The story of Lisa and Lori and your mortgage
I want to share a short story with you…
In fact, this story unfolds around us every day – and in fact we are all players in this drama!
This story is all about mortgages and Canadians and how we deal with them…
As you read along ask yourself which one are you?
Lisa and Lori each earn $55,000 a year from their respective jobs. Both have $35,000 in savings. They live in Vancouver, British Columbia so a starter condo will set them back to the tune of $350,000.
Both Lori and Lisa got pre approved mortgages and were able to go condo shopping knowing that their financing was in place. The pre approvals were no problem for the banks to OK as they felt that these women would be good “risks” for the loans and able to service the mortgage payments based on their respective incomes.
On the one hand, just as her parents had told her to do – Lori wants to get rid of her mortgage as soon as possible. She spent some time on her banks Web Site with their “Mortgage Freedom
Calculator”. Based on her inputs she decided on using her entire life savings of $35,000 as a 10% down payment, and chose a 5 year closed mortgage at 6% with an 18-year amortization period.
Her mortgage of $315,000 means that her monthly payment is $2,375. She will reach her goal of being mortgage free in 18 years – 7 years earlier than the standard 25 year amortization and saving a whopping $107,804 in interest costs alone!
Lisa on the other hand chooses the same 5 year closed mortgage term at 6% but with a 25-year amortization. She goes for the 5% “down” option with $17,500 of her $35,000 savings and finances
the remaining balance of $332,500. Lisa’s monthly mortgage payment is $2,127.
The monthly difference between the two mortgage payments is $248. (Let’s say $250 to keep it simple).
Lisa’s mortgage balance is higher than Lori’s, $332,500 compared to $315,000 but her monthly payment is just $2,127 because she went with the 25 year amortization.
Where as, Lori is sending that extra $250 each month to her mortgage lender, Lisa invests these savings of $250 each month for five years, earning 8% before taxes per year.
The result: At the end of five years, Lisa has a total in savings of $17,599. Lori has no savings.
Suddenly and without warning, both women are re-engineered out of their positions due to corporate downsizing. This comes as no big surprise given the instability in today’s job market. Who will survive?
But, is Lori or Lisa in a better position? Well, let’s see…
Remember, Lori wanted to get rid of her mortgage as soon as possible and so used all of her money as a down payment, so she now has no savings to rely on.
However, she has $57,369 worth of equity built up in her house because she started with such a
large down payment and has been making larger monthly payments since the beginning of her mortgage.
Unfortunately, that won’t help her to put food on the table and she now has no money coming in.
The only thing that Lori can do to support herself is to use her credit cards, thereby creating consumer debt for which she cannot afford to pay because she has no income.
As she is now unemployed, she cannot refinance because her bank denied her application for a home equity line of credit due to lack of stable income! If Lori is to access her home equity in order to
support herself, she will have to sell her home. This would force her to do the one thing she wanted to avoid to begin with – lose her home.
Sadly, Lori has just discovered the biggest secret of home ownership the hard way: Your mortgage is actually a charge against your income – it is not a loan against the value of your home.
With no income, you are powerless to borrow money against your equity.
Lori must land another job, and fast! Not something that is easy to do in an unstable job environment. Not only can she not afford to feed herself, Lori is about to lose the roof over her head!
Now, let’s see how Lisa is doing. Lisa has only $33,793 in equity built up BUT she has $17,599 in savings! She will be able to make her monthly mortgage payment with ease, even with no job.
In fact, she has enough money saved to make her monthly mortgage payment for 8 months! No worries here!
Lisa sleeps soundly at night without worry that she will lose her home.
Here is the irony: Lori wanted to avoid a large mortgage and did everything she was able to pay off her mortgage quickly. To her dismay, she has discovered that her plan backfired in her face.
Rather than protect her home, she now faces losing it!
The moral of the story? You should never hand a large down payment to the bank. You should never be in a hurry to pay off your mortgage. The less money that you have and the less secure your income, and job situation the more important the idea of carrying a mortgage is to your financial well being.
Now here’s an interesting angle of an alternate savings program.
Lisa could have taken out a $50,000 investment loan and with an interest only payment – based on 6% interest she could have used her $250 a month to service this – instead of just saving it.
The beauty of this program is that in Canada the interest cost is tax deductible because she borrowed to invest.
In this case, to the tune of $3,000 each year. She gets to deduct this amount from her taxes just as if she had put the money into an RRSP.
However, the real beauty is that she has more money immediately working for her AND her investment portfolio is not bound by the restrictive rules and taxes that come with RRSP investments.
Furthermore, each and every year she gets to “write off” the $3,000 so at the end of 5 years she has written off a total of $15,000 (and all things being equal received government refunds totaling $6,000).
And how has the investment done?
Well, if she were to achieve 8% a year in a conservatively managed balanced fund her investment
portfolio would be worth in the neighborhood of $73,466.
Let’s say that because of her job loss she prudently decides to cash out $50,000 from her portfolio to pay off the loan. She is still left with $23,466 remaining in her non registered portfolio.
This is $5,867 MORE than the more traditional “Canadian way” of saving monthly.
In fact, it is essentially 23 months of $250 a month saved – MORE!
Lisa still has the $33,793 in equity built up in her home as before, however now if she wants to dip into her savings (which is the investment portfolio) she does not have to fear the tax burden as if the money were in RRSPs.
Now, who do now think is the smarter of the two? Lori or Lisa?
Which one are you? Which one do you want to be?
This example reinforces what I believe to be true.
Do you know what it is?
Don’t tie up all your financial resources in your home!
Two critical points that you must be aware of and clearly understand right now if you are ever to generate wealth:
1. Nobody ever got rich by saving money alone!
2. Paying off debt is not the same as accumulating assets!
Many people believe that it would be to their financial benefit to eliminate their mortgage. They think that if they don’t have to make a monthly mortgage payment, they are in much better financial shape than the guy who does have a mortgage.
In my opinion, this belief is completely in error.
Your current thinking got you into the situation where you are now – if you are not totally pleased with this picture you are going to not only have to change your thinking BUT change your game plan.
About The Author
Mark Huber is a is a full time certified financial planner (CFP).
Mark has distilled 22 years of insights and experience in the financial services industry into “The UnCanadian Way” series of eBooks, audios and videos.
For the latest: “How To Get Rid Of Your Mortgage – The UnCanadian Way”
2008 Mark Huber
This article may be freely distributed if this resource box stays attached.
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