Home ownership usually occupies a significant position in both the budget and the balance sheet. Since it is one of the largest financial commitments you can make in your life, the issue of home ownership needs to be discussed objectively.
Resist the temptation to include any anticipated increase in the value of your home as a source of funds for retirement.
Two questions arise. Is it better to rent or own? If I decide on ownership, what is a reasonable amount to spend? The answers are less obvious than they may seem.
Rent vs. Own
An important consideration is whether or not home ownership makes financial sense for your current situation or whether renting is the better option. The answer to this question is far from obvious and often influenced by many misconceptions that have become ingrained in our psyche.
You may ask, “What about throwing money away on rent and not building any home equity?” The counter to that argument is, “What about throwing your money away on interest?” For many people who buy a home, the major cost is not the house; it is the interest they pay on the mortgage.
That money doesn’t go to building equity; it goes directly to the bank and it can be more than the value of the house itself.
In order to make an accurate comparison, you need to take into account the mortgage payments, taxes, utility costs, maintenance and condo fees (if any) when comparing the cost of a house to apartment rental. For older homes, the cost of renovations and upgrades is often a cost that is overlooked.
You should also consider how much you could have made if you had invested the down payment rather than used it for the purposes of buying a house.
The cost of renting an apartment typically consists of your rent and some utilities. If that number is less than the cost of home ownership, thedifference can be invested for growth. That is how you build equity when you are renting.
It is a difficult comparison to make because so many factors need to be considered. Without considering the investment aspect, these considerations include:
• Price: Is the house market over or undervalued with respect to rental prices? This is not a straight forward comparison because of the many factors that need to be considered.
• Stability of payments: Those who are concerned with the possibility of rental price increases over time may like the security of knowing that their mortgage payment is fixed, thus providing some certainty for budgeting purposes. However, mortgage rates are constantly changing and the possibility of a significant rise in mortgage rates can put a family budget in jeopardy. Taxes and condo fees are also subject to change (increase) with little control for the owner.
So, while the notion of having a stable payment for budgetary purposes is nice in theory, in practice the home owner faces as many obstacles to price stability as does the renter.
• Pride of ownership: This is an aspect that is very difficult to quantify, but it cannot be dismissed out of hand. It is important to differentiate between the pride of ownership (a house that you can actually afford) and satisfying the desire to live in a big house with a mortgage that can create severe economic hardship if interest rates rise.
• Ability to personalize your home: If a homeowner wants to build a deck, fence or renovate a bathroom he just has to do it. As a renter, you may have less luck in getting a landlord to change a bathtub just because you don’t like the color.
However, even property owners are subject to limitations. This is particularly true in the case of condos or townhomes.
• Lifestyle decisions: You may be passionate about gardening or you may dislike yardwork, the location of a house may be closer to a school for your child than an apartment, and other lifestyle reasons could influence your decision on whether to rent or buy.
• Duration of ownership: Transaction fees for real estate purchases and sales can be significant. If the expected duration of your stay is relatively short, the transaction fees can put you in the red, even if the value of the home has increased.
Some of these fees are: real estate agent fees, legal fees, land transfer taxes, CMHC mortgage insurance, mortgage closing costs and so on.
The idea of a young couple buying a “starter home” with the intention of moving up in 3 or 4 years once they have “built equity”, makes a lot of sense to a realtor who is collecting commissions, but very little sense to a family who might see all their “equity” end up in the hands of third parties.
Calculators that are useful when making the decision whether to invest in real estate can be seen on the MoneyPages website at http://moneypages.ca/page/23/real-estate-overview
Renting until the purchase of a home makes financial sense is a strategy worth considering; just remember to invest the difference to build your wealth.
It is unlikely that your banker or real estate agent will promote that strategy because it is not in their best interests, but it may be in yours.
For a great many people, the image of home ownership is a bigger factor in their decision than the financial reality. It can be an easy leap to convince yourself that bigger is better when it is something that you want but don’t really need.
Dangerous debt levels
Home ownership has been used as a status symbol in recent years but few people realize the cost of that status symbol.
The following chart illustrates the growth in debt that Canadians have assumed when compared to their income levels; a level of debt that may be unsustainable.
The only reason that they can still afford to make the payments on these debts is because interest rates have remained at historically low levels in recent years. Should those rates rise even marginally, a great many Canadians could be at risk of defaulting on their payments.
None of this is an indictment of home ownership, but if it is the path you choose, choose what you need and what is affordable rather than what you want. You should have a good idea of what that is before you talk to your banker or your real estate agent.
What is affordable?
For those who want to own a home, they should buy one that they can afford. If it happens that you can afford an expensive home, there is nothing wrong with that. However, the balance sheet of many Canadians indicates that far too much emphasis is being placed on real estate without regard to overall finances.
The question isn’t just whether you can afford a home at today’s mortgage rates; it is whether you can afford the home in a “normal” interest rate environment. Since this book was originally published the Office of the Superintendent of Financial Institutions has created new, stiffer rules for mortgage qualification. You can see the qualification rates on the MoneyPages website at http://moneypages.ca/page/72/selected-rates).
The DebtPlanner from MoneyPages can help you assess your overall level of debt while the Mortgage Affordability Calculator can help you with determining how much you can spend on a new home. The Mortgage Affordability Calculator takes into account the stress test introduced by the Canadian Banks.
A study by the Bank of Canada found that:
“While measures of housing affordability remain favourable, thisis largely because interest rates are unusually low. Rates will not remain at their current levels forever. The impact of eventual increases is likely to be greater than in previous cycles, given the higher stock of debt owed by Canadian households. At a 4 per cent real mortgage interest rate—equivalent to the average rate since 1995—affordability falls to its worst level in 16 years.”
When the Bank of Canada talks about a real mortgage interest rate of 4%, it is referring to the amount by which mortgage rates exceed inflation.
In other words, if inflation rates averaged 2%, then mortgage rates would have averaged about 6%.
When determining what you can afford, some lenders will base that affordability on the lowest mortgage rate available, but that is a strategy that leaves no margin for error. Interest rates will fluctuate and anyone who lived through the mortgage rates of the early 1980s can tell you horror stories.
As the Governor of the Bank of Canada, Mark Carney, said in his address to the Vancouver Board of Trade in 2011, “Even a fixed rate mortgagewill re-price a number of times over the life of a mortgage”.
The following chart illustrates the 5 year rate on mortgages over the past fifty years. The average rate over that time has been in excess of 9% with rates peaking at over 18% in 1982.
Many homeowners who have been counting on interest rates to stay low forever could face financial hardship should rates approach historical averages.
Monthly payments on a $250,000 mortgage with a 25 year amortization would go from $1285 with a 3.75% interest rate to $2100 with a 9% rate. Payments would increase by over $800 per month!
Interest rates and affordability
When calculating affordability, use the higher of the current mortgage rates or a rate that is approximately 4% over inflation. The inflation rate in Canada over the past 25 years has averaged between 2.25% and 2.5%.
That means you should use a hypothetical interest rate of at least 6.25% and 6.5% when calculating affordability.
Let’s assume that your calculations indicate that you could afford a mortgage payment of approximately $1700 per month. That would equate to a mortgage of $250,000 at 6.5% for 25 years. In this case, you would set your limit for a mortgage at $250,000 and then begin shopping for rates.
If you could find a rate for 3.75%, your payments would only be about $1285 per month.
By spending less than you can afford, you would have a cushion of $415 per month in the event that interest rates rise. One strategy would be to apply that $415 per month directly towards the principal of your mortgage.
If rates remained constant, you would have paid your mortgage off six years early and if rates rose, your home would still be affordable.
The question isn’t necessarily whether you can afford to make your mortgage payments at current rates; it is whether you can afford the payments when rates are near their historical norms, which is about 4% above the inflation rate.
In the first decade of the 2000s we have been living outside of a normal interest rate environment where rates have been equal to, or lower than, inflation. It has lulled many into the impression that these are normal circumstances, but they are not. Historically, five year mortgage rates have averaged about 4% over inflation. In 2012 these rates were close to 1% or 2% above inflation.
In a 2012 poll conducted by Harris Decima, 29% of Canadians felt a rise of two points in interest rates would make it difficult for them to meet their mortgage payments and a further 29% would be severely affected by a rise of three or four points in interest rates. Don’t count on mortgage rates staying low forever; build in a cushion.
The following table compares two couples who are trying to determine what they can afford in terms of a house purchase. The first couple has determined that they can get a mortgage for 3.75% and have based their affordability on that rate.
They are counting on rates remaining at the current level or falling for the duration of their mortgage.
The second couple also realizes they can get a mortgage for 3.75% but want to be sure that they can still afford the house if rates rise to 6.5%.
In the end, they both take out a mortgage for 3.75% but the second couple has purchased a more affordable house with a smaller mortgage. If rates did climb, this couple could still afford the payments.
As we have seen, mortgage rates over the past fifty years have been above 3.75% for a much longer period of time than they have been below that level. Be realistic when calculating what you can afford.
Other home ownership costs
There are additional costs to maintaining your home that need to be considered. These will include property taxes, utilities, insurance and maintenance. The actual cost of many of these items can be obtained from your real estate agent or from the person who is selling the home.
A rough guide for estimating the annual property taxes is about 1.0% to 1.25% of the property value. An estimate on utilities and insurance is also necessary to determine your total monthly expenses and ultimately the size of a mortgage you can safely afford.
The value of a house you can afford depends on a combination of the down payment and the affordability of the total monthly payments that you might be faced with. The total cost of your mortgage, property taxes, insurance, utilities and any condo fees should represent no more than 30% of your gross income. That will leave room for other budget expenses.
Don’t forget to factor in the transaction costs that are associated with the purchase of a home. Typically, real estate fees are absorbed by the seller, but as a purchaser you will still be faced with closing costs which include, among other things, legal fees.
Extra caution should be used when buying an older home. Significant repair, maintenance and renovation expenses can add to the cost. A home inspection is advised, and if any issues are identified, the cost of addressing those issues must be incorporated into the cost of your home.
A summary of additional costs that you may face when buying a home can be seen on the MoneyPages website at http://moneypages.ca/page/37/real-estate-information-centre
Canada Mortgage & Housing Corporation (CMHC)
When considering the purchase of a home, most lenders will require a minimum down payment of 5% of the purchase price. With a down payment of 5% you will be faced with paying high CMHC fees which adds to the overall transaction costs.
The fee declines as the down payment increases and with a down payment of 20% or more. Because of the additional costs of CMHC fees, a down payment of more than 5% is desirable, while 20% or more is preferable.
The Mortgage Planner http://moneypages.ca/calculator/29/mortageplanner on the MoneyPages website calculates CMHC fees on real estate transactions.
Before making the decision to purchase a house, other factors come into play. You may have a car loan or lease, a student loan, a line of credit or other payment obligations. All of these obligations, along with your mortgage payment, represent your total debt service costs. The amount of these obligations divided by your total gross income represents your total debt service ratio.
According to Investopedia, the debt service ratio is a “measure that financial lenders use as a rule of thumb to give a preliminary assessment of whether a potential borrower is already in too much debt.
More specifically, this ratio shows the proportion of gross income that is already spent on housing-related and other similar payments. Receiving a ratio of less than 40% means that the potential borrower has an acceptable level of debt.”
In other words, the decision to purchase a home cannot be made without considering your other financial obligations. Choices may have to be made. Some of these may be a smaller home, a less expensive car or deferring a purchase until your financial situation warrants taking out a mortgage and making a major purchase.
Keep in mind that the job of the banker is to lend you as much money as you can afford with minimal risk of default. Their job is not to set you up with a mortgage that represents a reasonable level of payments and that leaves you with enough to enjoy a comfortable lifestyle and the ability to save for retirement.
If you buy a home you can afford there may be an opportunity to upgrade if and when your financial situation dictates that the added expenses will fit within your new budget.
Be sure to factor in real estate fees, closing costs on the sale of your existing home and closing costs on the purchase of your new home if you are thinking of making a change.
The truth is that the less you spend on real estate, the more you will have for lifestyle expenses and the more you can set aside for assets that can generate long term growth for your retirement. And if you can’t afford to upgrade, at least you have not put yourself at a financial disadvantage by taking on more debt than you can afford.
As a reminder, MoneyPages offers an affordability calculator
Additional payments against the principal owing on your mortgage can be considered as savings, rather than the cost of shelter. It not only saves significant interest costs, it also allows your mortgage to be repaid more quickly.
Once your mortgage is repaid, a greater percentage of your income can be re-directed to building your investment portfolio.
Some advisors do not advocate paying down a mortgage. It may be because they truly believe it is a poor strategy or it may be because they would like the additional funds flowing into the accounts they manage.
Don’t hesitate to ask lots of questions about the advantages and disadvantages of paying down your mortgage.
• In the long term, mortgage rates have averaged about 4% above inflation. Keep that in mind when planning for the financial commitments you may be faced with when buying a house.
• When calculating the affordability of a home, the total monthly costs involved in owning that home should not exceed 30% of gross household income.
• The total of all monthly mortgage and load payments should not exceed 40% of your total household income.
• Paying down the principal on your mortgage is a risk-free investment.