Last week, a friend tagged me in a Facebook post requesting my personal finance wizardry skills regarding borrowing to make a down-payment on a home, and I was happy to oblige. Unfortunately, when I saw what the authors of the post were advocating, I couldn’t help but give my heated two-cents. The authors of the post did not take well to my voice of reason and my comments were deleted and I was promptly banned from the Facebook page.
The post I was responding to was by a local mortgage broker encouraging people to take out a line of credit in order to make a down-payment on a home. They touted low interest rates and stable house prices a reasons to take advantage of the opportunity, then drove the point home that doing so would put you ahead of renting using some really manipulative math.
You can view the original post here, but the gist of it was that paying your mortgage and making interest-only payments on a line of credit worked out to the same out-of-pocket costs as renting, and therefore owning, at whatever the cost, was preferable.
There is so much wrong with this thinking, I hardly knew where to start.
Before we go on, I just want to ask you to please share this post with a friend or family member who is house hunting. Many people look at loans, lines of credit, or even credit cards as possible sources to top-up, or even fund their entire down-payments. This is a dangerous way of thinking, and traps people into a debt-spiral and a home they cannot actually afford. Remember, when it comes to making major decisions with your money, patience pays. Taking an extra few months or years to buy a home the right way will spare you financial anguish for the next 25 years, whereas rushing into home ownership without your financial ducks in a row will cripple your wealth accumulation for the rest of your life.
Below are 7 problems with borrowing for a down-payment!
Problem #1: a 5% down-payment gives you only 1.6% of equity in your home and leaves you underwater on your mortgage from day one
Most people erroneously assume that 5% down translates to 5% direct ownership in their home, but this is not the case. In Canada, if you are putting down less than 20% of your home, you must pay mortgage insurance on the difference, which essentially reduces how much your down-payment is worth. Rob Carrick of the Globe & Mail shared the math in this chart:
In the case of the example used by the mortgage broker in the Facebook post I’m harping on, putting only $15,000 down on a $300,000 requires you to get $10,260 of CMHC insurance as per RateHub’s mortgage payment calculator — effectively reducing the value of your down payment to a paltry $4,740 when you buy. As a result, you end up a $295,260 mortgage and a $15,000 line of credit, and no hope of seeing a positive net worth anytime in the next year.
$295,260 mortgage + $15,000 line of credit debt = $310,260 total debt, or 103% of the home’s total value.
In related, unsurprising news: Canadians now owe $171 for every $100 they earn. Probably because they also have cars, student loans, and credit cards on top of the 103% they owe for their house.
Problem #2: utility bills and property taxes are a real thing
At first glance, it might seem like the annual costs of renting or paying a mortgage are equivalent, but they’re not. Renting has its privileges, not the least of which is zero property taxes and very low utility bills. Many rental properties even include utilities in the rental price, reducing the out-of-pocket costs for heat and water (and sometimes cable, internet and telephone) to zero for the renter. A homeowner can easily pay $300+ for power and water. The larger their home, the more expensive it is to keep warm and cozy.
RateHub.ca gives me an estimate of $148 per month in property taxes on a $300,000 home, or nearly $1,800 per year. That’s a big bill for someone who couldn’t even scrape together a down-payment! Additionally, you should expect to pay approximately 1% to 3% of your home’s value in maintenance and upkeep each year. Some people who buy a new house think they avoid this, but if you have to do things like buy a lawn mower to keep your new square of grass, you’re spending on home maintenance. You will never own a home with no maintenance costs.
I did a quick calculation of the out-of-pocket annual costs of a renter vs. a buyer that borrows on a line of credit for a down-payment. Here is the summary below:
As you can see, the borrower is actually worse off than the renter to the tune of nearly $8,000. EIGHT THOUSAND! The high cost of home utilities, maintenance and upkeep, plus property taxes make owning a home more expensive than renting.
The longer I rent, the more I like it — and the more I face naysayers. But the truth is, banking the monthly cash difference between renting and owning can more than make up for the absence of equity in home ownership. In fact, in this market, you’re probably better off.
Problem #3: don’t forget about closing costs such as home inspection, home appraisal, and lawyer fees
If you’re borrowing for a down-payment, chances are your probably don’t have an extra couple thousand dollars kicking around for closing costs. A home inspection will cost $300 to $500, and then you’ll spend an extra $1,000 on lawyer fees plus $300 on title insurance. In other provinces, transfer taxes and fees can eat up even more cash. To say the least, there’s far more costs associated with buying a home than simply slapping down a wad of bills for the down-payment. I did a quick calculation comparing the change in net worth of a renter vs. a borrower at the end of one year, and this is the result:
Thanks to extra costs that either need to come out of savings or be paid for with more debt, the borrower will lower their net worth by over $12,000 right off the bat when they buy the house. They’ll make up about $8,000 through mortgage payments during the year, but because they’re also paying an extra $9,000 in annual costs including line of credit interest, utilities, home maintenance, and property taxes, they will likely never catch up. Assuming home values rise, so will their property taxes, so unless they aggressively pay down the line of credit and/or their mortgage, they will be on a hamster wheel trying to “build equity through home ownership” for the next quarter century.
Always keep a few extra thousand dollars on hand for closing costs and fees when purchasing a home, otherwise these will catch you by surprise.
Problem #4: the housing market in Alberta is in decline
I cannot say this enough times to make anyone hear it. It seems most 20- and 30-somethings are so eager for home ownership, they’re neglecting the stark reality that real estate is going down, not up, in our province. Those that purchased their homes in 2014 and 2015 are in flat-out denial that their homes have decreased in value because this reality is so painful to acknowledge. There’s a good chance that if you purchased a home in Alberta with less than 10% down anytime in the past 24 months, you are now underwater on your mortgage. I have yet to see anyone admit this to themselves, but the Calgary Real Estate Board and Edmonton Real Estate Board statistics are public for all to see. You gambled and lost, you would have been better off waiting.
If a $300,000 house drops in value by 2% to $294,000, the borrowing buyer is still on the hook for their $295,260 mortgage and $15,000 line of credit. Which means, they will now owe 106% of their home’s value.
As a general rule of thumb, when it comes to wealth-building, I strongly discourage people from investing in assets that are declining in value.
Problem #5: if you make interest-only payments on a line of credit, you will never get out of a debt
Someone that borrows $15,000 for a down-payment is way, way, way worse of than a renter — to the tune of $15,000 plus interest. I have no idea why this ludicrous Facebook post didn’t acknowledge the fact that when you take out a loan for a down-payment, you end up with a loan. While it’s possible you might be able to make interest-only payments on this debt so long as you live, why would you want to?
A home-buyer that funds their down-payment with a $15,000 line of credit debt has $15,000 more debt than a renter who was not so careless. They also have an additional $1,000/year bill to interest. Interest is this really stupid thing modern society has created where you pay and pay and pay, and have never have anything to show for it except an empty wallet.
I realize trying to get Canadians to live their lives without debt is just me screaming at a brick wall, day-in, day-out, but I’m going to keep trying. Life without debt is better. Choose it.
Problem #6: you will be totally effed if interest rates increase because you have a mortgage AND a line of credit
I didn’t really think that 6.79% interest rate on a line of credit was that great, but it’s certainly lower than credit cards or other loans out there. However, for someone that borrows at the max of their affordability, even the smallest increase in interest rates can have a catastrophic effect on their finances. For the house, they’d be ok for 5 years assuming they lock in low rates for that term, but they’d have to start paying more for the line of credit right away. A small rise in interest rates of only 1% would raise their annual interest costs on their $15,000 line of credit from $1,018.50 in interest to $1,168.50 — an increase of 15%.
The same 1% rate increase on their mortgage 5 years from now at time of renewal, would increase their monthly payment by about $100. If interest rates rise by more than 1%, their mortgage payment will increase by hundreds of dollars each month.
It’s also important to note that a rate increase will increase your monthly payments, but at no benefit to you. It’s just interest. You will paying more for the same thing. You can test your vulnerability to a rate raise here.
Problem #7: performing financial gymnastics to buy things you cannot afford is one of the reasons the Canadian housing market is so heated and over-valued in the first place
Most of the reasons mortgage brokers suggest now is a “great” time to buy a house — like low interest rates and the ability to borrow to fund your down-payment — have led to our problematic real estate market to begin with.
Everyone is so caught up in buying a house, they never stop to think that a truly bizarre thing would happen if people acted more responsibly, such as waiting until they had 20% to put down: house prices would decrease.
Making the market more accessible through low interest rates and quick & dirty loans for down-payments, gives more people the ability to buy a house, which increases the demand for houses, which drives their prices up. Canada needs to take swift and firm action to stabilize the market through stricter borrowing laws, higher down-payment requirements, and higher interest rates, because right now, we are selling housing to people who cannot afford them.
And those who have to borrow on lines of credit in order to scrape together a down-payment are those people.