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You’ve probably never thought about not paying the principal on your mortgage. It sounds almost un-Canadian.
But it’s a crazy-sounding idea that, in limited cases, is not so crazy.
Out of thousands of home loans in Canada, only two products let you pay just the interest each month:
- A Home Equity Line of Credit (HELOC)
- An interest-only mortgage (I/O).
HELOCs versus Interest-only Mortgages
Here’s a quick look at how they compare.
HELOC Pros:
- You can pay off a HELOC anytime without penalty, unlike prime I/O mortgages, which entail penalties
- More lender options.
Interest-only Pros:
- You can get a fixed rate (almost all HELOCs have floating rates)
- Usually a bit easier to qualify for than a HELOC (due to a lower stress test rate)
- Interest-only rates are mostly cheaper so the payments are usually lower. Rates today are as low as:
- 3.64% fixed
- prime + 0.15% variable
That compares to floating HELOC rates that average prime + 0.50% (4.45% today) and range from prime – 0.20% (currently only one lender on promotion) to prime + 1.00%.
- Because the rate is usually lower, the payments are lower than most HELOCs.
- On a 3.19 per cent $300,000 mortgage amortized over 30 years, you’d pay $1292 a month.
- On a 4.45 per cent $300,000 HELOC, you’d pay $1102 a month ($190 less)
- On a 3.64 per cent $300,000 I/O mortgage, you’d pay $903 a month ($389 less)
- Easier portability, in some cases.
Spy Tip: If you want to estimate how much you’d save in payments with an interest-only mortgage, enter your mortgage details in the first column of this mortgage calculator. Then enter the same info for the second mortgage, except make the amortization “999” (this replicates an interest-only mortgage, which does not amortize).
If you had to summarize, I/O mortgages are more suited to people who have a legitimate longer-term strategy for paying interest only.
The Investment Angle
I’m not a fan of I/O mortgages in the hands of spendthrift homeowners. I/Os are like a Ferrari 812. If you don’t know how to drive one fast, you may just crash and burn.
That said, my piece in the Globe and Mail today shows how using an I/O mortgage can build a bigger nest egg for the right type of disciplined borrower.
In short, it entails using the monthly payment savings of an I/O mortgage to shovel more into your RRSP (assuming you have RRSP contribution room). For lack of a more creative title, we’ll call it the “I/O RRSP Accelerator.”
Because paper space limitations never allow a full discussion of financial strategies, there were other little wisdom nuggets I couldn’t include. Hence, here are 10 more points that folks should consider before weighing this strategy:
- Let’s get the disclaimer out of the way real quick. We are not investment advisors or financial planners, so this is not advice. If you want to explore this strategy, talk to a licensed CFP who knows leveraged investing intimately—preferably a fee-only advisor who isn’t biased by the commissions they earn on financial products.
- If you have a significant amount of high-interest debt, pay it off before even thinking about investing. An I/O mortgage can be instrumental in accelerating such repayment, assuming you’re not able to roll that expensive debt into your mortgage.
- If you expect a higher tax bracket in retirement, an RRSP strategy like this is not appropriate.
- Investments can be volatile. The I/O RRSP accelerator is unsuitable for people who are not growth-style investors (i.e., if you prefer “safer” bonds to stocks, this isn’t for you).
- Further to #4, if you can’t afford to wait over a decade to ride out portfolio volatility and/or might need your funds sooner, you’re better off paying down your non-tax-deductible mortgage than building your RRSP faster.
- Among other things, success hinges on your rate of return when investing. If you don’t think you can average over 5.5% returns a year on your RRSP investments, you’re probably better off just banging away at your mortgage.
- RRSPs provide essential diversification. That’s vital when the unthinkable happens. If housing tanks and you lose your job, for example, an RRSP is more liquid than your home. That’s one unsung benefit of this strategy.
- If you ever want to wind down the I/O RRSP Accelerator—perhaps because interest rates soared, or your risk tolerance changed—you can switch back to a regular mortgage at renewal with no ill effects.
- Proper planning is essential to judging your RRSP value after taxes. Certified Financial Planner Jason Heath notes, for example, that: “If you’re married, you can a split your RRSP withdrawals (once converted to a RRIF) with your spouse after 65. If you can control your income, and take RRSP withdrawals early in retirement, before you start CPP and OAS (deferring them to 70), you can take RRSP withdrawals at a low or no tax rate.”
- Despite a much bigger RRSP, the thought of having a mortgage left over after 25 years isn’t so exciting to some people. But remember that when you go to pay off that mortgage in 2044, you’ll be paying with deflated dollars thanks to the time value of money. Your mortgage payments remain locked in at 2019 dollars but your earnings grow. Had you got an interest-only mortgage 25 years ago and your earnings rose with inflation, you’d be making 53% more money today, while making the same or less nominal mortgage payment than you did two-and-a-half decades ago.
Heath summarized the I/O RRSP Accelerator nicely, saying: “RRSP contribution over debt repayment makes that much more sense when your tax bracket [before retirement] is higher, your risk tolerance in your RRSP is higher, you have a company-matching contribution, you expect to be in a lower tax bracket in retirement, etc.”
As with any financial tactic, this one requires that you carefully asses your investment psychology, discipline and return potential. But if you make the cut, it’s a powerful new tool in your savings toolbox.
Note: This story is editorial commentary. We are not financial planners and we don’t promote investments. This article is general information only and not advice of any kind. Investing involves risk of loss and returns are not guaranteed. Please seek professional counsel before embarking on any financial strategy.
21 Comments
In the UK they have interest only retirement mortgages where you only pay the interest until you die or move: https://www.whatmortgage.co.uk/news/equity-release/mortgages-retirement-best/
Can you do that with this one from Merix?
Hi mapleman,
Theoretically you could, so long as you qualify when you get one, pay as agreed and remain in your home. According to the lender, you’d just be renewed into a new I/O at current rates at maturity.
Glad to see this product resurface. Regulators have taken away so many flexible mortgage products in Canada. It’s about time we get one back. In the hands of someone sensible, it’s a powerful tool.
Hi Spy – Can I/O mortgages be used to buy properties that are rented out? Thank you!
Hi Charlotte,
Yes they can. The lender charges a 15 basis point premium for rental properties. Hence, a 5-year fixed I/O rental rate would be roughly 3.84% to 3.94%.
Is Merix the only lender in Canada who offers Interest-only product? Or, are there any institutions who offer it or similar?
Hi John,
As far as I’m aware, Merix and its related companies are the only sources of prime interest-only mortgages in multiple provinces (except in Quebec).
There are lots of alternative-lender options but they typically offer non-prime I/O products at much higher rates/fees.
I suspect we’ll eventually see more lenders selling this product but it will probably never be anywhere close to mainstream.
Good to see more options being introduced into the market for those who know how to take advantage of them responsibly. That said, I would think there’s a sizeable percentage of borrowers who should steer clear. But any financial advisor worth their salt would easily be able to tell which camp a client falls into.
Agreed BC, It’s a product meant for less than 1 in 10 borrowers.
A fee-based advisor is still going to be biased, even if they don’t receive commission off the sale of financial instruments. Their fee, which is typically a fixed percentage of the size of the portfolio, will increase with the more money you give them to manage. Might as well go into a Ford dealership at the same time and ask if an F-150 will improve the quality of your life. Lol.
Lots of flat fee and hourly advisors out there, Don.
We don’t vouch for anyone on this list but here’s a start, courtesy of John Robertson (@Holy_Potato) –> https://docs.google.com/spreadsheets/d/1iGzy9kkSXqjGbhXfcfczs9qwSQfI1PdRuNUOMybxvl4/edit#gid=0
This is meant for Don:
Don, what are you recommending? To speak to a commission based advisor or to no advisor at all?
Interest Only Flex Mortgage conversations I always talk about a young couple starting a family and taking the IO Flex as an option during maternity leave of up to 18 months ($428 EI weekly) and day care to follow in many cases for 3+ years. Here is an example I show them
Guelph, ON (because young couples are typically not buying in Toronto or Vancouver)
– avg home $566,688
– mortgage at 80% LTV and 3.09% rate is $1,929.64 monthly payment
– day care cost is $40 – $70 day or $800 on the low end per month
– IO Flex at 65% or $368,500 fixed interest only (3.79%) and 15% or $85,050 amortizing (3.29%) is $1,525.13 a month qualified under stress test at 5.706% blended
– savings of $400 a month or half the day care costs for the first 5 years
Yes I know people are programmed to pay off their mortgage quicker however the cost of a newborn is not cheap. The IO Flex allows clients 20% prepayment so if the clients can manage the higher costs they can always prepay the interest only or fixed portion. Another benefit with this product not being a LOC is there is never a chance that the client will possibly have to use the limit as opposed to the balance for future borrowing.
If Don is touting commissioned advisors, then by his analogy you might as well go to a crack dealer and ask if smoking crack will improve the quality of your life.
Hello
Can you get part of the mortgage interest only and part of it regular?
Thk you
@Polesitter01
Yes you can. Up to 65% of the mortgage can be interest-only. The rest can be in the form of an amortizing mortgage, for a total maximum loan-to-value of 80%.
Rates on regular mortgage segments are much lower. e.g., As low as 3.09% for a regular 5-year fixed portion versus 3.64% for the interest-only portion.
If a couple or others who have new jobs, limited down payment and/or do not qualify for a conventional mortgage, it may qualify them, giving them an option for home ownership. If they are planning to stay in it for 5 plus years, the equity may grow for a down-payment when they upsize in the future, and their incomes increase giving them more options later.
A good option in a hot real estate market. i.e. Buy a rental property near an economic boom centre. Let the equity grow and write of the interest.
For investors, they can free up cash flow for other options, RRSP top ups, afford a cottage/cabin/boat/vehicle payment, a real estate flip, a leveraged investment opportunity (i.e. buy low during a market downturn), etc.
Risky if facing an economic downturn and falling real estate prices, so longer term is the better option and not for the faint of heart.
People with “limited down payment” and those who “do not qualify for a conventional mortgage” cannot get this interest-only product.
You need at least a 20% down payment and you have to be more qualified than a regular conventional applicant, not less.
I do like your rental property idea but note the maximum allowed TDS ratio is 40%.
A-Broker, are you sure about that? Isn’t Merix, for example, an alternative lender? Granted, they charge slightly higher rates than the A lenders do for conventional borrowers, but I think the whole point of an I/O mortgage is its appeal to those who are outside the box, so to speak.
Merix is mainly a prime mortgage lender. Its rates are often below the big banks.
The interest-only mortgage is for very creditworthy homeowners only. You can see this for yourself by checking their guidelines:
http://www.merixfinancial.com/programs/interest-only-flex.pdf
I see what you mean. Thanks for the link, Mark. Good information here.