Full disclosure, there is a bias within the following words.  I have tried for a few weeks now to create more balance within this post, but in the face of effective interest rates of 53.38% (read on), it was exceedingly difficult to find significant strength in the ‘Pro’ stance.

 Short Version

Contemplating a cashback mortgage?  Please read on for the effective costs of such a move, there is no ‘free lunch’.

Top of mind should always be that Lending Institutions are Profit Driven Corporations beholden to Shareholders. This is the economic model we have adopted.  The age old debate between Capitalists and Socialists about the merits is a healthy one for our society to continue to have.  Being aware of the nature of the entity one is dealing with is always helpful.  Lenders are Capitalistic, not benevolent, in nature.

Within Lending Institutions there is an inherent drive to create superficially simple and attractive offerings for consumers.  The presentation of which tends to belie the underlying complexity of financial instruments itself.  The sole purpose of any product offering is to increase profits and drive market share in favour of the lender.  These products are laced with seemingly innocuous restrictions (prepayment penalties) designed to keep the client (i.e. borrower) locked into a cyclical relationship with their lender.

Long Version

The vast majority of Mortgage Brokers are aware that for their clients a cashback mortgage stands to create greater pitfalls than benefits.  The downside of (breaking) a cashback mortgage can be devastating.  Once an applicant understands all the metrics involved they often arrive at an alternate solution.  In life rarely do the easiest and best moves align with each other. Of 928 mortgages written in our office to date, only a single applicant has opted for the cashback product.  This was for a client with a truly unique profile;

• Significant gross personal income
• A detailed & manageable plan to pay the entire mortgage off in less than five years.
• A recent life event had removed all savings and liquidity from their life, as well as their dwelling.
• Renting was not an option for their specific circumstances

Basically 1 in 1000 clients found this product to be an effective lending solution.

The aforementioned client profile is the exact opposite of most who consider a cash-back mortgage product.  Often the applicant considering a cashback option has slipped into debt that they cannot keep up with, or have been unable to save up a down payment for a purchase.  In either instance a hard look at budgets and behaviour may indicate that a different long term solution is a safer choice.  Consider that past inability to budget properly may reflect future long term habits which are being temporarily glossed over and not truly corrected with this product.

What is a ‘cash-back mortgage’ exactly?

Essentially a mortgage which is signed at a higher than market interest rate, (this would be the ‘give’ from the client to the lender).  In exchange the client receives X% of the gross mortgage back in the form of cash at the time of signing (the ‘take’ from the lender for the client).

The % amount of cash back offered tends to range from 2% to as much as 5% which can be a very attractive amount of money.

The dazzle of the lure, the cash, often distracts from the barbed hook, i.e. the proportionately higher interest rate which effectively funnels all of the upfront cash back to the lender with significant interest over the term of the mortgage.

There is no free lunch.

It is important for clients to take a step back, pause, and review the mathematics.  Mathematics which often are not set out clearly at all during the approval process. We will use an example in the mid-range of options in the market, the numbers are that much more aggressive with increased percentages of cashback as the interest rates rises notably with the percentage of cashback offered.

We are happy to run the math on your own personal scenario.

A $100,000 3% cashback mortgage (as of Aug 2014 offered at 3.9% for 5 years – a 1% premium over current market rates) effectively costs an additional $4,989.60 in interest over the first five year term. In other words, the lender grants $3,000 up front, and claws back $4,989.60 in additional interest over the 5yr term… but this is only the beginning.

The $3,000.00 should not be viewed as 3.9% money, rather one should consider that there is a 1% premium being paid on the full $100,000 amount simply to create access to the  $3,000.00. Thus the entire excess interest paid on the $100,000 should be applied to only the $3,000.00 to get an accurate cost of the ‘free’ money.

The true cost of this $3,000.00 ‘gift’ equates to a 53.38% annual interest rate.

This is assuming an effective amortization of 5 years, same as the mortgage term. Unfortunately the $3,000 is in fact not fully amortized (paid off) during the first 5 years.

You may be asking yourself at this point what interest rate is considered ‘usury’ in Canada?  The answer is 60%, so this arrangement is all good…for the lender.

back to the numbers…

Ending balance comparisons 60 months later;

$86,901.89 – $100,000 mortgage 3.9% amortized over 25 years. (The cash-back rate)

$85,309.67 – $100,000 mortgage 2.9% amortized over 25 years. (The standard rate)

Despite paying the additional $4989.60 in interest for the first five years, the outstanding balance at the end of the five-year term remains $1592.22 higher than would the mortgage balance of a non-cashback mortgage with its lower effective interest rate.

The ripple effect

Assuming mortgage renewal into a standard mortgage is chosen.  (A second cashback would serve to magnify the negative impact significantly) We still see the continued ripple effect of the initial cash back decision ten years later. For the purposes of this example, we will assume interest rates are exactly the same as today.  Higher interest rates only serve to exacerbate the numbers, deepening the impact of a questionable decision made years earlier.

$86,901.89 – renewed at 2.9% over a 20 year amortization, as opposed to renewing a standard mortgage (also at 2.9% over a 20 year amortization) will which would have lower balance of $85,309.67 – results in;

• $207.60 in additional interest over the second five-year term
• $1,275.42 higher ending balance 10 years after the initial decision.

There is ‘really-really’ no free lunch…really!

Let’s assume 10 years later that the client writes a cheque for the $1275.42 difference to get to an even balance with the standard mortgage holder, the cash-back borrower is, ten years later, effectively paying a total of;

• $4989.60 – additional interest or the first five years
• $207.60 – additional interest over the second five years
• $1275.42 – additional outstanding mortgage balance at the end of 10 years

This is a grand total of $6472.62.

Ten years earlier the client received $3000 ‘cash-back’ which felt like free money.  The reality is that to wind up with the same mortgage balance 10 years later as their neighbor that did not opt for the cashback mortgage they have paid an additional $6472.62.

This equates to an annual interest rate on the $3000 initially advanced of; 31.86% annual interest rate over a 10 year period.

But that’s not all folks, there’s more…

There remains an additional landmine within this product.  Prepayment Penalty Implications. This becomes a very lender specific issue, with nearly all Chartered Banks and Credit Unions falling into one category (ultra-aggressive) and non-bank lenders falling into a notably more generous camp. If/When a mortgage is broken early, the pre-payment penalty is rarely the 3 months interest so many expect, far more often it is the IRD – Interest Rate Differential penalty calculation that is implemented.

Stats show that 6 out of 10 Canadians break their mortgage an average of 38 months into the term. At this point the cash-back client has also paid $83.16 in additional interest per month, per $100,000 of mortgage money advanced. At 38 months this is an additional $3160.08 in interest per $100,000 of mortgage advanced.

Click here for a Chartered Banks prepayment calculator and you will quickly see that the penalty 38 months into a 60 month term is approximately $4500.00 per $100,000.00 of mortgage money.  About $3,750.00 MORE expensive than with this more favourable lender.

Read more on the heat being applied to the Chartered Banks byzantine penalty calculations here, along with one lenders stats on the % of CDN’s breaking mortgages each year (including year 1).

Then we have the (rotten) cherry on top;  In most instances the initial cash advance of $3000.00 (per $100,000) ‘cash-back’ is also clawed back.  This completely negates any perceived advantage remaining. The entire experience potentially costing, on average, $6810.08 in additional interest and penalty expenses – per $100,000 borrowed as opposed to taking a superior non-cash-back mortgage with a more forgiving non-bank lender.

One is arguably better served charging the $3,000.00 to a line of credit or even a credit card.

This last statement seems a pretty clear indictment of the ‘cash-back’ product a very poor solution for ‘debt consolidation’. Instead it typically clears the path for repeat bad habits taking suddenly cleared credit cards right back to their limits once again in short order.

Consider whether or not it is a Financial Institutions mandate to;

1. Design simple money saving products which a consumer can easily understand and benefit from?

OR

2. Design complex profit generating products which both consumers and regulators with find too difficult to analyze effectively but ‘feel’ OK with? The cumulative impact of such products combined with complicated prepayment penalty calculations conspire to take from the average CDN, and give to the average CDN Bank-Stock-Shareholder.

Moral #1 of this story – Buy Banks Stocks

Moral #2 of this story – Consult with an Accredited Mortgage Professional and have us ‘Do The Math’ on your behalf.

Thanks for your time!

Dustan Woodhouse –AMP