Should you go with an open or closed mortgage? It depends on your current financial situation and what you expect your financial situation to be in the future. Essentially, you pay a higher rate to have more flexibility with an open mortgage. My advice? Go with the closed mortgage. Only buy a property if you plan on owning it long term, ideally 10 years or more. And, the interest savings will be tens of thousands of dollars over that time. If you find your financial situation changes or you get a job elsewhere, rent the home out until the end of the term and then sell. Note that both fixed-rate and variable-rate mortgages can be either open or closed mortgages.
Prepayment Penalty Fees
With either variable-or fixed-rate mortgages, there is typically a fee associated with selling your property before the end of the term, assuming you have a closed mortgage.97 This fee is referred to as the mortgage prepayment penalty.
In the U.S., the amount of the mortgage prepayment penalty varies from bank to bank. Typically, they fall under the following types for fixed-rate mortgages:98
•Fixed, flat fee,
•Percentage of the owed interest,
•Percentage of the remaining balance, or
•Sliding scale.
For example, some lenders may charge penalties such as 80% of six months of interest on your final loan balance, while others will calculate between 2% and 5% of the balance itself.
In Canada, the mortgage prepayment penalty for fixed-rate mortgages is the greater of:
•Three months of interest or
•The interest rate differential (IRD).
Three months of interest is the amount of interest you would have paid in a three-month period on your current mortgage.
The interest rate differential is a little trickier. This is your lender’s way of determining how much interest they will lose by letting you break your contract early, and then making you pay the interest to them. To calculate the IRD, your lender looks at your mortgage rate, how much time is left in your mortgage term, and the mortgage rate they could charge someone now for a new term equal to the remainder of your term. It can be worse. Many banks use the posted rate at the time you received your mortgage versus the actual negotiated rate you received to determine the difference, which makes the differential even larger.
For example, let’s say you received 3.89% on your five-year fixed rate, have 24 months left in your contract, and $250,000 outstanding on your mortgage. Depending on the bank, they would look at what the posted rate was for a five-year rate the day you originally signed your contract with them. For this example, we use 5.49%. Then, the bank would find out what product would cover the remainder of your term. In this case, it would be a twoyear fixed-rate mortgage, and let’s say the posted rate is 3.14%.
IRD=
(5.49% posted rate at original mortgage date – 3.14% posted rate for remaining term) / 12 months= 0.0020 IRD Factor
0.0020 IRD Factor x $250,000 x 24 months remaining = $12,000
For variable-rate mortgages, the penalty in Canada is three months of interest. As previously stated, a variable-rate mortgage typically has lower rates than a fixed-rate mortgage.
For example, let’s say your interest rate is 2.50%, and you need to break your mortgage early.
Mortgage prepayment penalty fee=
2.50% your existing mortgage rate x $250,000 / 12 months x 3 months= $1,563
As you see, the mortgage prepayment penalty can be large. So, this is another reason to hold real estate for long periods and only look to sell when nearing the end of the term.
Making Early Payments
If interest on your mortgage is low, then it makes sense to borrow money in the form of a mortgage. While this statement is generally true, many people use this argument as justification to spend more money in other areas of their life rather than save and invest. Some people I know use low interest rates to buy brand new cars and live on high-cost lifestyles supplied by cheap debt. Their investments, on the other hand, are small in comparison. These people are better off paying down their mortgage, rather than buying the latest iPhone, because they are using the leverage afforded by the mortgage to purchase liabilities rather than assets.
The same reasoning applies if interest rates increase. As rates increase, you save more interest over time if you make additional payments. For example, if you have a 25-year $250,000 mortgage at an interest rate of 5% and make an additional $100 per month in payments, you shorten your mortgage by 2.9 years, saving $25,009 in interest. If you make an additional $200 per month in payments, you shorten your mortgage by 5.2 years, saving $43,800 in interest.
Assuming a $250,000 Mortgage at 5% Interest
Additional Monthly Payment Total Interest Savings Mortgage Shortens by
$50 $13,471 1.5 years
$100 $25,009 2.9 years
$200 $43,800 5.2 years
$300 $58,499 7 years
If you make $0 in additional payments, you end up paying $436,204 over the course of 25 years.
Total payment= $250,000 + $186,204 interest= $436,204
If this was an adjustable-rate mortgage, there could be a risk that rates rise over the 25-year period, costing the purchaser even more in interest if they do not make additional payments. While the stock market would return more over the same time, do not discount the savings attributed to making payments early, especially if you find it hard to save money outside of your mortgage.
Using Leverage to Your Advantage
You can make a lot of money by carrying a mortgage balance on your rental houses rather than buying them with cash. For simplicity’s sake, say they cost $125,000 each, and you have $125,000 to invest. You can put down 20% down on five houses ($25,000 each x 5 = $125,000) or 100% down on one ($125,000 x 1 = $125,000). Let’s say rent in the area is $1,500 per month.
If you buy rental properties and use the 50% rule, which is a conservative rule of thumb, that assumes 50% of your rental income goes toward operating costs of the property, such as taxes, repairs, and property and management fees.
Scenario 1: Pay $125,000 cash for one property
•Monthly cash flow: $1,500
•50% Rule: $1,500 x 50%= $750 for expenses
•Net monthly cash flow: $1,500 - $750= $750
•Yearly net cash flow: $750 x 12= $9,000
Scenario 2: Pay 20% down or $25,000 each for 5 properties
•Monthly cash flow: $1,500 x 5 units= $7,500
•50% Rule: $1,500 x 50% x 5 units= $3,750 for expenses
•Monthly interest cost at 5%= $390 x 5 units= $1,950
•Net monthly cash flow: $3,750 - $1,950= $1,800
•Yearly net cash flow $1,800 x 12 = $21,600
You make more than 2x your cash flow using Scenario 2. And, this assumes no price appreciation. On top of that, for rental properties you can write off your interest in both Canada and the U.S. Plus, you can also deduct depreciation from the income you make from your property, resulting in fewer taxes owed on the income earned.
Why not just invest in real estate then? Again, appreciation is not guaranteed. Furthermore, it depends on a person’s risk tolerance. Could you sleep at night knowing you owed $375,000 across five properties? What if they are not occupied? Moreover, it is hard to find a property that fits the 50% rule. If you cannot find a property that meets the criteria, or at the very least has a positive cash flow, then rental properties are not recommended. Lastly, the fees associated with buying and selling are a hindrance to your long-term success, so only dive into real estate investing only if you have a long-term outlook.
HOME EQUITY LINE OF CREDIT (HELOC)
A Home Equity Line of Credit (HELOC)99 is a revolving loan funded by your home’s equity, previously known as a second mortgage, and often tied to a bank account or credit card. Many banks give you a line of credit equal to about 80% of your equity.
So, the owner of a $200,000 house, with $50,000 paid off, will have access to a $40,000 home equity line of credit. Often people use a HELOC to consolidate thei
r high-interest debt, make home renovations, or pay for schooling for their children. Sounds great on paper, but using your house as collateral when you have worked hard to pay back your mortgage is not recommended unless you are in a good financial position.
Five reasons to avoid a HELOC:100
1.Miss payments, and you can lose your home. While it may make sense to consolidate your high-interest credit card debt with your low-interest HELOC, you could potentially lose your home if something comes up and you cannot make the payment. If you miss a credit card payment, you may be exposed to fees and a decrease in your credit rating, but you will not lose your house.
2.It is not a dependable emergency fund. Banks can freeze your HELOC at any time if your credit rating drops.
3.They are variable rates. HELOCs are appealing because of the low interest rates, but if interest rates increase, then your debt costs increase as well. As a result, you could have a five-year fixed rate mortgage combined with a variable-rate HELOC, which adds uncertainty to debt management. Some HELOCs are available with a fixed-rate option, which may be a better choice.
4.HELOCs may require a balloon repayment. This means that you pay back all the money owed at the end of a predetermined period. If finances are tight, then making this payment could be difficult.
5.You may not be able to refinance without paying your HELOC first. If you want to refinance your mortgage because rates have decreased, you may have to pay back your HELOC first.
If you have no debt, an emergency fund, and built up investments, then using a HELOC as springy debt to complement your emergency fund can make sense as long you do not use it as your initial source of liquidity. And, always keep it at a zero balance.
SUMMARY
If decide you would rather buy a home than rent and have done your research, then follow this checklist:
1.Have all debts paid off first and your emergency fund established.
2.Real estate is long-term. Otherwise, it is a poor investment. Keep a property for a minimum of five years and preferably 10.
3.Do not be house rich and cash poor. Focus on investing excess savings in index fund ETFs.
4.The bigger the down payment, the better.
5.Use online calculators to determine what mortgage payment you can afford comfortably. Keep it under 25%, preferably under 20%, of your gross income.
6.Shop around for rates using sites like bankrate.com and ratehub.ca.
7.Consider what you really want in a house and stay consistent.
8.Get prequalified by a bank.
9.Remember, location, location, location.
10.Only use home equity lines of credit if you are in a good financial position and as springy debt to complement your emergency fund.
This final part of the book focuses on two aspects: Retirement and Happiness. In Chapter 13: Find a Purpose in Retirement, I talk about finding a purpose in retirement. The goal in retirement should be to have enough money so that you can live comfortably without needing to work AND do what you have always wanted but never had the time for. Maybe you would like to volunteer more, travel, or make a legacy for your children. Whatever it may be, too many people strive only for the financial goal and once achieved, retire without having made future plans. Over time, they become restless and depressed. Instead, decide before you retire what you want to do and create those goals in advance. It will help drive you and keep you motivated to meet your financial goals. It will also be a far more rewarding and exciting time once you are retired.
In Chapter 14: Happiness, I end the book by providing ways to lead a happier and more fulfilling life so that you can live to your utmost potential. You have one life, so enjoy it! Live your life the way you want to experience it. Remember, early retirement does not mean the end of your working career but instead means being the best version of yourself. You will finally have the time to concentrate on what you really want to do. The tips in this book are meant to provide a way for you to achieve that, without sacrificing your quality of life or happiness on the road to get there.
CHAPTER THIRTEEN
FIND A PURPOSE IN RETIREMENT
FILLING THE VOID
The concept of retirement is unique to the past five decades. Not too long ago, the average American had two stages of life— work and death. Today, the average American retires at age 62. Compare this with 100 years ago when the average American died at age 51. People are now living longer, well into their retirement years.
The biggest questions then become:
•How are you going to achieve a sense of accomplishment and satisfaction without going to work?
•How will you be able to relate to your friends and family if you retire before they do?
•If you retire early, who will you spend your time with?
For most people, the novelty of retirement wears off after a month or two. You may start to feel that you no longer have a reason to wake up in the morning. Once you do get up, you may feel you have nowhere to go. There is no more socializing in the office, no more going for coffee, no more people stopping by your desk, no more clients, and no more challenges to give your life purpose.
Much of the Western world misperceives what contributes to a happy and fulfilling retirement. Many people have grand ideas of how great and wonderful life in retirement will be. These ideas can include no more daily commute, no more dealing with a boss, always traveling, sleeping in, and doing what you want when you want.
Retirement can be many things. For some, it is living their fantasy, for others it is disappointing, and for yet others, it is a struggle. In fact, for many, the reality is the opposite of their fantasy. This is especially true for those with few interests outside of work. According to a study by the London-based Institute of Economic Affairs, depression risk increases by 40% after retiring.101
Many save for 40 years to build a retirement nest egg but are unprepared when the time comes. People focus only on the financial aspect of retirement, forgetting to consider the other factors.
Work fills four unique voids in our lives:
1. Sense of Community
Our social connections are the single largest driver of our happiness. New York Times bestselling author Daniel Gilbert writes in Stumbling on Happiness, “If I wanted to predict your happiness and I could only know one thing about you, I wouldn’t want to know about your gender, religion, health, or income. I’d want to know about the strength of your relationships with your friends and family.”
You may not miss your workplace when you retire, but you will likely miss the people you work with. Social interaction makes life more enjoyable for most of us. Many people get their only companionship from work. They lose the skill to develop new friendships outside of the workplace. To feel part of a community, individuals must put in the effort to be active in the community, whether through volunteering or being part of a club. A sense of community translates into social, emotional, and physical well-being. Research shows that people who have intimate relationships with others live happier, healthier, and longer. Those who are lonely stand a greater chance of dying an early death. Former U.S. President Jimmy Carter said:
“There are two basic secrets to successful aging: one is staying active in doing things that we find interesting. And the other one is having an intimate relationship with other human beings, so we don’t just become a vegetable sitting in front of a flickering TV screen and depending on other people to do things for us that we are capable of doing ourselves.”
A sense of community can have more of an impact on the quality of your retirement than good health and finances.
2. Structure
Most of us believe that we are supposed to be working continually throughout our adult lives, for no other reason than to fill the hours between 8 am and 5 pm with some structured activity. Working at something that you dislike, even if it has no other purpose, provides routine and structure in our lives that we derive comfort from.
3. Stimulation
Wo
rk gives us a setting to learn and discover new things about the world and other people. There are many diverse perspectives and personalities that you would never encounter elsewhere. Retiring in the traditional sense removes a primary source of stimulation from our lives.
4. Purpose
Many of us give so much to our jobs that we do not have the time or energy to develop other interests. Work is the primary source of identity for many of us and where we put most of our energy and creativity. To lose work means losing our identity. This is arguably the most important void that needs filling when we retire. Once we have a purpose, everything else falls into place.
FINDING A PURPOSE
Pasricha writes in the Happiness Equation that men and women in Okinawa live an average of seven years longer than Americans and have the longest disability-free life expectancy on Earth. Researchers from National Geographic were so intrigued by this phenomenon that they studied Okinawa residents in search of the reason for their longevity. The key finding? Okinawans do not “retire” like Americans do, living life on the golf course, sitting around on cottage docks, and staring at the clouds. No, they do not even have the word retire in their vocabulary. What they do have is called “ikigai,” which translates to “the reason you wake up in the morning.”
Ikigai is the reason you find people over the age of 100 in Okinawa: Teaching their craft to students, practicing martial arts, fishing, or hanging around with their great-great-great-granddaughter. Researchers at Tohoku University took the study a step further. They spent seven years in Sendai, Japan, studying over 43,000 Japanese by asking them the question, “Do you have an ikigai in your life?”
At the end of the study, they found that those who reported having an ikigai were more likely to be married, educated, and have a job. They were healthier overall and had lower levels of stress. Furthermore, 95% of them were still alive after the study. Only 83% of those without an ikigai made it that long.
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