Real Estate NewsCompound Interest Makes Canadians Pay
The good news -- according to the federal government – is that in the first quarter, outstanding Canadian mortgage debt was up 4.9% compared to the same period last year, having increased at 1% per quarter in 2000-01. Lower mortgage rates, higher house prices, increased building activity and a 1.4% per quarter increase in disposable income in 2000-01 helped support the growth of mortgage debt across Canada. However, the bad news is that while compounding mortgage interest continues to increase returns to lenders, it is building non-deductible debt for individual Canadians.
Not only are mortgages now a standard feature of home buying, they have also gotten bigger over the years. The ratio of mortgage loans to home values has risen from 37.5% in 1961 to over 50% in 1999. While the average value of Canadian principal residences in 1999 was estimated at CN$149,700, the average mortgage outstanding was CN$76,100. However, that mortgage debt will increase significantly before it is paid off thanks to compound interest.
The "average Canadian" paying off this "average mortgage" of $76,100, at a fixed interest rate of 7%, would spend much more than this amount, depending on the amortization period.
Paying off the $76,100 mortgage:
*In 25 years, would cost $158,241
*In 20 years, would cost $139.252
*In15 years, would cost $116,620
Compound interest not only involves interest on the amount borrowed, but also includes interest charged on the interest. When saving money, compounding is a positive accelerator of the saving process since it builds the balance more rapidly. When borrowing funds, compounding becomes a debt accelerator.
In general, with compounding, the amount of interest charged in a period, for instance over six months or one year, is added to the balance to create a new amount on which to calculate interest. For example, when 8% interest is compounded annually, at the end of the first year, the interest charged on $50,000 would be $4,000. In the second year, interest would be charged on the new balance of $54,000.
Eventually, the original amount of money borrowed would double in size to $100,000 as the interest accumulates.
Compound Interest Rule of 72: To determine the doubling point, divide 72 by the percentage of interest.
Continuing with the general example above, the $50,000 debt would double to $100,000 in (72/8=) 9 years, if the interest rate remained unchanged at 8% and no principal was repaid. At an interest rate if 6%, the $50,000 would double in 12 years; at 12 %, it would double in (72/12=) 6 years.
You don"t have to know how to calculate compound interest to understand the significance of this debt accelerator, nor do you have to do the number crunching yourself when Internet-based mortgage calculators like those at a href=http://www.quicken.ca/eng/home_auto/home/mortgage_calc/index.jsp target="_blank">www.Quicken.ca do the work for you. Play with these calculators and you"ll see how effective doubling up payments or getting a 1/2% rate break can be.
The Federal Interest Act restricts compounding on residential mortgages with blended monthly payments of principal and interest to annual or semi-annual calculations. Not surprisingly, most mortgage lenders offer the semi-annual option because it favours them. Since financial institutions usually offer annual compounding when you invest your money with them, it is easy to see how Canadian mortgage-holders feel they are behind from the beginning.
Non-deductible mortgage payments accounted for about 1/5 of a household"s 2000 disposable income, ranging from 18% of income in Saskatchewan to a high of 25% in British Columbia. While most homeowners work hard to save on other shelter expenses like heating costs, too many seem resigned to the burden of compounding mortgage interest.
As well as the obvious "buy less and get a smaller mortgage"approach, there are strategies to help you save money on your mortgage:
*Start with a shorter amortization period and decrease the period on each renewal date.
*Increase the frequency and/or size of your payments.
*Pay down the mortgage with lump sum payments whenever possible.
*Deduct mortgage interest for the portion of your home used for a home-based business.
*Use a mortgage to raise funds for investment and turn mortgage interest into an income tax deduction
Almost 71% of new home purchases were financed with mortgages in 1999 and the federal government expects Canadian residential mortgage credit to reach about $461 billion by the end of this year. How much of that will come out of your pocket?
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