There comes a point in most people’s lives where they decide to buy a house. Often being the biggest purchase anyone will make, this is a decision that requires serious thought. There is a lot to consider aside from the down payment; location, size, design, new build or buying an existing property, etc.
In order to buy a house, you need to know what is in your price range. This means most people will need to go to their bank and pre-approved for a mortgage.
The pre-approval process takes several key pieces of information into account; income, credit score, current interest rates, total debt service ratio, gross debt service ration, down payment amount, etc. and tells you how much you can afford to pay for a house.
As a buyer, you have control over some aspects of the pre-approval and approval process, like the down-payment amount. Other things, like income, credit score, and debt service ratios can be controlled to a certain extent. However, to impact those factors it can take a substantial amount of time. Lastly, things like interest rates and available housing we have no control over.
One big dilemma when buying a house is determining how much you should put down and if you should make extra payments.
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Debt Service Ratio’s
There are two debt service ratios that are normally taken into consideration: Gross Debt Service (GDS) ratio, and Total Debt Service (TDS) ratio. Both of these will affect your mortgage approval amount.
Gross Debt Service Ratio
GDS refers to the ratio of the borrower’s housing costs as compared to gross income (that is, income before taxes). Housing costs include:
- Monthly mortgage or rent
- Property taxes
- Heating costs
- 50% of condominium fees
Financial institutions looking at lending money generally have an upper limit of around 32%. The lower the ratio you have the better. If you GDS is higher than their upper limit, you will most likely not qualify for a mortgage.
Total Debt Service Ratio
TDS is slightly more complex the GDS. TDS includes all the figures above but also includes the following:
- Car payments including leases
- Actual debt payments for installment loans
- Spousal and child support payments
- Garnisheed wage arrangements
- Court fines
- Loans where the borrower is a co-signer or guarantor for another entity
- A percentage of available credit for revolving debts; 2-3% is common on LOCs, 3-5% for CCs
- Some lenders will include debt payments related to credit that is available, but not used.
TDS takes into consideration all debt servicing requirements in a month. The upper limit higher than for GDS at about 40%. The same principles apply here. The lower the ratio the better and if you are above the limit you will not be approved.
When buying a house, generally, the purchaser must put money towards the house. This is a down payment. There are exceptions to this. For instances if someone co-signs, or their is equity in another property that is pledged against the new property. At the end of the day, it is up to the financial institution’s discretion.
Assuming that a down payment must be made, the general lowest acceptable amount is 5%. However, putting anything less than 20% would make it subject the high ratio mortgage rules. This means that the mortgage must be insured.
Insurance of mortgage can be done privately, however, it is generally done through Canadian Mortgage and Housing Corporation (CMHC). Between the 5% and 20% range the cost of insurance differs.
|Loan-to-Value||Premium on Total Loan|
|Up to and including 65%||0.60%|
|Up to and including 75%||1.70%|
|Up to and including 80%||2.40%|
|Up to and including 85%||2.80%|
|Up to and including 90%||3.10%|
|Up to and including 95%||4.00%|
This means that if you put 10% down on a house, you have to factor in an additional cost of 3.10% on to total loan amount. This can be quite substantial.
Conventional thinking would lead you to believe that the more you can put down the better. However, is this always the case? Is it better to only put down 20% than pay for the house in cash? What if you can afford 20% down? In that case, is it better to put down a lesser amount and pay more in CMHC? These are the questions we explore below.
How Large Should Your Down-Payment Be?
As nice as it would be if there was a one-size-fits-all answer, there isn’t. Just like most things in life, variables and circumstances must be taken into account. Some things that need to be considered are:
- Capital/available for down-payment
- Need for liquidity
- Type/size of the house needed
- Current interest rates
- Potential missed opportunities
- How comfortable are you carrying debt?
Aside from the actual number crunching, the factors above need to be considered as well. Do you have enough money to pay for the house in cash, or to put 20% down? Obviously, with less available capital, your down-payment will be restricted.
Need for Liquidity
Even if you have cash available to purchase the house without a loan, are you going to need that money in the future? Maybe you have just enough to put 20% down, however, you may need that money in the future. In that case, only putting 10% and paying the extra CMHC fee might be worth it.
Home Specific Needs
Maybe you have a larger family and need a five-bedroom house. In that case, you may only be able to afford a smaller down payment. Or you might not have that much capital available. This would affect the size of the mortgage that you could get.
Current Interest Rates
Another important factor is the current interest rates. If rates are low, like they currently are, the cost to borrow money is minimal. With a lot of mortgages being signed with rates as low as 1.89% for a five year fixed you are seeing people buying homes that they probably wouldn’t be able to afford if rates were 5%+.
Furthermore, if interest rates are low, putting down a larger down payment or extra monthly amounts may not be as beneficial. You can think of the interest charge as the amount you’re saving monthly. Doubling your monthly payments only saved you 1.89%. Would that money have been better off used elsewhere? Maybe investing it would have generated returns in excess of that.
Potential Missed Opportunities
This brings us to the next bullet point above. By increasing the monthly payments of your initial down payment, you could be missing out on other opportunities. Maybe you put down an extra $20k on your mortgage, maybe that money would have been better off going to your RRSP or TFSA.
Comfortability with Debt
Lastly, how comfortable are you carrying debt? Some people hate debt and are extremely adverse to debt. This might mean you rent longer, saving up more for a down payment to lower the debt burden. Conversely, it could mean someone never buys a house because they don’t want to take on debt.
At the end of this article you will find two different calculators: a Rent. Vs. Buy calculator, and a Home Mortgage Calculator. We would encourage you to use them and do some of your own number crunching.
For the sake of simplicity and length, we will use the same numbers for all the calculations. The numbers used will be as follows:
- Average rent: $1,200
- Yearly rental increase: 1.5%
- Renters Insurance: $50
- Average house price: $295,000
- Interest rate: 1.89%
- Property appreciation: 2%
- Property tax: $3,540 (1.2% of house price)
- Amortization: 25 years
- Annual Home Maintenance: $2,000
- Utilities: $150
- Home Insurance: $100
- Inflation rate: 2%
- Investment Rate of Return: 6%
Below we will look at the difference in putting 5%, 10%, 15%, or 20% down as a down payment.
5% Down Payment
Using the assumptions above, putting 5% down ($14,750) would make your monthly principle, interest, taxes and insurance (PITI) about $1,610. Over your 25 year mortgage you would pay over $71,000 in interest.
If you compare this to renting, renting is initially the better option. However, after 3.4 years you hit a break-even point where owning would have been the better option.
10% Down Payment
Using the same assumptions again, putting 10% down ($29,500) would make your monthly PITI roughly $1,550. Over the 25 year mortgage you would pay roughly $67,500 in interest.
If you compare it to renting, your break-even point where buying is better then renting is now 3.2 years. If you were to put away that extra $60 a month at a 6% return, in 25 years you would have $40,577.
15% Down Payment
Now putting 15% down ($44,250) would make your PITI roughly $1,485. Over the 25 years your total interest paid would be just short of $64,000.
In comparison to renting, your break-even point is 3.3 years. If you notice, that is actually a worse break-even point than putting 10% down. This is mostly attributed to the small reduction in CMHC costs when putting 15% down rather than 10%.
20% Down Payment
Lastly, putting 20% down ($59,000) would make your PITI about $1,380. This larger increase is due to the fact of no longer having to have CMHC insurance. Over the 25 years, just over $60,000 in interest would be payable.
Your break-even point in comparison to renting is only 2.4 years. This as well, is attributed largely to no CMHC insurance in addition to a smaller loan.
In the end, how large of a down payment you make is completely up to you. Do you want to keep more cash liquid and available? Or do you want to have slightly smaller mortgage payments every month? Maybe you need access to cash in the short term. In that situation increasing your down payment may not be the best idea.
One interesting thing to keep in mind is the different between 10% down and 15%. Objectively, based on math, 10% seems like the better option. However, if you aren’t sure how large of a down payment you should make, seek out professional advice. Talk to a mortgage specialist, or sit down with your financial advisor.
For a Rent Vs. Buy Calculator visit, What to Expect When Buying a House, and scroll down to the bottom.
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