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By Sean Cooper
Special to the Financial Independence Hub
Do you enjoy going on vacation? Who doesn’t? So, the term “mortgage vacation” has to be something similar, right? When you hear mortgage vacation, you’re probably picturing yourself laying on a warm, sandy beach, drinking an umbrella drink. Well I hate to break it to you, but although you got the vacation part right, you forgot the most important part: the mortgage part.
A mortgage vacation is a feature that lets you skip paying mortgage payments for up to a few months, but with a catch. You have to prepay the amount in advance. In an era where savings rates are near record lows and household debt is near a record high, mortgage vacations have become a popular feature with mortgage lenders. Who needs to save for a rainy day when you have a mortgage vacation?
A mortgage vacation can help you out when you run into financial difficulty or when you want to use your cash flow towards something else. But as the saying goes, there’s no such thing as a free lunch. By planning ahead of time, you can avoid taking a mortgage vacation and still be on your way to burning your mortgage.
What is a Mortgage Vacation?
If you’re like most homeowners, you’re introduced to mortgage vacations in this way. You get a letter in the mail from your lender letting you know that you’ve been approved for a mortgage vacation. Yippee! The banks market mortgage vacations like they’re a privilege for their best clients, but as I mentioned earlier, there’s a catch. Hidden in the fine print is what happens when you skip your mortgage payment.
To get a better understanding of mortgage vacations, it helps to go through an example. Let’s say your mortgage payment is $2,000 per month, and you want to stop paying your mortgage for two months while you go backpacking through Europe. To take a mortgage vacation, you’ll need to prepay two months of mortgage payments. In this case, since your monthly mortgage payment is $2,000, you’d have to prepay $4,000.
I don’ t know about you, but $4,000 is a lot of money to come up with all at once. That’s why it helps to plan ahead and prepay the amount over a longer period of time. For example, if you have 16 months until your trip to Europe, you could prepay $250 per month ($250 X 16 months = $4,000). Since your regular mortgage payments are $2,000, that means you’d have to pay $2,250 per month for 16 months. So, mortgage vacations, don’t seem so bad, right? But we haven’t discussed the downsides.
The Downsides of Mortgage Vacations
It can be tempting to take a mortgage vacation. I mean, who doesn’t want a break from paying their mortgage? But unless you read the fine print and ask your bank the right questions, you may not be aware that when you take a mortgage vacation, you’re still accruing interest on your mortgage.
When you take a mortgage vacation, something called “interest capitalization” comes into play. Interest capitalization means your mortgage interest is added back to your outstanding mortgage balance. Not only could this end up costing you thousands in interest over the life of your mortgage, it could also extend the life of your mortgage by months or even years.
When does it make sense to go on a Mortgage Vacation?
Although taking a mortgage vacation can be costly, it’s a lot better than missing your mortgage payments. When you do that, not only can you ruin your credit history, it can lead to a power of sale or foreclosure. If you’re like most families, your mortgage is your largest financial obligation. Although a mortgage vacation can help you when you’re in a financial pickle, don’t forget that a mortgage is a loan. If you lose your job and run into financial difficulty, there’s no guarantee your lender will approve your application for a mortgage vacation.
Alternatives to a Mortgage Vacation
The best alternative to a mortgage vacation is an emergency fund. Depending on your financial obligations and job stability, you’ll want to set aside three to six months of living expenses in an easily accessible high-interest savings account. Because when it rains, it often pours. Three to six months living expenses is a lot of money to come up with at once, so if you’re saving from scratch, put aside whatever you can afford — $25 or $50 per month — and make it automatic. Before you know it, you’ll have a sizable emergency fund waiting for you.
Disclaimer: Contact a mortgage professional to see if the strategies mentioned apply to your specific situation.
Sean Cooper is the author of Burn Your Mortgage and managing editor of mortgagepal.ca
