Monday, March 26, 2007

Downpayments

Many discussions have centred around the vulnerability of current home buyers to a house price correction because anecdotally we feel that they do not have the equity to ride out a 20%+ price correction. I wanted to see if that feeling was accurate and I found an annual study by the CMHC of people who intend to buy a personal residence in the next 12 months. This study was done in May 2006.

CMHC interviewed 400 people who intend to buy a home in the Vancouver area and asked them several questions about their intent. 3 of these questions centred around their downpayment. First the asked them about the size of their downpayment. Next, they asked about the source(s) of their downpayment. Lastly, they asked about the main source of their downpayment.

I found the results interesting. Keep in mind that this survey is not only first time buyers but it also includes existing home owners.

Have a look through these survey results and tell me what you find interesting. I found it interesting that nearly 1/2 of all home buyers are using 'unconventional financing,' that is, less than 25% downpayment. This proves what I suspected about current homebuyers and downpayment size - these people are extremely susceptible to a negative equity situation if home prices correct.

Click the image to enlarge.




28 comments:

mohican said...

I also found it interesting that 1 out of 16 respondents intend to get help from parents either through a loan or gift.

Jesse said...

A few comments:

- A large proportion of respondents intend to buy in FV.
- No big surprises. But...
- The wonders of leverage in a rising market mean if you own a home you can put a larger % downpayment if you upconvert. Example: you buy a place for 100K with 10% down. Price goes up to 150K. You upconvert to a 300K place. Your % downpayment on the new place is now at least 20%. The % down might be the wrong question for CMHC to ask.
- 46% of respondents were not viewing places for sale. People are always optimistic before househunting. Kind of like going to war.
- Survey was administered in Q106 meaning the majority of 06 appreciation (>15% I think) had not happened yet.

Warren said...

Hey Mohican,

Interesting survey, although I'm not too surprised at the results. The # of people using under 25% dp is the same amount that is not using a previous source of equity, which means they are FTB or buying a 2nd/3rd/etc property for investment, and it makes more sense for them to borrow more (interest being tax deductible, etc.) regardless of the market conditions.

I thought there would be more people in the under 5% crowd, nice to see there aren't.

Personally, I bought with 5% down, borrowed from a family member no less, and paid back interest free. In retrospect it was very risky, and I was not well informed at all. But the market was flat (1999) and I got lucky.

I'm looking to buy again in the always-around-the-corner-crash without selling my current RE, my main reason for trying to move above 5% is the damn CMHC fees. Ideally I'd like to put down 25%, but 1) having that kind of money period, and 2) having it in a liquid investment are limiting factors.

Warren said...

Reading my post again, I don't mean to imply that FTBs get off the tax hook with mortgage interest, only investors.

FTBs just typically don't have a lot of cash for a DP.

To add to my own story, I was advised (and glad I was) not to use my RRSPs as a FTB. I'd advise the same for others considering it.

vineland said...

As for house buying, I would imagine most first time buyers are getting help, or they are much older. If you spend your years at University, then go get a well paying job, it takes a number of years to save up for a down payment, pay off University loans (if any) and find a job you feel you will be at for a long time.

On the other hand, if you have parents (or Grandparents) willing to help, then you can get in the market without too much debt. How else could a youngish, 28 - 32 year old couple get a house large enough for a growing family? Sure, a shoe box condo is affordable, but let's pretend a growing family wants a slightly bigger place to live, despite certain marketing schemes promising a better life in a shoebox than a suburban house (never seen an 'affordable' (cheap) 3 bdrm condo downtown on MLS)!

I also find that (grand)parents are much more likely to loan or, in some cases, give their kids money when there are grandchildren involved.

This may be what's driving the market as well as speculation, FTBs getting in with help from the 'rents.

Jesse said...

"I would imagine most first time buyers are getting help"

The CMHC report seems to differ from your claim. Only 10% surveyed get help from family in some form though this is likely a bit higher amongst FTBs.

That said, even 10% receiving help will add significant price pressure upwards: I would bet in most cases this extra DP does not change the LTV. In other words, leverage and speculation.

Jesse said...

Oops. This is only partially true. Total loan amount is typically capped based upon income. However there is likely a slight dependance upon downpayment % that could increase total allowable loan amount without taking on unreasonable risk. For the bank.

RentingSucks said...

"To add to my own story, I was advised (and glad I was) not to use my RRSPs as a FTB. I'd advise the same for others considering it."

What is the reasoning behind this? I have significant RRSP's and count the max $40,000 (you + spouse) as part of my downpayment. Even if I take that out I'll still have over 6 figures.
In the last few years I have even stopped contributing because it was hurting my ability to build a downpayment. My downpayment is almost where I want it to be for a price I'll pay for a home (requires about 20-30 perecent down in the area I want to live) so I might start contributing again soon.

I am also considering trying to build a portfolio outside the RRSP by using my owning cost minus renting cost differential to keep my options open. If it is outside the RRSP I can still switch it to housing if things get favorable otherwise I'll theoretically beat housing in the long run.

Warren said...

Well, from your handle I'm going to say you're pretty keen on owning.

rentingsucks:
In the last few years I have even stopped contributing because it was hurting my ability to build a downpayment.

Again, you are really focused on home ownership. I don't know your income level, but I use RRSPs for 2 things: saving taxes, and building for retirement.

We've all seen the graphs promoting the power of compound interest. Remember that these early contributions will grow massively over 30-40 years, all tax sheltered within an RRSP.

My downpayment is almost where I want it to be for a price I'll pay for a home (requires about 20-30 perecent down in the area I want to live)

Can you explain why this "area" requires such a down payment? I've never heard of that for an owner-occupied first time buyer.

The bottom line is how much compounding RRSP money you are losing by a) withdrawing, b) not contributing, and don't forget c) the required payback, which will limit the money you have to make net additions to the RRSP or other savings. This payback has already been tax deducted, so you have to make payments with after-tax money.

I am also considering trying to build a portfolio outside the RRSP by using my owning cost minus renting cost differential to keep my options open. If it is outside the RRSP I can still switch it to housing if things get favorable otherwise I'll theoretically beat housing in the long run

That sounds reasonable. By all means I don't advocate all money going into RRSPs, but the tax advantages are hard to beat.

Although I don't understand your large down payment requirement, make yourself a graph of the RRSP size at retirement among your various plans. I think that will speak for itself.

Mortgages are huge, but they are typically the best interest rate of any debt you can take on. I can't believe I'm saying this in the current market, but: don't be afraid to get a big one. Obviously make sure you are getting some value for that big mortgage.

Christine said...

Actually, it can be quite beneficial to use your RRSPs for a down payment as a FTB. Under the Home Buyers Plan, first-time homeowners (or those who have not owned for more than 5 years) can take money out of their RRSPs to use as a DP, tax free. The money has to be repayed to your RRSP over 15 years, but still, one is able to leverage those tax-free dollars.

Warren said...

I'm not completely against RRSP borrowing, but you have to run the math. It looks better than it really is. If you can't afford a place without it, maybe you are stretching yourself a little financially thin.

dingus said...

Much depends on your prognosis for retirement. If you do not have a pension, and you cap your RRSP at 40k and devote all other savings to a house, that may not be that prudent.

If you have a prospect of a decent pension (my situation, I'm happy to say), the utility of RRSPs decreases significantly, as the differential between current and retirement taxes may not be that significant. There's more flexibility with other savings -- they can be dipped into in emergencies, used for a dp, whatever, without the tax hit. The tax free compounding of the RRSP is powerful, but if you have a buy and hold strategy with shares, cap growth is only taxable when the gains are realized, and dividends get favourable tax treatment.

But seriously, I don't know why you wouldn't take advantage of the HBP, unless it's because you have no pension and have little RRSP savings. Even then, the interest on 20k for 15 years isn't going to make that much of a difference in your retirement, but does cut you some slack on your mortgage.

RentingSucks said...

My downpayment is almost where I want it to be for a price I'll pay for a home (requires about 20-30 perecent down in the area I want to live)

Can you explain why this "area" requires such a down payment? I've never heard of that for an owner-occupied first time buyer.


Sorry I didn't explain that well. The area I'm looking at needs to drop 20 - 30 percent before my downpayment hits 25 percent. This is the top end of what I feel I can afford and what I think the housing is worth. Otherwise I'm not gonna buy. That would be about a $400,000 home with $100,000 down plus $10,000 closing costs.

betamax said...

the interest on 20k for 15 years isn't going to make that much of a difference in your retirement, but does cut you some slack on your mortgage.

Agreed, and you don't have to take 15 years to pay it back.

I also have a pension, but I've decided not to count on it for retirement. Whatever's there is gravy, but who knows what the pension situation will be decades from now.

e said...

if you have contribution room available, you can just throw money into your RRSP, then take it right out to buy a home. that way you still have the tax refund, and just have to pay it back over 15 year (~6%/yr), so if you get a 40% refund (i.e. you're in 40% marginal tax rate), then you can last around 7 years without really suffering financially dime back.

or if you're really strapped, and maxing mortgage, you can take out of rrsp, then use as downpayment, then take out RRSP loan to replace the funds (assuming your rate of return on RRSP is more than the prime rate you typically pay on an RRSP loan).

anyway, just some ways to leverage the ol' RRSP to make home ownership a reality.

Warren said...

Even then, the interest on 20k for 15 years isn't going to make that much of a difference in your retirement, but does cut you some slack on your mortgage.

Well, 20k at a modest 6% turns into $45k. Its not the end of the world, but you're also missing out on your regular contributions for those 15 years since you are just paying back the HBP loan.

I was 23 buying my first RE, so the $20k I might have used (I actually did not have that much in RRSPs at the time), would have been a lot more.

All I'm saying is run the numbers before you do it, mortgage debt is the cheapest kind of debt to service.

Fencesitter said...

Warren said:
"Well, 20k at a modest 6% turns into $45k."

Take into consideration that your mortgage will likely be at 5% or higher, and those payments will be serviced with after tax income.

Since you will be withdrawing your rrps in the future at at least a 21% tax rate, that makes the effective rate of return on investing in your mortgage = (mortgage rate) x (1.21)

patriotz said...

assuming your rate of return on RRSP is more than the prime rate you typically pay on an RRSP loan

A bogus assumption. Never assume that the rate of return on any asset is larger than the cost of borrowing money to buy it. It might be, but that's the upside of risk. Risk has a downside too.

RRSP loans aren't tax deductible either.

Warren said...

fencesitter:

Warren said:
"Well, 20k at a modest 6% turns into $45k."

Take into consideration that your mortgage will likely be at 5% or higher, and those payments will be serviced with after tax income.


That's part of my point, mortgages (as compared to all other debts) typically have the best possible rate, so why not borrow more for them?

Personally, my next RE purchase will be a primary residence, and I plan to use the "Smith Manoeuvre" to deduct my mortgage interest and leverage investments in the market. Of course this is not for everyone, but there are consultants out there who can walk you through it.

Smith

Fencesitter said...

Warren, that is the opposite to what I am saying. Your RRSP is generating interest that will be taxed. That same amount applied to your mortgage will effectively generate interest that will never be taxed. (since if will never be charged). The investment in paying down the mortgage also carries zero risk, unless most RRSP options.

I understand your point, but I think that the HBP and RRSP vs. mortgage calculations need to include the tax savings by lowering your debt...


On a side note: This is my first time posting here, but have been a regular at VHB since he started it. It's nice to see someone putting in the time for detailed analysis.

Warren said...

fencesitter:
Your RRSP is generating interest that will be taxed.

Sure, when you're retired and have no employment income. The government recently extended the deadline for RRIF conversion to age 71.

I understand your point, but I think that the HBP and RRSP vs. mortgage calculations need to include the tax savings by lowering your debt...

Tax savings by lowering debt... sorry I don't follow. I think the competing savings here are:

RRSP tax sheltered growth vs. extra interest on your primary residence mortgage.

I guess ultimately I'd like to point out that your home shouldn't be the retirement basket where you put all of your eggs. There is a common misconception that "the market" is much more risky and volatile than real estate, which simply isn't true. That is a whole other discussion, but its important that people not sacrifice all of their RRSP or non-registered retirement savings just for the sake of a larger downpayment on a primary residence.

mohican said...

I like the discussion here. Good ideas on both sides.

I usually don't advocate using RRSP savings as a downpayment for two main reasons:
1) You miss out on tax-free compounded growth that could be significantly higher than your mortgage rate.
2) Your cashflow, post house purchase, will be impinged by mortgage AND RRSP re-contributions. This can make it very difficult for many people to repay their Home Buyers Plan RRSP withdrawal.

On a personal note - I chose to leave our RRSPs when my wife and I purchased our residence and went with a smaller downpayment. It has turned out to be a very wise choice since my mortgage rate has averaged approximately 4.5% since then and my rate of return on my RRSP investments has averaged 12% during that time. I am waaaay further ahead now than I would have been if I had removed all of that money from my RRSP.

PS - We also chose to contribute less to RRSPs since our home purchase in order to accelerate the mortgage paydown.

dingus said...

"I usually don't advocate using RRSP savings as a downpayment for two main reasons:
1) You miss out on tax-free compounded growth that could be significantly higher than your mortgage rate.
2) Your cashflow, post house purchase, will be impinged by mortgage AND RRSP re-contributions. This can make it very difficult for many people to repay their Home Buyers Plan RRSP withdrawal."


1) Put some numbers to that, and I may be convinced, but I still think it's a great source to tap for a dp (I'm numerically illiterate and very, very, lazy, so I'll decline to do it).

The calculation is a bit complicated. On the left side of the equation is the compounded growth of 20k from present to, say, 65, less mortgage interest paid (adjusted for inflation) on that 20k over 25 years. On the right is compounded growth of $1333 a year for 15 years, and thereafter to 65. Which is greater?

2) Repayment of the rrsp would be $111 a month. (20k / 15 / 12), and it's all principal. What would the additional mortgage payment be if that 20k wasn't used?

dingus said...

"PS - We also chose to contribute less to RRSPs since our home purchase in order to accelerate the mortgage paydown."

I don't see how that squares with NOT using RRSP's at the outset to lessen the mortgage balance. You won't rob peter to pay paul at the beginning, but will do so as time goes on?

Fencesitter said...
This comment has been removed by the author.
Fencesitter said...

A couple of comments:

"Sure, when you're retired and have no employment income"

This is assuming you will have no income from the OAS or CPP? If that is the case, then I agree, otherwise it will be withdrawn at a taxable rate, albeit likely the lower tax bracket.


"You miss out on tax-free compounded growth"

If you change this to "tax-deferred" then I agree. Congratulations on the 12% return, that was certainly a good move. However, for the risk adverse in the crowd, the guaranteed savings from a reduced mortgage could be attractive.

I think there are two major factors in the RRSP vs. Mortgage calculation: Income and Downpayment.

When you income is over 65K, the tax advantages of the rrsp deduction become greater since you will be more likely to withdraw the fund at a lower tax bracket. For those with the average 52K family income (surrey I believe?), it may not be an advantage.

If your downpayment is less than the 25% needed to waive CMHC/GE insurance, then that extra 2-3% when you renew should be added into the calculation as well.

I think that there is a transition point to both of these factors, i.e. if you have a good income and strong downpayment, the RRSP likely makes more sense. The type of RRSP investment also plays a large role in the potential return.

It can become a complicated model when risk factors are introduced...

To each their own

mohican said...

okay dingus - i got my financial calculator out this morning and here is the analysis.

Lets say a few years ago I bought a place for $140,000. My mortgage is over 15 years at a rate of interest of 5%. I had $20,000 saved up for a downpayment and another $20,000 in my RRSP so I have the choice to use the HBP or not. My RRSP has been earning 8% and I expect that to continue.

Scenario 1 - I use $20k from my RRSP to paydown my mortgage in addition to my downpayment. I amortize my mortgage over 15 years and I pay $788 / month on the mortgage. The balance is $0 at the end of 15 years. I also must repay my RRSP at $111 / month over 15 years and I invest that money earning 8%, resulting in an RRSP balance of $38,448. Total payments per month of $899.

Scenario 2 - I don't use the RRSP money and I only have $20,000 downpayment and a mortgage of $120,000 paid over 15 years results in payments of $948 / month. I don't make any additional contributions to my RRSP during this time but the original $20,000 has grown to $66,138. Total payments per month of $948.

Using the RRSP for a downpayment as in scenario 1 cost $27,690 of missed growth. Payments were $50 less per month in scenario 1 which results in a difference of approximately $13,000 by the end of the 15 years with interest. So all in all the person who kept their RRSP account in tact is ahead by over $14,000 at the end.

Note - the assumptions about the rate of interest are the key. If you change the interest rate on the mortgage to 6% or the RRSP to 12% the numbers work out far differently than illustrated. I am merely illustrating the decision process my wife and I went through a few years ago.

dingus said...

Hm!

Thanks for that.

As you say, the rate of return is an important variable. As an eeyore, I'd base assumptions on 6% rather than 8, but your investing experience may make you more optimistic than mine has made me.

Is 15 years for the mortgage realistic? Why not assume 25?

Also, if you're less than 25% down, additional dp will shave CMHC fees. With interest, that could be in the 4 figures at the end of the period you're talking about.

So why does this change going forward for you? Ie why pay off the mortgage as opposed to contributing to the RRSP once you have the mortgage?