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Robert McLister: Cash refunds can significantly reduce the overall cost of a loan, even if the mortgage term is longer
Published on February 9th, 2024 • Last updated 3 days ago • 3 minutes reading time
A cash bonus can equal a further 19 basis points off a three-year fixed rate, says Robert McLister. Photo from Getty Images
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Big banks have been throwing money at mortgage buyers for years, using cash bonuses as an incentive to win their business.
But in recent years, banks have upped the ante. Depending on your lender, you can now receive cash rebates of up to $4,000, possibly even more if your mortgage is high enough.
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These offers differ from the old “cashback mortgages,” which typically came with higher interest rates. In today's competitive market, cash offers can be found even at bargain prices – those unannounced offers that banks make to well-qualified borrowers who negotiate.
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Well, banks don't just hand out cash out of the goodness of their hearts. They want borrowers to commit in exchange for these sweeteners. This means that you usually have to choose a term of three to ten years. If you want to take out a short-term contract of one or two years, this is a matter that is not subsidized by the banks.
In this context, an unusually high proportion of mortgage buyers have taken out one- or two-year mortgages. These shorter terms offer the flexibility to switch to a lower tariff sooner. Many find this tempting, given that the Bank of Canada will be scaling back its tight monetary policy this year.
Others, particularly conventional borrowers, want a short term because the variable rate discounts are worse than normal. They plan to extend the discount for a year or two and then expand it to a higher variable discount in 2025 or 2026.
At that point, if history is any guide, variable pricing could potentially improve from around minus 0.60 percent today to around minus 1.00 percent.
Cash refunds change the math
This desire to game the rate market leads some to commit for only a year or two, meaning they forego cash discounts. But borrowers beware: declining cashback offers can put a dent in your wallet.
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The reason for this is that cash refunds can significantly reduce the overall cost of credit. This can make a longer term more cost-effective, even if you prefer a shorter term.
For example, on a three-year, $500,000 mortgage, a bank might give you $2,500 in cash. If you opt for a one- or two-year term instead, the cashback will disappear faster than a toupee in a convertible.
But let's analyze the numbers further.
Imagine you are torn between the following two mortgage options:
Option 1: A two-year fixed interest rate of 6.04 percent without cashback – which you can probably extend into a variable interest rate of minus 1.00 percent within 24 months.
Option 2: A 5.49 percent three-year fixed rate with $2,500 cash back. Now let's assume that you take a 25-year amortization of your $500,000 mortgage, make no mortgage modifications for three years, and the federal funds rate falls eight times, with a 25 basis point decrease at every other Bank of Canada meeting, starting in July.
If you simulate all of this to estimate your expected borrowing costs, here's what you get.
Without cash back, the two-year fixed rate saves about $200 on paper after three years (including the one year of variable rate after renewal).
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A few hundred dollars isn't exactly the stuff of financial legend.
Additionally, to our knowledge, renewal rates in two years could be higher than expected. So there is a risk in this two-year term.
When you factor in cashback, the optimal mortgage becomes much clearer. At least on paper, the hypothetically lowest borrowing costs shift from the two-year fixed term to the three-year term. In short, the cash bonus represents an additional 19 basis points reduction in the three-year fixed interest rate.
Remember the section above about not making any mortgage modifications for three years? We make this assumption because if you terminate the mortgage early, banks usually demand some or all of the cash refund. This applies in addition to any early repayment penalties that may apply. Penalties and clawbacks can quickly derail a good mortgage deal.
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The gist is this. For borrowers who pay off their mortgage until maturity, cash refunds can turn the tables on which term is mathematically best. If you're weighing up between variable or one-, two- or three-year fixed financing, calculate the expected total cost of the loan over three years or ask a mortgage advisor to do this for you. In cases where short-term and longer-term mortgages have similar projected borrowing costs, cash can be crucial.
Robert McLister is a mortgage strategist at FixedorVariable.ca and editor of MortgageLogic.news. You can follow him on Twitter at @RobMcLister.
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