It’s come as no surprise that interest rates have risen over the last few years. The surprise, however, is by how much rates have risen.
Most people didn’t expect how high nor how fast Prime and mortgage rates rose. This is directly a result of statements from the Bank of Canada and Federal Government. I’ve talked about the phrase “transitional inflation” before, which is basically a made up term to try and placate Canadians into what we’re experiencing right now as “normal.”
It's been almost two years since I started explaining what was going to happen with rates and approximately where they would end up. The key message I want to convey is that people need to start Bulletproofing their Lifestyle.
What I mean by this is making financial decisions which will protect you from economic shock (which is coming), personal shock (unexpected life issues such as lost job, illness, etc.), and financial duress.
Structuring Your Mortgage
The first step to structure one’s financial situation is to open the maximum amount of cash flow. This may seem counterintuitive to the objective of paying your debt off faster but not necessarily the case. This encourages one to manage their cash to their current situation.
Most mortgage products have two options for prepayment privileges. The first is to increase your monthly payment by a fixed amount based on a percentage of the existing mortgage payment, usually in the 10% - 20% range depending on the lender. This is the least flexible option as banks don’t want to keep changing this option monthly.
Option two allows for prepayment privileges based as a percentage of the original mortgage amount, again depending on lender in the range between 10% - 20%, and minimum increments of $100 or $1,000. My preference would be lenders with the minimum requirement of $100 as more people are able to find an extra $100/month versus $1,000.
Therefore, one would take the maximum amortization available to them to reduce their obligated monthly payment thus freeing up cash flow. They still have the option to make privilege payments depending on what they can afford, so if it’s $200/month, then they would make this their principal payment.
If there’s an expected shock and cash becomes tight, then the option is not to make the extra $200 payment as it’s not obligated.
Reducing a Mortgage Payment
I recently worked with a client where this option was used.
The client’s mortgage was up for renewal in August. They are expecting their first child, so they will be temporarily losing income. At renewal, they opted to make a principal payment to reduce the outstanding balance and transferred the mortgage to a 25 year amortization. This dropped their obligated monthly payment by $1,000/month.
The working spouse is easily able to manage their obligated payments without negatively impacting their lifestyle while they await the arrival of their child.
Note that they have the option to keep their payments the same by utilizing the privilege payment options. If they want, they can maintain the same amortization, but if there are any complications, they don’t have to make those extra payments as these payments are optional.
In essence, they are preparing themselves against economic and financial shock by making their finances flexible.
Increasing Liquidity and Net Worth
The key to managing your finances is ensuring any extra payments are made when and if possible, or the extra cash flow is being used to increase one’s liquidity.
Liquidity is the efficiency or ease with which an asset or security may be converted into ready cash without affecting its market price. Essentially, the ability to convert an asset into cash.
This is important as this is our emergency reserve. The emergency reserve is the pool of resources that will be utilized to help manage unforeseen or unplanned situations. It may be in the form of cash, stock portfolio, available credit on your home equity line of credit, etc.
The quicker this conversion happens, the more liquid you are.
For example, if you’re able to save $1,000/month cash flow, then you could take $200/month and apply it to an investment vehicle or a savings account. You could also take another $200/month and paydown the principal of the mortgage and still have $600 extra disposable income.