Imagine you have been looking for a boat, motorcycle, RV, ATV, or some other large purchase and suddenly found the perfect one. And look, it’s on sale for a “limited time.” Does this sound familiar? You don’t have enough cash, but you just can’t pass up this deal so you decide to borrow the money. But what do you do — get a loan or add it to your mortgage?
This is actually pretty common. Canadians have grown accustomed to using credit to make large purchases. More people today have credit cards and lines of credit than ever before. This demand for credit has created a variety of new credit management options for people as well. One credit option that has grown in popularity over the past few years is taking on new debt by refinancing a mortgage.
Growing Home Equity Values
Over the past decade, Canadians have seen their home values grow dramatically. For many home owners, this growth has increased the amount of equity they have in their homes.
Here’s an example:
Imagine you purchased your $250,000 home in 2009 with a standard 5% down payment of $12,500. Your outstanding mortgage principle (what you still owe) would be $237,500 and your equity would be $12,500. Your home equity is the amount of money you would keep if you sold your home and paid off your mortgage (ignoring any fees and charges associated with the sale).
Now it’s 2014, and your home is currently valued at $300,000. Your mortgage principle is now $210,000 and the home equity has grown to $90,000. Most of that equity growth is a result of your home increasing in market value. Not bad!
Using Home Equity to Make Large Purchases
What some people do is use some of that home equity to make the large purchases. In the above example – imagine you took $30,000 to buy that boat you’ve always wanted. Your mortgage principle would increase to $240,000 and you would have a boat to use. Your mortgage payments would increase, but your payment would be lower than if you took out a regular loan to buy the boat on top of your current mortgage payments.
Lower payments are better right? Well, maybe not…
Loan vs. Mortgage
Let’s compare this example using a regular loan to make the purchase vs using your home equity and adding it to your existing mortgage.
In this situation, you can see that adding the cost of your boat purchase to your mortgage will actual cost you $8,769 more than if you took a regular loan. Now, some of you are wondering “How can that be? The monthly payments are smaller, and the interest rate on the mortgage is much lower than the loan.” The problem is that you’re actually paying for that boat for a lot longer period, 15 years longer to be exact.
At least you have lower payments right? Well – that’s only temporary.
Comparing Payment Costs
Let’s compare the total monthly payments over each of the next 20 years.
If you paid for your boat with a loan, your total monthly payments drop to only $1,269 after the loan is paid. That’s $181 less than the expanded mortgage option. So while you pay a smaller monthly payment in the first five years, you actually make larger payments for the final 15 years!
From a cost perspective, paying for the boat with a loan is the better option. From a payment affordability perspective, the loan could be a better option as well. This is especially true if you expect to have a lower income in the future (think early retirement) or if you expect to have higher expenses (think tuition for the kids) in the final 15 years of repayment.
This is definitely a tough decision and there is no one-size-fits-all answer. Expanding your mortgage payment may be the right choice in some situations. For example, if the purchase is an emergency and you can’t afford the addition loan payments.
If you’re considering a big purchase in the near future, it’s a good idea to sit down with a financial advisor and see what option works best for you today AND tomorrow.
*Interest rates are for demonstration purposes only.