When I first arrived in Canada, I was astonished: “Are you saying I can buy a home with a 5% down payment? THAT'S SO CHEAP!”. Yeah, right. A house is probably the biggest purchase you'll ever do, so you better get your numbers straight, right?
But this is not another post about hidden closing costs or how much your mortgage insurance will cost you. We'll look at these topics, yes, but then I suggest a different way to look at your down payment and your CHMC insurance.
“House poor” is what we call someone who buys a house and ends up not being able to pay for it. This happens not only because of emergencies and unforeseen changes in one's life, but because people just don't stop to do the math of how much house they can afford, let alone to think about possible changes and emergencies along the way during these loooong next 25 years…
For example: you and your husband want to have (more) kids some day in the near future (let's say in less than 5 years). You just don't go buying a one-bedroom apartment today, because you will need a bigger house in 5 years (to accommodate your new offspring). But, in the other hand, you just don't go buying a four-bedroom, two-bathroom, two-floor detached house either, because you don't need it now — and WHY would you buy something you don't need?
You don't want to see yourself in a situation where you have to sell your car or keep refinancing your home ad infinitum to meet your mortgage responsibilities every month, I am sure.
Qualification vs affordability
The bank will say you qualify for a half million dollars mortgage. That does not mean you can afford a half million dollars home, there's a huge difference here.
The way banks calculate their mortgages does not take into consideration your lifestyle, the way you manage your money or your plans for the future. It's your job to figure these things out (though I can help you with that) and decide if the numbers the bank is showing you are real for you.
Think about this: the bank doesn't really want you to default on your payments, but they WILL lend you more than you can comfortably afford. They want you on that blurry line between a good client and a bad client.
5% down – it's so cheap!
Depending on the selling value, you may be able to buy a house with a small 5% down payment. For a $500,000 house, the down payment can be as low as $25,000. That's ridiculously cheap, right? WRONG!
Amount in cash you need to buy a $500k home: $25,000
For any down payment smaller than 20% ($100,000 in our example here) you are obligated to pay for mortgage insurance (also known as CMHC insurance).
Ah, insurance is always good, right?
Wrong again. This particular insurance product is designed to cover and protect the bank, not you. But you are the one paying for it. So, if you don't pay your mortgage, the bank will receive the jackpot and you will still have to pay the mortgage. Sweet, eh?
Another nice detail about the mortgage insurance: you can add it to your monthly payments, diluting it throughout the years (thus making your monthly payments bigger). But since it'll attach to your mortgage, if you sell your home you have to pay it off at once (a small detail realtors always forget to tell you when they say real state is an amazing investment). Unless you are buying another home, in which case you can probably transfer your insurance to your new mortgage.
Basically, the mortgage insurance is the penalty you pay for not coming up with a decent down payment.
A new look at the CHMC insurance
But Daniel, we don't have a choice!
Yes you always have a choice. I can give you several options right of the bat: 1. wait a few more years and save more money, 2. buy a smaller or cheaper house — or 3. don't buy at all!
If you choose to wait, it means you'll rent for a few more years. My friend John Robertson (author of “The Value of Simple”), created a great Rent vs Buy calculator. With it you can check if it makes sense for you to rent or to buy right now.
In our half-a-million example, we have the following CMHC mortgage loan insurance costs:
- 5% down payment ($25,000): $19,000
- 10% down payment ($50,000): $13,950
- 15% down payment ($75,000): $11,900
There's no scenario where paying less than 20% upfront makes financial sense here. Bear with me: if you have $25k to use as a down payment, you will have to pay $19k more for you house, as insurance costs. If instead you add this $19k to the $25k down payment you already had, making it $44k, you still must pay $18,240 in insurance! That's crazy! You added $19k to your down payment to reduce only $1,000 from the insurance!
Pro tip: If you happen to have anything between the 5% minimum and 20% for the down payment, study the numbers to see if it's not better to use part of it as the down payment and part of it to pay the insurance in cash. You'll pay less monthly this way ($2,096 vs $2,020 for monthly mortgage payments in our example – it may seem a small difference, but think this difference times 25 years! Spoiler alert: you can buy a CAR with the difference).
In our example above, if you have $44k, use $25k as down payment and $19k to pay the insurance upfront — you will have a smaller monthly payment!
Amount in cash you need to buy a $500k home: $44,000
How to transform $25k in $8k
Then you think “My house costs $500k. Since I already paid 5% of it ($25k) I will only borrow $475k from the bank” — WRONG.
You forgot the insurance. Man, I was talking about it two seconds ago! Let's take a look at how much you do really owe after “paying” the down payment:
- 5% down payment ($25,000): $494,000 – you lose ~76% of your down payment
- 10% down payment ($50,000): $463,950 – you lose ~28% of your down payment
- 15% down payment ($75,000): $463,900 – you lose ~16% of your down payment
Does it make any sense? You are buying something with a price tag of $500. You come up with $25 and still have to pay $494!! Your $25 was reduced to less than $6! Think about a good investment! “Here, you give me $25k and I give you $6k in return”. No, thanks!
The bigger your down payment, the less you lose. And starting in 20% you are losing nothing and only then you are really adding value to your home!
Close these costs!
So until now we calculated we need to cash out $44,000 to buy our dream house. but this is just the beginning… This is the money you will give to the bank. There's a lot of other people wanting your hard earned money when you buy real estate.
We call these “closing costs”. And they are always underestimated. Land Transfer Taxes, taxes on the insurance, lawyers, real insurance, inspection… And note that we are not even talking about fixes or improvements you are thinking about to do once you move in (or before).
According to an online simulator, adding the closing costs for our dream house would fire the costs up to $55,000 (!!!)
Do you have any friends who bought a house recently? This is why it's normal that you will not see them for several months after they sign at the dotted lines. They simply don't have the money to get out of their dream houses. It's normal to hear people saying “we had to scrape the last cents from our bank accounts to pay for unexpected costs”. Thing is, they are not unexpected. You just didn't know about them, and you didn't plan to face them.
Let's update the amount of cold cash we'd need to have in hands to buy that home, shall we?
Amount in cash you need to buy a $500k home (with 5% down payment): $55,000
So let's see how our monthly payments would be in our example, both including the insurance in the monthly payments and having paid it up front:
- Down Payment With insurance Insurance paid up front Difference
- 5% down payment: $2,310 … $2,222 $88
- 10% down payment: $2,170 … $2,084 $86
- 15% down payment: $2,043 … $1,990 $53
- 20% down payment: $1,870 (there's no insurance costs here)
Life isn't fair, is it? People who have more will pay less. This is how it works.
If you can't come up with 20% of your dream house, what makes you think you can afford to pay these monthly values? Probably you can't.
And what would you do if rates went up and your monthly costs go $300 higher than these numbers? House poor, remember? And let me tell you something: rates will eventually go up. It's a matter of time. Can you really count on your salary going up to keep up the pace?
And since now you are not renting anymore, there's a lot of other costs associated with your home ownership. Property taxes, municipal taxes, insurance, maybe utilities (some renters have them included in the rent value). Have you checked if there's any fees or taxes specifically for your neighbourhood? Garbage collection, maybe?
That's NOT all, folks
The mortgage payments are only the tip of the iceberg. Remember: you still have your car leasing, your grocery bills, cell phones, internet, heating, electricity, dining out, student debt, credit cards… in other words: your life is still going on. Every. Single. Month.
And now that you are a landlord (sounds fancy, eh?) you cannot just call your landlord when something breaks or leaks in your home. You have to fix it yourself or hire someone to deal with that. And, uh, of course this will have a cost attached to it.
As you may have guessed, we have a rule-of-thumb for maintenance costs. Count on having to shell out anything from 3% to 5% of your property value each year for running costs.
For our $500k house example, that would range from $15k to $25k a year.
Did you have a raise in salary of $25k last year to accommodate this new costs in your life? Do you expect to have such raise next year?
But Daniel, I have a house and in no way I spend this much money in maintenance!
This is an average, and an estimate. Wait until you have to change the water boiler or redo your roofing, and then calculate these costs spread by the years that you didn't have to spend big buckets of money in maintenance. Put in a spreadsheet every single cent you've spent changing light bulbs or painting or buying tools to DIY anything in your house. Then let's talk about your maintenance costs, ok?
Wait for your basement to be filled with water knee-level after the first spring you are living there, or for the first heavy November rain to hear the water dripping on your ceilings, and when these moments come you will wish you had put away 3% of your property value each year to deal with them.
If you didn't, then you will have to dig into your savings or retirement, or even worst, pay with your credit card and end up in debt. House poor.
But hey, at least you have your own white little fence, right?
Should I wait, then?
Well, sometimes all you have to do is wait. I know, there's lots of pressure nowadays for you to “get into the market” and just buy a home. But I always ask “why?”
Sometimes renting is just as reasonable as buying. There's nothing wrong with renting, specially when considering financial options.
I understand there's more to it than just maths. Cultural, social, family and friend's pressure (not even talking about the media, banks and even the government), they all seem to want you to BUY a home, no matter what. And we fall for this pressure, because we've been taught since our earlier days that “renting is throwing money away”. Well, that's not always the truth.
Buying a house is always more expensive than what we'd expect. Specially if you don't come up with a sizeable down payment.
In the case your down payment is less than 20% of the purchase price you will have to pay the CMHC insurance.
Usually, everybody and their moms will tell you to just go for it and roll over the insurance into your mortgage. I propose that you pay the CHMC insurance upfront, in cash, so you can have a (slightly) smaller monthly payment for the years to come.
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