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Cash Back Mortgages are a Bad Idea

With the Government cracking down on $0 down payment mortgages to avoid what’s happening to the real estate market south of the border, banks are resorting to zero down by another name. That is, cash back mortgages.

A cash back mortgage may sound like a great idea; buy a house with some down payment money saved and get the money back on closing to do with as the home buyer wishes. The catch being that the home buyer will face a higher interest rate, at the inflated posted rate, for typically 5 years. No big deal right?

An Example

Lets illustrate a cash back mortgage scenario. Going through some rates on the net:

  • 5 year discounted fixed rate is approximately 5.55%
  • Bank posted rate is 7.15%.
  • This represents a difference of 1.6%.

Say for example that the house purchase price was $200,000 and requires at least 5% down ($10,000). If the discounted 5 year rate was chosen, a total interest of $49,499.01 is paid after 5 years based on monthly payments of $1,165.28 (25 year amortization).

If the “cash back” option is chosen, a total interest of $67,595.35 is paid in the 5 years based on monthly payments of $1,419.40 (25 year amortization).

For the “privilege” of keeping the $10,000 down payment in the home buyers pocket, the higher interest rate will cost an extra $18,096.34 in 5 short years. It’s no wonder that banks are quick to offer this type of product, it’s cash back in their pockets. To put this in perspective, if the $10,000 cash back was invested, it would take an annual return of 23% (before tax) over 5 years to grow $10,000 to $28,000.

Final Thoughts:

To summarize, here are some reasons why a cash back mortgage is a bad idea:

  • The borrower pays significantly more in interest which simply means that the banks are the ones who are benefiting.
  • The monthly payments are higher which can crimp monthly cash flow.
  • The borrower now has the choice of what to do with the money. This is usually not wise for most as the average Joe will simply spent it.
  • Even if the cash back money is invested, it would be crazy short sighted to expect 23%+ annual returns over 5 years in the markets.
  • Paying down the mortgage is, for most, a great idea.
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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 61 comments… add one }
  • MoneyGrubbingLawyer August 11, 2008, 9:26 am

    Cash back mortgages have been around in Canada for a few years, but with the CMHC changes they’re being pushed pretty heavily right now, especially to first time homebuyers.

    Your calculations and assessment are spot on (there was a similar article in the Globe and Mail a few weeks back). Unfortunately, such calculations actually require some thought and savvy. To many, the initial pitch sounds like great financial planning- instead of buying furniture on my credit card at 19%, why not use the cash back option and only pay 7.75%? However, many people fail to take the next step and calculate the effect this option has on the big picture, and ignore the fact that the higher interest rate is charged to the entire mortgage balance, not just the cash back amount. As is often the case, the devil is in the details.

    FT, I’d be interested to hear what you consider to be the best way for new homebuyers to purchase appliances and furniture for their house- is it best to save for the purchases and pay with cash, instead of using those savings to increase the downpayment? What about taking advantage of no interest / no payment financing options offered by some retailers?

  • DAvid August 11, 2008, 9:47 am

    Options for furnishing new house:

    Have a small house rather than a larger one = less furniture.
    Make do with less. Acquire furniture as you need it. Watch for sales.

    Bring existing furnishings from former residence.
    Borrow or buy used furnishings & appliances.
    If necessary, see if you can have the appliances included in the mortgage. This likely has a similar cost to reducing the down payment and paying cash for furnishings.
    HELOC or LOC
    Last choice in my opinion is 0% interest options, as there are usually financing charges greater than the interest would be, and the rates if you can’t pay in full are exorbitant.

    DAvid

  • David V August 11, 2008, 10:06 am

    I looked at these types of mortgages last summer and the idea sounded interesting. But I looked at the numbers and thought “well that doesn’t make sense.”

    But onto the other idea about furnishing a new house. I’m planning on buying my first house in the next year and will have pretty much no furniture when I move in. My big issue is that the furniture I like is not cheap.

    My plan is to figure out exactly what I need the day I move in (a chair, my bed etc) and then try to figure out what other items I need and save up for them. I figure I’m trying to buy the furniture I can keep for years and years (not Ikea) so taking my time buying it isn’t a bad idea.

    As per the original post, if you pay $50 000 in interest in the normal course and $68 000 in interest by taking the cash back) isn’t it only a difference of $8000 out of your pocket? You’re given back $10 000 in the example, so somehow that should be accounted for. That said, if you’re going to use it on consumer items it wouldn’t make sense.

    d

  • Big Ryan August 11, 2008, 10:58 am

    I could see this as an attractive option for people who are having trouble getting the 5% down. Like you said, it’s basically 0% down in the end.

    As for appliances, I was able to get a no interest deal for 3 years ($99 admin fee) for mine. We probably would have taken advantage of this deal even if we had cash saved up, since we had to buy 5 appliances. The $99 charge ends up being less than 1% per year on a total purchase of $5000.

  • Chuck August 11, 2008, 11:17 am

    Our first house was a new home so we were able to include the appliances in the purchase price of the home. Though even with a “used” house you can negotiate the current appliances in the purchase price.

    Through the builder’s lender we got a much better rate than TD would give us, and they gave us a gift card for $3k at a furniture store.

    You’ll find there’s no shortage of relatives wanting to give you their garish furniture. Slipcovers are a godsend. As we saved up we would then buy furniture for each room.

    Also with home ownership, its important to set aside money for the pricey fixes you’ll need along the way. With new houses there’s a tonne of stuff like fences, and concrete edging for the driveway. For used houses I had to replace a hot water heater 9 months after we moved into our current home.

  • Basim August 11, 2008, 11:42 am

    I agree that the cash back doesn’t work if you’re going to live in the property, but its a not bad idea when re-investing the cash back to buy another property

    If you a venturing into rental properties and are in a high income bracket, Why not buy one rental with a mortgage that does cash back, then use the same cash back to buy another one

    This only works if you can qualify for 3 mortgages

  • Nolan Matthias August 11, 2008, 2:32 pm

    Keep in mind that the 5% cashback flex down mortgage was designed to get consumers into houses who didn’t have 5% down or who needed to pay out debt to qualify for a mortgage. It was the first generation of zero down products in Canada. The product is not meant to give you money to consume, it is designed to give you the down payment to buy a property to owner occupy. It will become a very good option once the 100% financing options dry up in October for first time home buyers.

  • Gates VP August 11, 2008, 2:43 pm

    Crazy (risky) indeed, thank you for making the numbers accessible to everyone. I’ve never heard of these things (and it was jaw-dropping even before you explained it).

  • Gates VP August 11, 2008, 2:49 pm

    @Chuck:: quoted for truth, Also with home ownership, its important to set aside money for the pricey fixes you’ll need along the way.

    Which brings us to @Nolan: Keep in mind that the 5% cashback flex down mortgage was designed to get consumers into houses who didn’t have 5% down…

    If you don’t have the cash flow to save for the 5% down where are you going to get the cash flow to keep up with the housing overhead?

    The problem here, is fundamentally a risk problem. This “cashback” thing is high-risk behavior being packaged as something else. Look at Basim’s example, he’s talking about leveraging one down payment into 3 mortgages. He’s now on the hook for three houses with a down payment that could only justify one.

    That’s the definition of high-risk.

  • Nolan Matthias August 11, 2008, 3:20 pm

    Gates, you are absolutely right. However it does not change the fact that if you buy a house to live in it, and the payments are reasonable for your income, then you are better off owning than renting in the long run.

    The only people who are taking a risk are the ones who can’t afford their payments, speculators (like you said), and the ones who panic and sell when housing prices fall. Long term if you are buying a house to live in and make your payments, it is not risky behavior. Saving a 5% down payment in this market isn’t as easy breezy as it once was and the cash back down payment is a good alternative.

  • DAvid August 11, 2008, 4:43 pm

    Another situation where 0% down or cashback mortgages may have value is in markets where the escalation in housing prices exceeds your ability to save a down payment. If you could save $1000/month above your rent, but housing prices are increasing at $1200/ month in your market, you may be wise to pay the interest premium to get into the market earlier, rather than later. markets such as Vancouver, Calgary, Saskatoon, and this year, St. John’s, show this type of imbalance. We are very happy we entered the market when we did, even though we were highly leveraged. Four years later, the housing market has grown beyond that we feel we could afford.

    DAvid

  • Jordan Clark August 12, 2008, 3:33 am

    I have to disagree with David’s assessment that doing a cashback mortgage is a good option when markets are growing more rapidly then your ability to save. Beside’s FT’s example of the additional costs, I believe by definition the average person should be able to live in the average shelter. People have to live somewhere, if you can’t afford to buy at all then I agree there is an imbalance because the market is likely over valued and it will start making a correction. Don’t forget that leverage works both ways, it can help you build wealth quicker in an increasing market, and it can also destroy wealth in the same way when the market reverses.

    What happens is people very quickly end up holding a mortgage on a house that’s dropping in value, so you owe more then it’s worth. That means to sell it you have to pay someone to take it or declare bankruptcy. Buying a house at the highest it’s ever been in history (even adjusted for inflation), when you can’t even afford it is insane. People need to look very carefully when they enter these very risky situations because they are exposing themselves to something with the power to financially destroy themselves.

    I really like the service at TD bank but I cringe and think of closing my accounts every time I walk into the branch and see those posters with the 7% cash back mortgage with a moving & furniture truck in front of a new house, because I know they’re praying on the ignorant customers just desperate to get in before they’re “priced out forever” or other such non-sense.

  • john August 12, 2008, 1:21 pm

    Just a couple of comments.

    A cashback is just another type of loan. You get 10,000 and repay the 10,000 plus 8,096.34 in interest which is an interest rate of about 13%. If you need to borrow money and the best rate alternate rate is higher than 13% then you should get the cashback……

    There are however a couple small details about cashbacks.
    1. Cashbacks mess up your mortgage amortization.
    If your mortgage rate is 4% and the cash back adds another 1% in interest there is a 25% increase in your interest costs but your mortgage payment will only increase by about 10%. that is because as rates increase a smaller proportion of the payment is allocated to principal in the early years of the mortgage. this of course leads to slimebag brokers/bankers making this sales pitch:
    if you get a 5% cashback of 10,000 your payments increase by $60 per month which is an interest rate of 7%.
    Which is of course wrong, a lie, and fraud.
    2. Cashbacks and payout penalties
    A. All cashbacks have a repayment clause if you payout early. Its something silly like if you payout in the first year you must repay 100%
    80% in the second year and so on.
    So imagine that you paid out your mortgage 11 months into the first year. You will have to repay 100% of the cashback even though in the first 11 months you paid enough extra interest to repay roughly 20% of the cash back plus 15% interest.(18,096.34/5 =3,619 ) Which now means the effective interest rate on that cash back is about 35% for the 11 months you had it.
    B. IRD penalties
    If you have to pay an IRD penalty to break your mortgage and the penalty is calculated as the difference between a bond rate and your mortgage rate your getting really screwed. lets say your mortgage is 5% including a 1% increased due to cashback the bond rate is 3%. this is a penalty of 5%-3% = 2% for the remaining term. If you didn’t have a cash back the penalty would have only been 1%. So now if you payout your mortgage in the first 11 months you pay a penalty of (1% * 4 remaining years) 4% due solely to the cash back.

    to summarize:

    You paid roughly 35% in the first year on the cash back. Plus 4% of your mortgage principal in penalties which is another $8,000 which is 8,000/10,000 or 80%. So now having paid out after the first 11 months you will have paid a positively criminal rate of 115% in the first year.

    Quick someone send an e-mail to Paliare Roland

  • Gates VP August 12, 2008, 5:16 pm

    So my reply devolved into a post (to not hog space):
    http://gatesvp.blogspot.com/2008/08/housing-illusions.html

    Nolan and Jordan are both quoted, please feel free to post replies / rebuttals here or there (I’ll read both :)

  • Nolan Matthias August 13, 2008, 5:42 pm

    Gates post makes the following statement about me – “This has been hashed and re-hashed on this forum and elsewhere. The data in no way supports your thesis and I would urge not to spread such dangerous information.”

    I would like to issue a challenge to Gates to show that a house purchased today will be worth less in 25 years than what you bought it for. In other words, show the data instead of just talking about it.

    Frugal Trader – What are your thoughts on this?

  • FT FrugalTrader August 13, 2008, 6:33 pm

    Historically, real estate values are known to keep up with inflation. Perhaps Gates is talking about specific situations?

  • Aaron August 13, 2008, 10:58 pm

    the math here needs a tremendous amount of work, as John pointed out. Youll never be rich if calculating 23% interest on 10k to grow it to 18k in 5 years. The calculation is simply 10000*(X^5) where x is the interest rate ( ie 1.13 is 13% on the principal) and 5 is the number of years. In this case 13% is the number…

  • DAvid August 14, 2008, 1:08 am

    Nolan,
    I don’t want to speak for Gates, but I believe the point he is making is there are many instances where renting, and investing the difference between renting and all the costs of home ownership can have financial advantage. For some folks renting is a far better choice than home ownership. As he stated, the topic has received much discussion, and there are innumerable ‘rent vs. buy’ calculators on the ‘net to provide examples.

    The assumption that home ownership is an excellent investment is largely inaccurate. As Frugal Trader states, for the most part, residential property values parallel inflation, while other investments can outpace inflation. Also, the simple measure of comparing the purchase price of the home vs. it’s selling price does not take into account all the costs of ownership (including mortgage interest).

    All is not as it first seems. You might wish to provide the information to support your thesis before challenging Gates VP.

    DAvid

  • FT FrugalTrader August 14, 2008, 7:55 am

    Aaron, speaking of math, the article states that it would take an extra $18k on top of the $10k. So it would require the growth from $10k -> $28k in 5 short years.

  • Gates VP August 14, 2008, 11:44 am

    Hey @Nolan, I think that DAvid pretty much nails it.

    The average monthly cost of home ownership is almost always more expensive than the average cost of a rental. So the big calculation here is finding the difference. If I rent and save the difference, how much money do I end up vs. owning a home? You might end up with a $200k home, but I might end up with $250k in the bank (or the other way around).

    Try the NYT calculator below and you’ll start to get a feel for the numbers. One of the big problems you’ll find is that little differences start to add up. If your investment make 10% vs 9%, you could suddenly be ahead, if your repair costs are bigger or bigger at the wrong time, you could suddenly fall behind. You could also be trapped in a overpriced housing market (i.e.: Edmonton a year ago). Check out the current supply and demand curves. Housing prices shot up to 300k+ and now suddenly the demand is 6 times the supply. Locking in your house at 300k+ was definitely an expensive proposition, I know working professionals were taking (university degrees, full-time jobs, etc.) who would have needed a 40-year mortgage (at Edmonton salaries) just to pay for these places.

    Your mileage will vary quite a bit, you’ll have to do the math for yourself. I encourage you to read the discussions below (both for and against) and use the calculators below. I think that you’ll start to see lots of ways that renting can put you ahead of the game.

    Calculators:
    Excellent one from the NYT, notice the number of sliders and options
    Canada’s office of consumer affairs
    Ginnie Mae

    Discussions:
    Myths that ruined the housing market
    The Simple Dollar: here he “thinks it through for himself”. This article is like 5 pages long and he’s still waving his a lot. (in response to the first link in fact)
    Kiplinger.com
    http://www.rentlaw.com/rentbuy.htm
    Four-Pillars
    Get Rich Slowly
    Recent Kiwiblog

  • Four Pillars August 14, 2008, 1:20 pm

    Gates – thanks for including my post in that list. I checked out the other links – very interesting.

    For the average homeowner in the average market – I’m not sure if there is a right answer regarding renting vs buying. Renting an equivalent property generally only comes out ahead if the renter saves part or all the difference in monthly costs – how many average people do this? I’m sure there are some that do but obviously there are some that don’t. And for the people who wouldn’t save if renting – are they also borrowing from their home equity if applicable?

    Bottom line (and the point of my post) is that a financially responsible person will do well whether they rent or buy – and of course, the opposite is also true.

  • Nolan Matthias August 15, 2008, 1:47 pm

    I understand the rent vs. buy thesis that several of you have brought up. However no one has brought up the point that buying protects you from future rent increases.

    Look at the market in Canada. If you had bought a $250000 condo five years ago at say $140000 in yesterdays dollars, you would be paying about $750 in mortgage payments, permanently. To rent that same condo today, you would be paying almost $1250. You can’t just factor into your calculations what you save on todays date, you have to look at the future. The question would be what would you be able to do with that $500 now as opposed to the $100 you might have saved by renting per month over the last 5 years.

    Furthermore, This site talks a lot about the Smith Manouvre. If you had bought 5 years ago you would now have $90000 in equity to potentially invest. Calculate the compound interest on that and there is no way that renting would have superseded value when it comes to wealth building.

    Now, the obvious objection to this post will be, nobody new the market was going to jump like that. Well, that was the point of my first post. No one knows what the market is going to do, so the best thing an individual can do is to get in the market, stay in the market, buy only what they can afford and be diversified. To put your money in solely stocks, or solely real estate is ignorant. You must own both and over the long term your wealth will accumulate.

  • Gates VP August 15, 2008, 7:23 pm

    @Nolan: If you had bought a $250000 condo five years ago at say $140000 in yesterdays dollars, you would be paying about $750 in mortgage payments, permanently

    And what if you had bought a 150k condo five years ago at say 200k? You’d still be paying the same mortgage even though your home value had dropped. You’d be at -50k in potential equity. Heck, even with a 20k down payment, you’d still owe more than the house is worth.

    In fact, you’d be subject to one of the risks I discussed. If you lost your job and had to move at that point, you’d be forced to sell the house at a loss.

    Some more useful links:
    John Chow: The House You Live In Is Not An Asset
    Get Rich Slowly: If your goal is to build wealth, you will be much better off investing your money in the stock market than buying a home. While both stocks and housing are cyclical markets, long-term historic trends show that housing appreciates at a rate barely above inflation, while stocks tend to return an inflation-adjusted 7-10%.

    We’re also at the end of 15-20 year upswing in housing prices. More fun links: Priced out forever.

    Nolan: You must own both [stocks and real estate] and over the long term your wealth will accumulate.

    Really? According to who? Do we have names?

    I have posited that home ownership is a very personal decision and that you can generate wealth either way. You’re stating quite the opposite.

    I’ve made a blog post and two extensive replies. I’ve provided hyperlinks to multiple view points with extensive examples worked out and individual calculators provided. You’ve given me lines like this with no evidence to support the claim. No hyperlinks, no in-context quotes, no examples with supporting data. You have one shady example with a 5-year time window.

    You’re basically providing zero value to this conversation.

  • DAvid August 15, 2008, 10:29 pm

    Nolan said: I understand the rent vs. buy thesis that several of you have brought up. However no one has brought up the point that buying protects you from future rent increases.

    But buying leaves you exposed to interest rate volatility. You may not remember the rate hikes of the early 1980’s, but mortgage renewals at 17% or higher caused many folks to return their keys to the bank, shattering their home ownership dreams. I feel that you are missing the downside potential in your discussions.

    Look at the market in Canada. If you had bought a $250000 condo five years ago at say $140000 in yesterdays dollars, you would be paying about $750 in mortgage payments, permanently. To rent that same condo today, you would be paying almost $1250. You can’t just factor into your calculations what you save on todays date, you have to look at the future. The question would be what would you be able to do with that $500 now as opposed to the $100 you might have saved by renting per month over the last 5 years.

    However, if you bought a $100,000 house in the mid-eighties in St.John’s, NL, it appreciated to about $140,000 in the following 17 years — a rate less than i2% per annum. The stock market over the same period had considerably greater returns. You havenot included Condo Fees as well. These would increase considerably over time.

    Furthermore, This site talks a lot about the Smith Manouvre. If you had bought 5 years ago you would now have $90000 in equity to potentially invest. Calculate the compound interest on that and there is no way that renting would have superseded value when it comes to wealth building.

    However, the Smith Manoeuvre does not contemplate using the increased equity in your home. It does not increase the loan amount beyond the initial mortgage amount. The tenant would be making investments into their portfolio in larger amounts from day one! They arguably could hold a margin or investment account supported by the difference in monthly accommodation costs.

    As you state, we don’t know what future direction the markets will take, however, if past performance is any indication, in many markets in Canada, one could have done better by regular investments while renting, than by depending on the incremental increase in home values as the way to wealth. In my own case, I have seen a considerable increase in my family residence value, but unless I move to a low cost town, I have no real means to extract that wealth. I currently own a home in large part due to the lack of rental accommodations in the the town I live in, but the times I have rented have been far more beneficial to my financial health.

    DAvid

  • Cannon_fodder August 21, 2008, 8:49 am

    I’ve stated it before, but when I was on my own, I always rented. When I was tempted to look at a condo, there was a certain innate desire to own something of quality. Thus, while I was prepared to spend less than $1,000 on renting an apartment in the GTA, any condo I would have looked at would have cost at least 50% more when comparing equivalent holding costs. So, you are not always comparing apples to apples.
    I consciously decided that I would rather maximum RRSP contributions rather than buy a condo and have my RRSP contributions be affected. I didn’t need to have the nicer living space (which the condo would have brought) but I will need to retire.

    Now, on the other hand, with a family, it made more sense (and there was certainly an emotional component to it) to own a house. But it wasn’t because of the investment component of buying a house because, quite frankly, I don’t think of home ownership as a great investment. In the last 5 years our house value has increased at just over 5.15% CAGR. However, we have also sunk several thousand into it (patio, fencing, minor landscaping).

    Now, think about what it would cost to sell this house. Unlike selling stocks, the cost to sell a home is extremely expensive – probably around 3-7% of the value of the home when factoring in real estate commission and lawyers’ fees. That is quite a ‘back end load’ fee! It doesn’t cost very much to leave a rental property.

    I, too, was one of those unfortunate ones in the early 90’s where we had to sell our home 5 years after we purchased it and didn’t even recover our initial selling price. Coupled with the property taxes, increased utilities, legal fees, realtor commissions, etc. – it was a terrible investment.

  • JohnT September 7, 2008, 11:01 pm

    If renting makes more sense than owning aren’t the guys who buy realestate and rent it out suckers? Don’t landlords do OK? They have to pay a mortgage, property taxes, repairs, make sure they have tenants, etc, etc and still somehow make a profit off of renting the place to someone who is better off renting than owning? I don’t get it? Maybe I’m slow.

  • Scott September 8, 2008, 11:51 am

    Landlords are business people; property is their business. They “sell” places to live, like Tim Horton’s would sell you a doughnut. Of course they are going to be making money, but this is about private residences.

    What is meant is that if it costs you $1000/mo to rent (just for rent) and $1800/mo for a mortgage payment…PLUS mortgage insurance, house insurance, utilities, repairs, taxes, etc., it is cheaper to rent than to buy. Take the difference in cash and invest it. In 25-years you might come out farther ahead by renting and investing rather than owning.

    There are calculators out there that will let you run scenarios.

    Also, think in terms of $/sqft to give you a P/E ratio, like stocks have. How much would would you pay for a “house stock” with a P/E ratio of 50, 80, 100?

    Thing is, people in North America especially, have this great desire to “own”. Look at all the generations of Europeans and New Yorkers who will rent for their entire lives and are completely comfortable with it. Just a different mentality. If owning your own home is important to you then buy a house and forget about it. If increasing your net worth and maximizing your returns is more important to you, then you may consider renting.

  • Gates VP September 10, 2008, 2:01 pm

    JohnT: If renting makes more sense than owning aren’t the guys who buy realestate and rent it out suckers? Don’t landlords do OK?

    I think Scott nails it.

    And it’s also worth noting that not all landlords do very well. How many landlords have you ever met that can give you an hourly rate for their “lording duties”? Home values and the time spent on homes is measured in years and humans tend to be very bad about calculating that kind of stuff.

    At best I’d suggest that most landlords are giving themselves a secondary stream of income at the cost of their own time. FrugalTrader here can supplement his day job with some extra rental income, but I’m sure he’ll tell you that he spends a bunch of time on it and he’s probably not making more than he does at his engineering day job.

  • JohnT September 15, 2008, 6:49 pm

    Hmmm. So landlords are willing to spend $1800/mth on mortgage payments + utilities + insurance+ taxes +++ and only get $1000/mth in rent.

    That doesn’t add up. That would be a pretty stupid landlord.

  • cannon_fodder September 15, 2008, 8:27 pm

    JohnT,

    I could be wrong, but I think the point was that an individual could either buy a home and have a mortgage payment of $1,800 /month plus all of the other costs or rent at $1,000/month and invest the difference and actually come out ahead in terms of networth.

    In many cases, a person will end up renting an abode that is not as nice (area, square footage, amenities) than they would own. That can help explain why there is such a large difference between the 2 scenarios. In a way it isn’t really comparing apples to apples, but it is reality. Personally when I was faced with the option to buy a condo in the Toronto area vs. renting an apartment, the cost difference was almost double, but that is because what I was willing to pay in rent was much less than if I was willing to ‘invest’ in home ownership.

  • JohnT September 16, 2008, 11:05 pm

    Well in those terms it makes sense.

    You could get further ahead by renting a piece of crap than by living in a nice place. I guess dreaming of piles of money in a brokerage account and living in a place that stinks is better for some than having enough to retire on and living in a place with closet doors that don’t fall off the rails every day.

    Not everyone lives in Toronto. I was paying $800 a month for a two bedroom that stank and had closet doors that fell off the rails everyday. The maintenance guy would come by and “fix” the closet doors every once in a while. I now pay a little more at $829 a month mortgage + utilities + taxes for three bedrooms and three times the space. It doesn’t stink but I have had to adjust my closet doors a few times. I bought five years ago for $180,000 with 25% down and I just sold for $269,900 privately with no commision to a broker. I don’t know about everyone else but buying seems to have worked for me.

    I just bought a new place. I will have real doors on my closets instead of those crappy sliding doors.

    I think that if you compare equivalent homes you won’t be further ahead renting.

  • Gates VP September 17, 2008, 11:45 am

    JohnT: So landlords are willing to spend $1800/mth on mortgage payments + utilities + insurance+ taxes +++ and only get $1000/mth in rent.

    This is why most landlords focus on “duplexes”, apartments and other mass market housing units. No one spends $400k on a new home in Saskatoon just to rent it out :)

    So yes, there are a few things going on here:

    Cannon_Fodder catches one part: In many cases, a person will end up renting an abode that is not as nice than they would own..

    Now there are some single-family homes that people do rent. It is possible to make reasonable comparisons with similar units. But then, as you say, how do landlords “make money” if it’s cheaper to rent?

    Well the truth is, the landlords who are making money renting single-family homes likely didn’t buy those homes today. They likely bought them when the markets were more balanced. Right now, most places in Canada have very expensive homes.

    Example: My Mom lives in a place that would go for around 300k. Let’s say I dropped 50k in savings and took up a mortgage on the house. My (30-year, 250k) mortgage payment would be $1,500 to $1,600 / month. But that house was purchased in 1990 on a sub-$1,000 mortgage. Do you see the disconnect here?

    It’s unlikely that I could buy the house today and rent it for a profit, but it’s quite likely that my mother could. Why? Because housing prices have increased quite drastically, far more than inflation.

    How much? The Bank of Canada has an inflation calculator: $100,000 in goods in 1990 would now cost $147,000. That house is now 18 years older and yet has somehow doubled in inflation-adjusted value?!?

    You have to realize that housing has been on a 15-year run in terms of growth. Homes purchased in the 90’s could reasonably be rented by their owners even though new buyers would not be able to do so.

    It looks like you’ve been riding that home ownership wave: I bought five years ago for $180,000 with 25% down and I just sold for $269,900 privately with no commision to a broker.

    And you’re probably doing “OK” by it, but the house you bought with your new money is likely going to be worth less than your list price in 10 years. (or salaries are going to be way higher)

  • Submit Mortgage Article October 15, 2008, 1:53 am

    Great post.

    Another point why it is bad is a bit of psychological.
    If the borrower does not put a down payment he/she might not have a sense of commitment.

    The best deals when funding/lending/sponsoring is involved is when all parties have something to lose and have a lot to gain. With down payment all parties are committed.

  • Steve February 19, 2010, 3:04 pm

    FT,

    Hope you can give me your opinion on this question:

    Cash Back mortgages are bad, when the rate is higher vs a regular fixed rate, I get that, but what if the rate is the same?

    Is it really “free money”?

    Is is a good deal at this point?

    Thanks!

    • FT FrugalTrader February 19, 2010, 3:06 pm

      Steve, make sure that they are offering you the same discounted rate, and not posted rates. If they are offering you cash back + the discounted rate, then I would take it! :)

  • No Debt Guy July 19, 2010, 6:49 pm

    Although this is a very old post I did some math with the numbers. Based on the post information a 5% down payment from your pocket compared to 5% cash back the difference after 5 years is just under $7,200.

    Whether it is good plan is dependent on an individual’s circumstances, but it can work in some situations.

  • LeeMathew April 29, 2012, 9:38 pm

    This thread is a little old, and I hate to bring it up again. A lot of great examples were given, and the general consensus is that a cash back mortgage is a bad idea when switching to a mortgage with a larger payment vs rent, ie: 1800 mortgage vs 1000 rent. But what about a situation where the mortgage payment would be virtually identical to the rent, give or take fifty dollars or so.

    We have an opportunity to purchase the apartment we currently live in (converting the building to condos) at a price that is below the market norm for our neighborhood, and the renovations to be completed are top notch.

    However, since it is last minute, we don’t have a down payment ready, and only have thirty days for our tenant right to first refusal. The mortgage payment, including condo fees and property tax, would work out to only 50 dollars more per month than we are currently paying, although this is based on a 5% down payment, I’m sure with a cash back mortgage, we would be paying slightly more than this.

    Is there any advice you guys can give me in this particular situation?

  • Gates VP April 30, 2012, 8:29 pm

    @LeeMatthew: you will get a lot of opinions on this one, because it is a detailed decision.

    First off, rent vs. mortgage costs.

    In my personal studies (lots of spreadsheets) rent ~= mortgage is the balance point for considering the home ownership path. However, the first few years are basically a wash. You will have to spend money on legal fees, titles, etc.

    Plus you will also have to pay property taxes and condo fees. Generally, these will be in the hundreds / month. Anywhere from a few hundred to several hundred. Also many rental places in Canada include water, electricity & gas in the rent, you will pay for these once you’re an owner.

    Ensure that you are accounting for these in you new monthly budget before you decide if you can afford the place.

    However, since it is last minute, we don’t have a down payment ready…

    I hate to be the bearer of bad news, but this is a red flag. I mean if you can’t even make a 5% down payment how are you going to cover all of the other costs (like closing costs, professional inspection, extra insurance, etc)?

    Where is your cash? Is it trapped in some GICs / CDs? Is it inaccessible in your RRSP? When will your down payment cash become available?

    Are you OK with cutting your monthly savings in order to finance the increased expenditures? Do you have enough cash to cover the mortgage for a few months if you or your partner lose a job?

  • Shayne April 30, 2012, 9:00 pm

    Rather than a cashback mortgage do you have access to a line of credit for the downpayment? This is a far better way to go.

  • Ed Rempel April 30, 2012, 11:10 pm

    Hi Lee,

    I have some suggestions for you, but first you need to decide whether or not buying this property makes sense for you.

    First, you should only buy if you are confident you will want to live in this place at least 5 years. If you buy and sell in less than 5 years, you are unlikely to make anything, even though you will have lots of your capital tied up in it.

    Second, read what Gates wrote. You can’t just compare mortgage to rent. You need to compare total occupancy costs in the 2 options. The part of this that most people miss relates to renovations and improvements. Owners often spend a lot renos, that usually only add a bit of value to the home. Renters generally don’t waste money on renos. Are you likely to be avid renovators?

    Third, most people assume that if the costs are close, it is smarter to buy rather than “throw your money away in rent”. This may or may not be true. If you buy, you are still renting – you are renting the money to own. Normally, you can count on some slow, steady growth in real estate prices over the years, but there is a lot of speculation that it may be overvalued today. My best guess is that real estate is inflated, but won’t crash. The most likely scenario is just little or no growth for a few years. My point, though, is don’t automatically assume that if you buy, it will go up.

    Fourth, is this a good price. If you overpay for a home, don’t expect to make anything on it for many years.

    If after this it makes sense to you to buy, you need the best method. We see Cash Back mortgages as utter desperation. To get the cash, you have to agree to a very high interest rate for many years. It is clearly not worth it, unless you have no other options at all. Try everything else first.

    It sounds like you only have the 5% down if you do a Cash Back mortgage? Here are some other options:

    1. Shayne’s option – Do you qualify for an unsecured credit line?
    2. Are you a first-time home buyer? You can borrow from your RRSP. You may be able to take an RRSP loan for up to $25,000 each, wait 90 days and then use it for your down payment. Your 30 days is probably to decide. If you tell them you agree to buy but they will need to wait the 90 days, most likely they will wait.
    3. Is borrowing from relatives an options? Yes, it is desperate, but less desperate than a Cash Back mortgage.

    If you can buy, then avoid the big mistake of falling into the 5-Year Fixed Mortgage Trap. Long term fixed mortgages are a lot more expensive nearly 100% of the time. Usually variable is a great option, but not really today. The best deal today is a 1-year fixed at about 2.59%. Stay short and save money.

    Ed

  • zerotohero August 28, 2013, 1:26 am

    Hey FT!
    I’ve only scanned the comments but I didn’t see anyone mention taking the cash back and immediately dumping it against your principal to lower you effective interest rate.
    I’m currently debating CIBC’s 7% cash back offer with 3.45% 3 year fixed rate. This will give me $19,800 cash back, after immediately applying to my principal amount I will still pay about $18K more in interest (compared the the 2.99% best fixed rate offer) over the period but will have dropped my effective interest rate to 2.3% and paid off $14k more of principal in the 3 years.
    What are your thoughts on this scenario?

  • Sebastien Benoit September 5, 2013, 5:19 pm

    FT:

    You’re assuming that the downpayment is being given back to you, reducing the downpayment on your mortgage, so the mortgage amount is actually going to be the full 200k. That’s not true, and I can’t see how it would be within regulations to allow a 100% financed mortgage to go through (as it breaks the 95% LTV rule)

    rehashing your example we get this:
    5.55% on 190k for 5 years, total interest cost for the term: $49,498.52
    7.15% on 190k for 5 years, total interest cost for the term: $64,214.88
    Total interest cost difference for the term: $14,716.36

    to borrow 10k for 5 years will cost ~4.7k in interest, which is an effective rate of ~8.03%. Not bad for 2008.

    A more recent and relevant example: my brother bought a house and because they didn’t have the DP readily available they opted against the discounted rate of 3.99% at TD and went for 5.14% with a 5% cashback. Through the generosity of family members they gathered the 5% DP, and on closing they’ll get the cashback to pay them back (if they want, since it was a .. gift)

    The price was $294k, 5% is 14.7k.

    3.99% on 279.3k for 5 years, total interest cost for the term: $49,197.27
    5.14% on 279.3k for 5 years, total interest cost for the term: $67,246.61
    Total interest cost difference for the term: $18,049.34

    So for them, to borrow 14.7k for 5 years will cost them ~3.3k in interest, which is an effective rate of ~4.19%. Much better than the 6.25% I’m paying in my unsecured LoC.

    So, am I wrong? Are buyers just getting back their downpayments, and their mortgage is the full value of the house? Or is this truly a cashback program that is separate from the mortgage?

    I just called my brother and asked what his mortgage amount was, and he said that he remembered it being around ~285 (considering the CHMC fee and all) but certainly not 294.

    Thanks!

  • FT FrugalTrader September 6, 2013, 9:30 am

    Interesting recent comments. I will take a look at the most recent numbers as there have been a few mortgages changes over the years since this post.

  • FT FrugalTrader September 6, 2013, 9:33 am

    @zerotohero, it looks like that scenario could work. If the cash back is more than the increased interest, then I’d certainly take it!

  • Ed Rempel September 6, 2013, 9:31 pm

    Hi zerotohero,

    Are you sure your figures are correct? I tried some calculations, but nothing makes sense. CIBC does not have a 7% cashback offer that I can find, either.

    Cashback offers almost never work. Try comparing to the lowest rate today, such as the 2-year fixed 2.79%.

    Ed

  • zerotohero September 9, 2013, 2:44 am

    Ed- You’re right…I had some numbers crossed there but my result is still positive with the Cash back.
    Its only 3% cash back, which on my soon to be mortgage of 660k is $19800.
    If I dump that against my principal dropping it to 640,200 then paying the 3.45% stated rate, the effective rate over the three year period is 2.3%.
    Even the two year 2.7% can’t compare to that.
    The best 4 year rate i’ve been quoted is 2.99%. At that rate i’d pay close to $7k less in interest over three years but the $19,800 in cash up front is well worth that.
    For Cash back option I’m using $730.16 (quoted from CIBC) for the weekly payment amortized over 25 years and a starting balance of $640,200.

    Other banks won’t offer the cash back option unless you are a first time buyer. I think this is because its assumed that most if not all first time home buyers would not take the cash back and put it against the principal (most spend it on closing fees, furniture, etc..)
    I’m still trying to find the catch to this CIBC cash back option….

  • Shayne September 9, 2013, 12:32 pm

    There is no real catch unless you need to break the mortgage before the term is up. You will then have to repay the cash back on top of the penalty.

  • Sebastien Benoit September 16, 2013, 1:14 pm

    Any luck on sorting this out, FT?

  • FT September 16, 2013, 2:35 pm

    I put my feelers out to a mortgage broker, but no word yet! Will post when I hear something.

  • Shayne September 17, 2013, 11:21 pm

    Sebastien,

    The cash back is essentially separate. Most of the time it works in the favor of the banks, but CIBC does have some deals that are incredible.

    If you need a down payment you would be better served using a line of credit instead of taking a higher rate from a cash back deal.

  • Sebastien Benoit September 18, 2013, 8:02 am

    The effective rate worked out to be 4.19% for my brother with TD.. His LoC rate is certainly not that low. I fail to see how this is not a good idea for someone who would be borrowing the money anyway.

  • Shayne September 18, 2013, 10:35 am

    This is why you should use a good broker. :)

    I will use your brother’s numbers as an example along with your 6.25% rate on your loc. Firstly 5.14% is a good number to use as the 5% cash back rate. Unfortunately you cannot use 3.99% as the discounted rate as that is far from a discounted rate, at least over the last year. I am going to use 3.39% as the best rate in this example. This rate was available as recently as a month ago.

    So the question is, would you rather pay 5.14% on $297,300 or pay 3.39% on the same amount and in addition pay 6.25% on $14, 700?

    With monthly payments being the same the end balances are in favor of using the line of credit to the amount of $6024.

    You come out ahead using a line of credit instead of the cash back mortgage as long as the line of credit rate is not above 15%.

  • Shayne September 18, 2013, 10:43 am

    And…..the effective rate on 5.14% with 5% cash back is actually 3.88%.

    So between the 5.14% with cash back and the 3.99% “discounted rate” the cash back is the better deal. The problem with this scenario is that 3.99% is far was far from competitive.

    Let me know if you want a better understanding off all of this. There is both math and logic at play and not a lot of people can work out these numbers.

  • Sebastien Benoit September 18, 2013, 11:58 am

    I understand what you mean Shayne.. I didn’t take into account the bargaining leverage one would have when cashback wasn’t on the table. That being said, I don’t think my brother would have been able to get better than 3.79% (whether by not having a better deal available, or by not trying to negotiate, either way.)

    but for sure, we should be comparing the best cases for both scenarios, and that’s not what I did.

    Thanks.

  • Shayne September 18, 2013, 12:16 pm

    There is alot to take into account.

    What is done is done but 3.79% would have been far from competative this year.

    @FT Do you want some calculators for your site?

  • Sebastien Benoit September 18, 2013, 12:26 pm

    3.79% is the best bank rate, and currently 3.49% is the best rate listed on ratehub.ca.. so if we take that into account this is what we get:

    3.49% on 279.3k for 5 years, total interest cost for the term: $45,214.81
    5.14% on 279.3k for 5 years, total interest cost for the term: $67,246.61
    Total interest cost difference for the term: $22,031.80

    So for them, to borrow 14.7k for 5 years will cost them ~7.3k in interest, which is an effective rate of ~8.43%.

    This is assuming that a) they would be able to negotiate the rate down to 3.49 (only True North Mortgage is offering a rate lower than 3.79% at the moment, in New Brunswick, according to ratehub.ca) and b) that they wouldn’t be able to negotiate the 5.14% interest down a bit (a fair assumption.)

    Now it’s looking like their line of credit would have been a better option.

    Thanks.

  • Shayne September 18, 2013, 1:40 pm

    You are doing the math wrong. To make a proper comparison you have to use the same monthly payments on both rates.

    But yes, loc is the better way to go.

  • Sebastien Benoit September 18, 2013, 1:59 pm

    The amount of the payment each month doesn’t matter here, it what the difference is at the end of the 5 years that counts… And how would the payments be made the same?

    If you want to make a statement like that, back it up by showing some math ;)

  • Shayne September 18, 2013, 2:22 pm

    Well I can back it up with math, but don’t even need too cause you will get it.

    If you are not using the same monthly payment then you would have to some how factor that in, so it is easier to use the same payment amount.

    And you can’t just take the interest paid, you have to look at the end balance of each mortgage as well. ;)

  • Shayne September 18, 2013, 4:28 pm

    Email me at shayne.slinn@gmail.com

    I have a pdf for you with some numbers to work with.

  • Aaron August 25, 2014, 2:54 pm

    As high as these payments sound its better than paying rent.After 5 years you can renegotiate for a much lower interest rate.

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