Cash-Back Mortgage Question
A reader who is a mortgage broker had a question about a recent post on this blog analyzing cash-back mortgages:
First, a little background. With cash-back mortgages the bank gives you some extra cash (3% of the mortgage amount in this case) when you sign up for the mortgage. They also charge a higher interest rate to make your payments higher so that they get their money back during the term of your mortgage. I created a spreadsheet to figure out the effective interest rate you’re paying with one of these mortgages.
After using the spreadsheet, it seems that the reader’s numbers are consistent with a 5-year term. If this is right then I think he used the spreadsheet correctly.
If the client makes prepayments on the mortgage, the equivalent rate gets even lower. How much lower depends on the amount of prepayment. We can see this by looking at an extreme case. Suppose that the client takes out the mortgage, accepts the cash-back, and then immediately pays off the entire mortgage. In this case, the client gets to pocket the entire cash-back amount.
Obviously the bank would not permit this. I’m suspicious that the bank may even not permit the modest 3% prepayment. If the reader can determine what prepayments are permitted by the bank on this type of mortgage, I can make a version of the spreadsheet that computes the effective rate for prepayment cases.
“My client is interested in either a p-.90% rate or the p-.50% CIBC 3% cashback mortgage. I’ve used your spreadsheet and (if I used it correctly) it says the equivalent of the cashback product is basically p-1.18%.
How would I calculate what the equivalent rate is if the client immediately invests the cashback into the mortgage as a prepayment?”
First, a little background. With cash-back mortgages the bank gives you some extra cash (3% of the mortgage amount in this case) when you sign up for the mortgage. They also charge a higher interest rate to make your payments higher so that they get their money back during the term of your mortgage. I created a spreadsheet to figure out the effective interest rate you’re paying with one of these mortgages.
After using the spreadsheet, it seems that the reader’s numbers are consistent with a 5-year term. If this is right then I think he used the spreadsheet correctly.
If the client makes prepayments on the mortgage, the equivalent rate gets even lower. How much lower depends on the amount of prepayment. We can see this by looking at an extreme case. Suppose that the client takes out the mortgage, accepts the cash-back, and then immediately pays off the entire mortgage. In this case, the client gets to pocket the entire cash-back amount.
Obviously the bank would not permit this. I’m suspicious that the bank may even not permit the modest 3% prepayment. If the reader can determine what prepayments are permitted by the bank on this type of mortgage, I can make a version of the spreadsheet that computes the effective rate for prepayment cases.
I find it amazing the cash-back mortgage comes in at a lower variable rate than the plain variable mortgage. Like you say, there are probably a lot of restrictions on pre-payments, but this would be a good option for someone not intending to do any pre-payments anyway.
ReplyDelete@Gene: I was surprised that the cash-back mortgage turnout to be better as well. One possibility is that people who opt for cash-back mortgages are more profitable than other customers because they tend to maintain lines of credit and fail to make any prepayments on their mortgages.
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