A mortgage advisor was trying to sell me on cash back mortgage. For most clients he said they use it to pay down debt at a higher interest rate or to buy the essentials for a first home. This is not my situation but he suggested it would make sense to take the 5% cash back and immediately apply it toward the principal. Doing this, even though the mortgage rate is 1% higher (3.79 instead of 2.79) at the end of the term the outstanding balance is smaller than it would be for the lower rate, if the payments were the same. Essentially he's pitching that it has a lower effective rate.
That last bit is where I question, because to get the payments the same he had to play around with the amortization period. I'm wondering if this is a gimmick others have encountered or is this a product which really is intended for a different use case but when applied this way it makes sense.
Based on comments from @dwizum and @chris-degnen I have done a little more analysis. I think there may be one other important aspect to Canadian mortgages which I need to surface: The term of the mortgage and the amortization period are generally NOT the same. In the US you typically get a 30 year amortization mortgage that you could hold for 30 years. In Canada it is unusual, and usually costs significantly more to get a mortgage for a term of longer than 5 years. So part of the analysis here reflects knowing that a new mortgage will be required in 5 years.
Following the link that @chris-degnen shared explaining how semi-annually compounded mortgages in Canada are different than a typical US mortgage I used the Monthly Payment Mortgage Calculator - With Amortization Table spreadsheet to build out a comparison in a Google Sheet. I have shared the spreadsheet here.
The options are defined as follows:
Standard: This is a standard 25 year amortization mortgage at a fixed 2.79%
Standard Adj Amortization: Same as the Standard mortgage but the amortization period was artificially shortened to increase the payment to compare against others.
Standard + Prepayment: Same as the Standard but a monthly prepayment was added to increase the payment for comparison.
Cashback: The mortgage option driving this question, 5% cashback on the mortgage immediately applied and reducing the principal but also at a higher rate of 3.79% and still a standard 25 year amortization period.
Effective: This backs out the "effective rate" of the Cashback option.
Given that the mortgage will need to be renewed in 5 years the question becomes how much money is paid over the 5 year term and what is the balance on the mortgage. The lowest balance option should enable the smallest loan amount at renewal.
The Summary as per the initial Summary sheet is:
Standard: $277,521 paid and $851,270 remaining
Standard Adj Amortization: $293,395 paid and $834,263 remaining
Standard + Prepayment: $293,377 paid and $834,282 remaining
Cashback: $293,377.80 paid and $823,960 remaining
Effective: $293,377.80 paid and $823,960 remaining
There is a larger ($264) monthly payment for the Cashback over the Standard. But if that is acceptable the Cashback option works out to be most advantageous even over adding that same amount as a prepayment each month.
As mentioned in the comments, if the mortgage is paid back early there is a penalty of paying back all/pro-rated 5% cashback. But if the mortgage is allowed to run to term then this is actually advantageous to pay 1% higher interest in exchange for the 5% in cash?