investing the remainder of her down payment would lead to a massive improvement in her retirement savings. As a bonus she would have a substantial cash reserve to help her deal with the unknowns of the future.

She was feeling good about everything she had learned, knowing that a deeper understanding of her finances would make future decisions easier.

She no longer cared about besting Jack, being right certainly felt good but she cared more about her family’s future.

Still she could not shake the feeling…what if she could do better for her family (this is the last time I promise!).

With dreams of a future where she could retire early, travel and help her kids establish their lives, she set off to the local used bookstore.

Flipping through the pages of old books always soothed her mind and strangely the musty smell of the book store calmed her.

Today would be different though. Instead of looking at thriller novels she was going into uncharted territory… the rarely visited personal finance section at the back of the store.

As she wandered over her eyes were instantly drawn to a slim bright blue book.

Gently she un-wedged it from in between two taxes for dummies books and read the cover… “Master Your Mortgage for Financial Freedom: How to Use The Smith Manoeuvre in Canada to Make Your Mortgage Tax-Deductible and Create Wealth” By Robinson Smith.

Well the author certainly was wordy with the title… she wasn’t sure he could have crammed any more words on the cover but she was intrigued.

She wanted financial freedom, she knew she needed to create wealth to achieve it and she was beginning to realize what “mastery” of her mortgage could do for her future.

She bought the book, took it home and began to read…

She began to unravel a way to add $2,300,000 for her retirement for her future, for her kids… not winning the lottery, not an inheritance but rather a thirty year old mortgage strategy she had never heard of.

Find out more

As mortgage brokers we are on your team. Our job is to understand your needs, plans and wants in order to understand your mortgage needs. We then look at a number of lenders to find the best products and solutions for you.

During our time in the industry we have learned a number of tips and tricks to help you save money and to pay of your mortgage faster.

If you have any questions or would like a customized mortgage plan let us know!

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