Mortgage options: is Cash Back a good deal?

With this weekend's balmy double-digit temperatures, we Canadians have finally been given a taste of spring. The sun is rising earlier and setting later, temperatures are rising, and our SAD is finally lifting.

And, of course, the mortgage advertising is once again beginning in earnest. With the majority of home sales closing between April and August, spring is the prime season for banks to push their mortgage lineup. Now that we've survived RRSP season, and are wrapping up our tax returns, it's time to be bombarded with mortgage rates and special promotions.

One of the products I've seen advertised this year is a "cash back" mortgage. Basically, when your bank advances the mortgage, you receive a percentage of the principal as a cash reward. You can then use this money for whatever you want. The banks want you to use this to pay for furniture, renovations, or vacations, but you can also use the full cash amount as a lump sum mortgage payment.

The typical trade-off with cash back mortgages is that you have a longer term and higher rate than a standard mortgage, so although you get some immediate cash in hand, you end up paying more in interest in the long run. I thought I'd have a look at the numbers, to determine just how good or bad this offering really is.

Example

To illustrate the trade-off between a cash back and standard mortgage, I'll look at the costs of the cash back mortgage, and compare them to the costs for a standard mortgage with a lower rate. For my calculations, I made the following assumptions:

• $300,000 mortgage, with 25-year amortization


• 5-year term, with 7.20% posted rate


• 5% cash back vs. 1.50% discount on mortgage rate

Note that, since I'm looking at a Canadian mortgage, I'm using the Canadian convention of rates being calculated semi-annually, not in advance. The calculations would work out slightly differently for homeowners south of the border, but the basic idea is the same.

Assuming that the borrower is making bi-weekly rapid payments (i.e. paying half the monthly amount every two weeks), the principal remaining at the end of the term will be $256,132 for the standard mortgage holder (5.70% rate), and $258,710 for the cash back borrower (7.20% rate). When you factor in the $15,000 cash reward, the cash back borrower ends up $12,422 ahead of the standard mortgage holder. If the $15,000 amount earns 3% interest in a savings account during the 5-year term, this increases to a $14,842 spread. If, on the other hand, the full $15,000 is used to make an immediate lump sum payment on the mortgage, the spread is even higher, at $18,600.

On the face of it, cash back seems to be an attractive option.

However, we're only looking at one side of the picture. The higher interest rate paid by the cash back borrower translates to a higher bi-weekly payment. In this example, the cash back borrower has made a total of $138,999 in mortgage payments, whereas the standard mortgage holder has paid only $121,307. That means the cash back borrower had to pay $17,692 more than the standard mortgage holder, which puts them behind by $2,850 unless the $15,000 was used as an immediate lump sum payment, in which case cash back comes out ahead by a mere $909. Even that $909 spread is barely a 2% return on the extra $136.09 in payments made every two weeks throughout the term.

Conclusion

Clearly, when you take into account the larger minimum payments that come with a cash back mortgage, it becomes a lot less appealing. The only way to come out ahead versus a standard, lower rate mortgage, is to throw in the whole cash reward as a lump sum payment at the beginning of the term. Even if you do this, however, you're not likely to keep up with inflation, so it's a far better idea to take a standard mortgage with a lower rate.

If you can afford the extra payments that would come with the cash back mortgage, then you can always increase the bi-weekly payment amount on your standard mortgage, and make even faster progress in paying off the principal.