Rewards credit cards are hugely popular among Canadians, with nearly 70 million credit cards in Canada alone. That’s nearly 3 for every Canadian! Some lenders are using similar thinking to offer people a cashback mortgage, which gives you a lump sum when you close the deal that you can use however you like.
Cashback mortgages can be helpful when paying for closing costs, renovation costs, or even for consolidating debt. But there are downsides to a cashback mortgage, too, such as a higher interest rate and strict penalties. Is it ever worth it to take a cashback mortgage?
Regardless of where you get your cashback mortgage from, they operate in the same way. You’ll get a portion of the total mortgage amount advanced to you on closing day. The money can then be used for whatever you want.
As you can see, there’s really not much to cashback mortgages. They’re very simple. The complicated part is figuring out if it’s worth it to you.
For first time homebuyers, cashback mortgages are especially useful because you don’t have to keep as much set aside to buy furniture or renovate.
One of the biggest hurdles for new homebuyers to overcome is lack of cash. It’s likely they spent most or all of their savings on the down payment to lower their CMHC premiums and save on mortgage interest. That doesn’t leave any money left over for furniture or savings. But you don’t want to sleep on a mattress on the floor and eat off of milk crates. Getting basic furniture is a must, and can cost a few thousand dollars.
Cashback mortgages give you access to thousands of dollars on closing day, which you can use however you like. If you get 5% cashback mortgage after paying 5% down, it’s like you get your whole down payment back right away!
If you used most of your money for a down payment, you may have been considering getting a loan or line of credit to furnish your new place. Perhaps you were even thinking of just putting it all on a low-interest credit card!
But unsecured loans like lines of credit or credit cards have much higher interest rates than a mortgage. The increased mortgage amount could cost less than a similarly sized personal loan, and is definitely cheaper than slowly paying down a credit card.
Another benefit is you don’t have to qualify for another loan. Applying for a loan just before getting a mortgage isn’t a good idea, as every hard inquiry on your credit lowers your score by a little bit. You want your score to be as high as possible before applying so you get the best mortgage rates in Canada.
Getting a loan before getting a mortgage will also increase your GDS and TDS ratios, which adversely affects your chances of getting approved.
But applying for a loan just after getting a mortgage may not be the best idea either. Taking on a mortgage is a huge liability on your financial balance sheet, so it can be harder to qualify for a loan after buying a home.
Since a cashback mortgage doesn’t require any additional credit checks or income verification, you’re already all set when you apply for the mortgage.
When putting together a down payment, one of the ways you can give it a boost is by borrowing funds. There are rules in place that determine how much you can borrow for your down payment, and qualification may become harder, but it can be great way to increase your equity and lower your CMHC premiums.
Cashback mortgages don’t add to your mortgage amount. Borrowing a portion of your down payment increases your equity, but leaves you with a secondary loan that you have to pay interest on. Often this will be at a higher interest rate than your mortgage.
If you pay off the loan with the cash back you get, you can clear the loan and keep the extra equity in your home. Your larger down payment helped reduce your CMHC premiums so your mortgage amount is even smaller than if you hadn’t borrowed a down payment.
However, there are still some downsides to keep in mind before getting a cashback mortgage.
Lenders will require you to get an insured mortgage before giving you cash back. That makes sense – they’re giving you money that isn’t on the mortgage amount, so they want to make sure they’re protected. It also doesn’t make much sense for a person with 20% down or more to get a cashback mortgage, as they already have a lot of money.
CMHC insurance increases the mortgage amount owing by 2.8% - 4.0%, depending on how large your down payment is. A 5% down payment, the minimum down payment in Canada, is required for any home purchase under $500,000, but also results in the largest CMHC premiums at 4.0%. Doing the math, we can see that getting a mortgage with 5% down only leaves you with 1% equity in your home.
5% down payment – 4% CMHC premium = 1% equity
This leaves you little leverage in your home for the first few years of your mortgage. Starting from 1% equity can mean having to wait years until you have enough built up to refinance or get a home equity loan.
You’ll also pay more in interest since you’re financing more money. The amount you get as cash back won’t be added to your mortgage, but the CMHC premiums will. Over the course of a 25-year mortgage, that extra CMHC premium will end up costing you more than the 4% premium by a couple thousand dollars. The exact number depends on your interest rate and mortgage amount.
The most important thing to remember about cashback mortgages is that you must complete the mortgage term. If you don’t, you’ll have to pay back the full amount you received PLUS whatever penalty the mortgage has.
If you took 5% cashback on a $300,000 mortgage, the penalty would be $12,000 + the Interest Rate Differential on that mortgage, which could be quite high.
Most people don’t plan on breaking their mortgages in the first place, but a large portion of them do. In fact, a majority of first-time homebuyers break their mortgage contract in the first five years of homeownership.
Realistically, the high penalties could mean you’re forced to complete the mortgage term. With very little equity in your home you could actually lose money on the sale, as you have to pay your realtors, and owe money after selling with no asset to secure it with.
On the other hand, if you complete your mortgage term, this isn’t a downside. It only affects you when you need to get out of your mortgage early.
Cashback mortgages are fixed-rate only. While the 5-year fixed rate mortgage is by far the most popular mortgage term in Canada, it may not always be in your best interest to get a fixed term.
For one, fixed rates have higher penalties than variable rates. Combine the higher penalties to break a mortgage with the fact you have to pay back your cashback amount, and you have a very expensive mortgage to get out of.
Fixed rates are also more expensive than variable rates. Variable rates have the potential to become more expensive than fixed rates by the end of the mortgage term, but that would require a lot of interest rate increases by the Bank of Canada. In many cases, variable mortgages are cheaper than fixed rates over similar term lengths.
If you know that you’ll be able to stay in the house for the whole term length, then a cashback mortgage can be a great idea to free up some cash after buying a home. Get in touch with a mortgage broker to discuss your options today.