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The times sure are a-changing.
As mortgage rates around the world climb inexorably higher on the back of central bank interest rate hikes, everything in the housing market seems to be changing, in ways that continue to surprise us.
Today’s reader case is a great example of this. What should have been a fairly straightforward analysis turned out to be anything but.
Read on to find out why.
Hey FIRECracker & Wanderer,
I am a huge fan of you both and inspired by your journey. Absolutely LOVE,LOVE, LOVE your book.(Did i mentioned that I love your book!?). Going on 10 times that I’ve listened to the audiobook and each time I listen to it, it’s like the first time all over again.
Anyways let’s delve into my dilemma. I believe that I have started my journey a little late. We don’t have much in terms of savings or investments, as we were quite financially illiterate in our early years and have finally hopped aboard the financial independence train. Now it is due time to play catch up. I am definitely a believer that it is better late, than never. With a little assistance from you , I think that achieving our goals will be possible.
Let me give you a little background. I am 40, an Administrative Assistant, living in Alberta making 45,000 per year and my partner works with a non-profit organization earning approx. 47,000. We have a daughter who is now attending school online, due to the pandemic. We have decided to keep her online as she is thriving and this also keeps a few costs down.
Here are the deets:
- Gross: 45,000 + 46,924.80/ Net: 36,972 + 37,440
- We keep our finances separate, so my partner deposits his portion (2074.00) into my account on a monthly basis
- Monthly expenses $3,011.00.
- Credit Cards paid in full:0.00
- Fixed Assets
- House purchased at 189,000
- Balance 135,000
- Monthly mortgage 880.00, property tax 140.00, condo fees 300.00
- 3.5% rate
- 2 older cars paid for in full
- RRSP 10,000.00
- Cash 2,000.00
- Emergency Savings 2000.00. Adding 200.00 per month until we reach 3-6 months of expenses
Note: We would like to pay off our mortgage as quickly as possible, therefore, we will begin to set aside 1,400.00/month towards our mortgage for the next 6 years, then reallocate this to investments. 600.00/month will currently go towards investments, until mortgage is paid and then this contribution will increase to 2000.00/month
Your insight would be truly appreciated.
This reader case initially caught my eye because they calls themselves “Late Starter,” don’t have 6-figure STEM salaries, and have a kid. According to haters of FIRE, these should be enough to disqualify you from ever becoming FI and I wanted to see if they were right.
It was also interesting because when the reader initially wrote to us, mortgage rates hadn’t started rising yet, so the environment they wrote to us and the environment we’re in now are completely different. Even so, they asked a really interesting question: Should they shovel as much money as they can into their mortgage so they can pay it off quicker?
It was probably just a normal, mundane question six months ago, but today, it’s super relevant for a lot of people. Because up here in Canada, the mortgages rates we can get aren’t locked in for 30 years like in the US. Instead, they’re typically sold with 5-year terms, at the end of which the remaining balance gets renewed at whatever prevailing interest rates are at the time, which of course means that the nice comfy 3.5% fixed rate mortgage LateStarter has will be replaced by one that’s way more expensive in just a few years. How will this affect their journey to FI, and how does dumping more money into their mortgage to pay it off faster affect this dynamic?
As we always like to say on this blog, let’s MATH THAT SHIT UP!
|Income||$36,972 + $37,440 = $74,412 (net)|
|Expenses||$3,011 per month, $36,132 per year|
|Investible Assets||$10,000 + $2000 + $2000 = $14,000|
I always love reader cases that challenge the haters that say FIRE is only for 6-figure earning tech bros or it can’t be done if you have kids.
You can, if you’re smart about your money. Which is what this family is. Right off the bat, you can see that their savings rate is very high. With net earnings of $74,412 and expenses of $36,312 per year, they’re saving $74,412 – $36,132 = $38,280. This gives us a very impressive savings rate of $38,280 / $74,412 = 51%, despite the fact that they say “we were quite financially illiterate in our early years.”
Yes, their net worth could be a bit higher based on their age, but given their salary and their ability to save over half of it while raising a kid, that’s no easy feat. Most impressively, they bought a house within their means and don’t have credit card or student debt. That’s already ahead of most homeowners who borrowed until they couldn’t borrow any more and are now so screwed they don’t know what to do. So, they shouldn’t be so hard on themselves.
So let’s start crunching some numbers. With yearly expenses of only $36,132 per year, they only need $36,132 x 25 = $903,300 to become FI. And since they save $38,280 per year, they’ll get there in…
And Here’s Where Things Get Complicated
Normally, we’d be done with this part of the analysis. The problem is, that assumes their mortgage costs are going to stay the same going forward. We know they won’t. Interest rates are going way up, with a massive 1% increase happening just last week.
So let’s figure out how to account for this. Given this new interest rate environment, when it comes time to renew their mortgage, LateStarter will need to account for this additional expense.
Unfortunately, our reader didn’t give us all the information on their mortgage that we would need, like how far they are into their current mortgage so we can predict when they’ll have to renew. So we’re going to have to reverse-engineer this information. We will be using the following mortgage calculator from Ratehub for this.
We know that their existing mortgage has a $135,000 balance, but we don’t know how far along their amortization schedule they are. And to figure that out, we need to know their starting balance.
They’ve told us their initial purchase price ($189,000), which is great, but we don’t know how much their downpayment was. Fortunately, they did give us their current mortgage’s interest rate (3.5%), and their monthly payment ($880), so if we put the information into Ratehub’s calculator and let it give us a range of possible mortgages with different downpayment options, we can simply pick the one that’s the closest.
A 10% downpayment gives us the right monthly payment, so let’s go with that. Scrolling down on the site, we can generate a mortgage payment schedule graph that shows how quickly the mortgage gets paid down. And by hovering over the different bars until we spot one with the right mortgage balance ($135,000), we can figure out what year they’re in.
Canadian mortgages typically renew in 5 year increments, so that means their next renewal is coming up at the 10 year mark. By then, the same chart shows that they’d have a remaining balance of $122,693 and 15 years left on their mortgage.
Economists are estimating that interest rates for fixed rate mortgages will settle in the 5-7% range (I think it might be even higher if inflation doesn’t start coming down soon), but to be conservative let’s go with the top end of that range and assume that worst case of 7%. By using the calculator’s renewal tab, we can figure out their monthly payment will change to…
This is a jump of 25%! That would be a pretty devastating blow to most households, but our reader made the very smart decision of not buying a house that’s too expensive. A 25% jump to their mortgage only raises their expenses by $1096 – $880 = $216 a month, or $2592 per year.
That pushes up their annual expenses to $36,132 + $2,592 = $38,724. That brings down their savings to $74,412 – $38,724 = $35,688. And their FI target also changes to $38,724 x 25 = $968,100. And also, remember that these changes only happen in year 3, which is when the mortgage should renew.
Their time-to-retirement changes to 16 years.
That’s actually not bad. You would expect a 25% increase in housing costs would have a bigger impact, and the reason why it doesn’t is because the 25% is of a relatively small part of their monthly expenses. If they had stretched to buy a house and their mortgage was a lot bigger, this would be a very different analysis.
What if they pay off their mortgage?
But what if they pay off their mortgage faster? Would that get them to their FI number faster?
They did mention they wanted to “put in 1,400.00/month towards mortgage”. How does that affect the math?
First of all, that would decrease their savings rate. Getting their mortgage payment from its current $880 to $1400 would mean taking an additional $1400 – $880 = $520 from savings every month, or $6,240 a year. That brings their savings rate down to $38,280 – $6,240 = $32,040.
And again, their mortgage monthly payment increases in year 3 to $1096, so in order to get $1400, we need to take away $1400 – $ 1096 = $304 from savings per month, or $3,648 per year. That brings their year 3-and-onwards savings rate down to $35,688 – $3,648 = $32,040.
If they start increasing their monthly payments right now to $1400, even if interest rates rise to 7% in 3 years at renewal time, by changing around the amortization number on the renewal tab and looking for when the predicted mortgage amount cross $1400, we can estimate how much shorter their new mortgage would be, which indicates they’ll be done paying their mortgage in 10 years from when they renew.
This would speed up the time to pay off their mortgage from 17 years to only 12 years from now.
However, because they’re diverting the money they would’ve invested towards their mortgage instead, it would lengthen the time they would get to FI temporarily, until the mortgage is paid off in 12 years. Then the $1400/month can be redirected into investing and their expense would drop, thereby dropping their FI number to ($3011 – $880) x 12 x 25 = $639,300. How does that affect their time to FI?
Their new” FI target becomes relevant only after the house is paid off, so the answer is 13 years. This shortens their time to FI by 3 years.
So the short answer is: Yes. You should absolutely pay off your mortgage as fast as possible. Not only does this blunt the impact of rapidly rising interest rates, you will accelerate your time to retirement because you’ll be able to eliminate your mortgage and make Financial Independence possible sooner at the same time.
LateStarter may have started late, they can still come out on top even in our current rate of rapidly rising mortgages. And all because they wisely kept the amount of money they spent on their home a very reasonable $189,000. That one decision made it possible for them to throw their extra cash into their mortgage and have an impact meaningful enough to not only blunt, but counteract the corrosive effect of higher interest rates on their finances. They’ve done a fantastic job of becoming home owners without destroying their financial future. Well done!
What do you think? Should LateStarter be throwing money at their mortgage or is there something else they should do with their money?
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