Friday, August 24, 2007

How much does that $200,000 home really cost?

How a $200K home costs $400K
Do you know what your mortgage costs?

The No. 1 financial tip I can dispense is to pay off your mortgage as soon as possible. This may not be as exciting as investing in emerging markets or hedge funds, but it's the most important tip you'll ever get.

Yet, more than half of Canadians underestimate how much home mortgages really cost. According to a survey released last week, GfK Roper Public Affairs & Media found 45% of Canadians don't realize how much they pay in interest payments over the course of a traditional mortgage. Only 20% correctly answered they'll end up paying 150% to 200% of a home's price over a 25-year amortization schedule.

Thus, with a 6.43% fixed mortgage, a $200,000 house will cost almost $400,000.

How can this be? In the early years of an amortization, most of your monthly payments goes just to interest -- if you set things up the way the bank wants you to. Under the guise of making your payments "affordable," you'll barely make a dent in reducing the principal on the loan.

This is a mug's game. What you need is higher and more frequent payments: The more you pay, the more you're paying down the principal and the less interest you'll be shelling out down the road.

The survey found the misperception is the same for both homeowners and renters: only 20% of either group knew how much mortgages really cost.

If anything, homeowners are getting more ignorant. The rise of interest-only mortgages or 40-year amortization periods can only be possible in a world where consumers are oblivious to the arithmetic of compounding interest.

Alan Silverstein, a real estate lawyer and author of The Perfect Mortgage, estimates that on a $100,000, 6% mortgage amortized over 25 years, homeowners pay an extra $91,940 in interest. The monthly payment is $639.91.

The lure with longer amortization is that the monthly payments are lower. What they don't go out of their way to tell you is those payments will drag on much longer and cost you even more interest in the long run. As Silverstein says, extending the amortization is "penny wise, pound foolish."

Thus, a 30-year amortization at 6% results in lower monthly payments -- just $594.82 -- but total interest jumps to $114,136.

Move out to 40 years and the monthly payment drops even more, to $545.09. But the total interest paid over those 40 years spikes up to $161,642, or more than 150% of the original price of the home.

In other words, with a 40-year amortization, the $100,000 home ends up costing $261,642. And, as Silverstein notes, you'll have to pay all that interest in after-tax dollars, so you'll have to earn perhaps 40% more than the $261,642 to carry that debt.

The reductio ad absurdum of this is interest-only loans, where not a penny of your payment goes to the principal. You'll be paying forever. This may make sense in the United States, where mortgage interest is tax deductible, but it's lunacy in Canada.

Remember the name of the game is paying down the principal. You do this by shortening -- not lengthening -- the amortization period, and increasing -- not decreasing -- the frequency of payments. Typically, once a year, you are allowed to give the bank a lump sum of 10% or 15% of the outstanding principal. This is a great but unappreciated benefit --all the payment goes directly to the principal, speeding the day when you are mortgage free.

Read more about How to Pay off your mortgage quicker

Toronto Real Estate Board (TREB) Average Prices and Graph

For more information please contact A. Mark Argentino

A. Mark Argentino, Broker, P.Eng.,
Specializing in Residential & Investment Real Estate
RE/MAX Realty Specialists Inc., Brokerage
2691 Credit Valley Road, Suite 101, Mississauga, Ontario L5M 7A1

BUS. 905-828-3434
FAX. 905-828-2829

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