Are Cashback Mortgages Worthwhile?

If you’re shopping for your first home, you are going to be bombarded with different mortgage options, products, terms. One of the biggest sellers for first time home buyers is a cashback mortgage. You get rate X, and you get 1% of your mortgage amount back upon closing. If you are a little bit skeptical - and you should be - you start wondering, What does it cost me, what is the catch? The catch is that your mortgage rate is higher, but where does it become a better deal?

Let me start by saying that if you need the 1% cashback to buy a new TV - which we will cover in later articles - then this article is not for you. This article will assume that you have the money to put right back into your mortgage in the form of a lump sum payment. If you are already bored with this topic then the short answer is that 5.00% + 1% CashBack is the same as 4.75% over 5 years. The 1% cashback is worth 0.25% of the mortgage rate.

Explanation

The simplest way to look at it is to take a $200,000 mortgage. We will refer to the 1% cashback mortgage as Case A, and the standard mortgage as Case B.

Case A

Mortgage Amount = $200,000
Cashback = $2,000
Effective Mortgage Amount = $198,000
Interest Rate = 5.00%

Case B

Mortgage Amount = $200,000
Cashback = $0
Effective Mortgage Amount = $200,000
Interest Rate = 4.75%

For the purposes of simplicity, all calculations are based on 25-year mortgage and payments made monthly. Everything will also be based around a 5-year fixed term, since after that point your interest rate will most likely change.

For Case A (these numbers come from the Royal Bank mortgage calculator):
After 5 years you have paid: $69,094.80 (Interest and principal included)
After 5 years you owe: $175.244.72

This is where things get complicated. If you punch the Case B numbers into the calculator you will find that after 5 years you have paid $68,095.20 (slightly less), and owe $176,311.11. Again slightly less, so how do you equate?

The answer is you change the amount you pay to be equal. To do this the easy way, I calculated the monthly interest amount as being:

Principal Outstanding * Interest Rate / 12.11827436 (which represents compound periods, I may revisit to make it more exact)

You will notice that I do not compound by 12 because banks compound daily, so I used a fractional amount to equate.

It may be off by a matter of cents over 5 years.

Using this method for Case B:
After 5 years you have paid: $69,094.80 (Interest and principal included)
After 5 years you owe: $175.186.38

The final result is a $58 advantage for the 0.25% rate reduction. This is close enough - for my interests - to be considered equal over the course of 5 years. So I am willing to say with a small amount of reasonable doubt that 1% cashback is worth a 0.25% increase in the rate, provided that you take the 1% and put it into the mortgage as a lump sum payment.

It is important to verify with your mortgage seller that an immediate lump sum payment is permitted. The preceding calculations rely on this fact and do not apply if you cannot make an immediate payment.

Tags: Cash Back, Cash Back Mortgages, Cashback, Cashback Mortgages