Kirk Wants a Free Down Payment Mortgage

“If you don’t feel comfortable with putting the $10,000 that you have saved over the last couple of years into the down payment of your home, why don’t you take advantage of the Free Down Payment Mortgage from Scotia Bank,” I said to Kirk as we discussed the pros and cons of putting all of his liquid assets into his down payment.

“But I heard that those cash back mortgages end up costing you a lot more money in interest.” He responded.

Kirk was right, kind of. Cash back mortgages do come with a higher interest rate, and depending on how you run the numbers, and the assumptions you make (correct or not), there can be a real case made from either side of the free down payment mortgage debate. In fact FrugalTrader over at the Million Dollar Journey Blog made a couple of good arguments against it about a year ago, although his calculations appear to be flawed. I get substantially different numbers when I run amortization schedules using the same assumptions he did (Please note I am a huge fan of Frugal Traders site and what he writes about personal finance, however when you write that often on any subject you are bound to disagree on occasion – think of this as a respectful opposition to the case that he made, as well as a complete endorsement of the information he provides).

In Frugal Traders article he made the following assumptions.
1. The cash back rate was 7.15%.
2. The discounted rate was 5.55%.
3. The amortization was 25 years.
4. The term was 5 years.
5. The cash back amount was $10,000.
6. The mortgage amount was $200,000.

FT calculated the interest paid over 5 years correctly on the cash back mortgage at $67,595.35, however when he calculated the interest on the discounted mortgage he miscalculated and came to $49,499.01. The number he should have come up with was $52,104.19. This would have made the difference in interest paid over the 5 years $15,491.16, not the $18,096.34 that he calculated. Furthermore, when he went to calculate the annual return needed to grow the $10,000 enough to make up for the cost of borrowing it, he calculated the return needed to make $28,000, instead of $8,096.34 (the difference between the additional interest cost and the $10,000 cash received up front), which lead to a calculation of 23%. The actual rate of return required to recoup the additional interest cost had the $10,000 been invested would have been closer to 10.98%. While FT’s intentions were good, his calculations were misleading. He also failed to discuss several other issues that affect someone like Kirk.

In Kirk’s case, the cash back mortgage should be considered. By putting all of his savings towards a down payment on a house, he would instantaneously be making himself house poor when there is no need. If Kirk were ever in an accident or lost his job, the cash back mortgage could potentially be his saving grace by giving him the means to cope for at least 3 months without an income. The cash back mortgage also benefits those trying to purchase a property, who may not have saved the money to do so quite yet. Some may argue that if a person hasn’t saved enough to put 5% down on a house, they shouldn’t be buying. Others on the other hand may argue that keeping people who haven’t saved 5% out of the market only makes it harder for them to eventually buy when prices are on the rise. Either way, what is important is that each individuals circumstances are considered and decisions are made based on those considerations rather than just a blanket positive or negative opinion given with respect to a particular product.

Fast forward from FT’s post to today, and the cash back mortgage looks relatively the same. Fully discounted rates are 4.24%, and cash back rates are 5.84%, making the calculations fairly similar to the assumptions made by FT a year ago. With the market being as active as it is once again, and real estate prices slowly on the rise, paying the roughly $5,491 in extra interest over the next five years could actually save a borrower from missing out on increases in property values that could happen over the next year. If property values increase by just 3% ($6,000) in the next year, the borrower will be in a net better position having taken the cash back mortgage than having waited until they had saved up the 5% down payment on their own.

In Kirk’s case, paying the additional interest is the equivalent of buying security. He will know going forward that if something happens that prevents him from working, he will not lose his home and will have time to regroup and get back on track. He is also not locking in his investment losses from the last 18 months, which will likely give him the opportunity to regain more than the additional interest cost by keeping his money invested.

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