Personal Finance and Buying a Home

Something that I haven't quite got my head around is how so many (thousands per month) people can seemingly 'afford' to purchase homes in the Vancouver area considering the prices at which local homes seem to be sold at. Greater Vancouver benchmark for all dwelling types is just about $520,000 as of June 2009.

Let's look at a sample first time home buyer.

Let's imagine John and Jenny want to get started on the property ladder after getting married last year. They have saved $10,000 over the past couple years and they have about $25,000 in their RRSP accounts which they intend to use toward a property purchase under the Home Buyer's Plan. Jenny's parents have offered to help them purchase their first home as well with an extra $20,000 'loan' to be used toward a down payment that may never need to be paid back. They don't have any credit card debt but are making payments of a combined $900 per month on two car loans which have 3 years left on them. Combined down payment = $55,000.

John makes $60,000 per year working in the technology field and his job prospects are very good given his education and work experience. Jenny works in sales and her income has averaged $50,000 per year over the past two years. Although she does okay at work, her job prospects are sketchy as the company she works for has seen business drop off considerably and has laid off a few people in the last few months. Gross Annual Income = $110,000. Net Monthly Cashflow = $6,000.

They are wondering what they are able to afford (apparently they don't have a budget) so they go talk to a mortgage broker about their situation. The mortgage broker punches some numbers into the computer and comes up with a preapproval amount of $430,000. John and Jenny are amazed, they wonder what they have done to make the bank love them so much! This pre-approval emboldens them.

They call up a realtor and begin looking at homes in the $400,000 to $500,000 price range. The realtor shows them several condos and a few townhouses which meet their criteria and they settle on a nice townhouse and make an offer for $450,000 which is accepted and the deal is drawn up.

John and Jenny put $45,000 down by using the parent's money and withdrawing from their RRSP accounts under the Home Buyer's Plan. They have paid CMHC and legal fees of $9,000 which gets added to their mortgage so they owe a total of $414,000 and they have decided to amortize over 35 years (they will be 65 when it is finally paid off if they stick to the original plan with the original rate) with a 5 year term and a rate of 4.5%. They will be making principal and interest payment of $1,950 per month, they have added life insurance to the mortgage ($50) and are paying property tax monthly with their mortgage payment ($200). They now get to pay strata fees of $200 per month as well.

Let's have a look at John and Jenny's monthly budget.

John and Jenny's total monthly obligations are:

Mortgage - $1,950

Life Insurance - $50

Taxes - $200

Strata - $200

Car Payments - $900

Food - $600

Fuel - $400

Home and Auto Insurance - $400

Telephone/Internet/Cable - $300

Clothing/Other/Misc - $300

Entertainment/Vacations - $500

RRSP contributions - $200

Total = $6,000

This couple can have a 'reasonable' lifestyle based on these numbers but let's look a little closer. Let's test this for several common risks:

Death - The mortgage is life insured, the survivor would be financially okay so long as the life insurance remains in place.

Divorce - They are in bad financial shape if this happens. Neither one of the two could afford the townhouse if they split up and the townhouse would need to be sold quickly.

Children - They are in bad financial shape if they have kids. Not only would they have extra monthly expenses, which they don't have room for in the budget, they would also have less income for a period of time as it is typical for the mother to take some time off work after giving birth. Even if mom went back to work there are daycare costs, which are not small.

Job Loss - They are a financial disaster if one of the two loses employment of any extended period of time. They would be forced to make some significant life changes and likely sell the home.

Interest Rate Rise at Renewal - If interest rates rise by 100-200 basis points they would be extremely rough financial shape. Unless they had an increase in income, they would likely be forced to re-amortize the mortgage and/or make other lifestyle changes. If rates increased more than 200 basis points, they would not be able to maintain their current lifestyle in any shape or form.

1) 100 basis point rise to 5.5%, maintain original amortization, payments rise to $2180 / month

2) 200 basis point rise to 6.5%, maintain original amortization, payments rise to $2420 / month

3) 300 basis point rise to 7.5%, maintain original amortization, payments rise to $2670 / month

Time - This is the most insidious risk of all and the least recognized. As a financial planner, I see many people who have put themselves into this type of scenario and they manage to muddle through life, manage to pay off a modest home by retirement and save a very modest sum of money. They retire at 65 and have a fairly low standard of living since they have no real significant savings and no pensions. If none of the above risks occured and they both managed to work a full career, get regular raises, contribute to CPP, receive OAS and have some modest RRIF withdrawals, they would make it through life without severe financial hardship but as a debt slave. The bank would have made over $400,000 from them in interest payments and they would have never saved much. They would live month to month their entire life and financial freedom would be a mere dream as they play the lottery each week hoping their number is drawn.

The reality is that the risks noted above are very real and for John and Jenny's situation to work out they need everything to work perfect, with no hitches, glitches or problems. This seems unlikely to me. It would be far better for them financially to leave themselves more room in their monthly budget so that they could:

1) Live / survive with only one income

2) Maintain mortgage amortization if interest rates rise

3) Speed up mortgage pay down by making extra payments as they receive raises if things work out well.

4) Increase their personal savings to RRSP and/or TFSA to ensure they have money for the unexpected and for retirement.

There are only two ways for John and Jenny to make the above work in a sustainable manner:

1) Continue renting and saving aggressively

2) Buy a much cheaper home and aggressively pay down the mortgage

What are your thoughts? Do you know John and Jenny? I do.

Bank Raises Rates on Variable Rate Mortgages

LORI MCLEOD, Globe and Mail Update, October 6, 2008 at 8:46 PM EDT

The latest victims of the growing financial crisis could be the standard discount available to consumers on variable mortgages, and home equity loans at prime.

In a move expected to be followed by other banks, all of which have been stung by higher funding costs, TD Canada Trust is raising rates on both types of loans, effective Oct. 7.

Rates on these products will rise to 5.75 per cent, a percentage point above the prime rate. Only last week, TD eliminated the discount on its variable rate mortgages, offering them at the prime rate of 4.75 per cent. During the housing boom of the past several years, consumers could often get their bank to drop the rate by half or even up to a full percentage point.

“While TD Canada Trust has endeavoured to not pass on the increases in rates to its consumers, this change reflects steadily increasing costs of funds in the current economic environment,” the bank said in a statement.

The percentage point increase raises the term interest cost on a $250,000 variable rate mortgage by $12,247.22 over five years, according to Royal Bank of Canada's online mortgage calculator. The difference is based on a 25-year amortization, a variable rate mortgage with a five-year term and bi-weekly payments. On that basis, the bi-weekly payment amount rises to $725.90 from $657.83.

The credit crisis and economic uncertainty have caused banks to stockpile their cash. That's driving up their short-term cost of borrowing from one another, and means margins on variable rate mortgage products are shrinking.

Rates on fixed-term mortgages went up last week too, as banks have passed on fewer of their savings from falling bond yields to consumers to consumers.

“The deterioration of global credit markets is beginning to squeeze the ability of even the strongest of financial institutions to raise longer-term funds, which could limit the provision of longer-term credit in Canada to businesses and households,” federal Finance Minister Jim Flaherty said in a statement Monday.

“Hopefully this isn't a permanent shift, but a short-term reaction to conditions the likes of which we really haven't seen before,” said Gary Siegle, regional manager at mortgage broker Invis.

With a discount, some customers can still get five-year, fixed-rate mortgages at 5.55 per cent, meaning a bi-weekly payment of $707.66 on a $250,000 mortgage amortized over 25 years. This means those looking for peace of mind in the current market turmoil aren't paying a premium to lock in, Mr. Siegle said.

Down Payment Dillemna

In response to several of the comments on the previous thread I'm posting some thoughts on what to do with your downpayment if you are patiently waiting for housing prices to have some kind of resemblance to fundamental valuation before you purchase. Here are the essential steps in my humble opinion:

Step 1: Determine your time horizon - this is easier said than done.
Step 2: Determine your risk tolerance - is some level of value fluctuation acceptable and if so, how much? +/-5% in one year? +/-10%? more?

Options:

1) If your time horizon is uncertain and you need stability and flexibility then a money market fund, savings account or short term GIC offers your only real options. Your rate of return will be significantly hindered. The best rate on these short term deposits is approximately 3% right now.

2) If you are confident that you won't see fundamental value for at least one year then you can clearly lock in for a 'good' rate on a GIC for at least one year. This has the advantage of keeping you disciplined but is much less flexible in terms of access to your money. The best rate on a 1 year GIC today was 3.90%. A 2 year GIC was 4.15%.

3) If you don't mind some mild fluctuation in your investments then a low cost bond fund such as the TD eSeries bond index fund could provide you with a decent coupon yield plus some potential upside if you think interest rates are going to fall before you purchase. If you have enough money some higher yielding corporate bonds can be purchased through a brokerage account. A quick search turns up several decent short term bonds with yields over 4%. Bonds have the advantage of being liquid so if you need access to the funds you will likely be able to get your money.

4) Equities - whether we are discussing an exchange traded fund, mutual fund, or an individual stock, be prepared for volatility. Even if you think you are investing in so-called safe securities, don't be fooled, a stock is a stock and the price of that stock is dependent on the perceived value of the corporation's earnings as seen by the buyers on that day. Your values may fluctuate violently and when it comes time to pull your money out, you may have less than you counted on. For a simple lesson on volatility, please look at the standard deviation of an investment before you purchase it. Bond funds have a low standard deviation because they are less volatile than equity funds.

I am not recommending one of these options over any other option but I hope the explanation is helpful. I don't recommend any allocation to equities higher than 30% for any time horizon shorter than 3 years and I don't recommend any allocation to equities higher than 45% for time periods shorter than 5 years.

Reader Submitted Question?

Here is a question from an email I received. What do you think this person should do?

We're selling a house in the states and will do very well (the downturn has not hit our neighborhood at all--doubled our investment in 5 years, not bad) and have a substantial downpayment but even hundreds of thousands of dollars here is really very little. But we also have investments that we could liquidate (not our retirement accounts) to pay the down payment--"total" liquidation would add about 80-85 percent to a downpayment. This would leave us with little reserve. But with a relatively low mortgage, we can save money prettyfast--right now we save pretty well--about 15 percent of after tax income--and that wouldn't change too much with the kinds of mortgage we're considering. Is that stupid?

Pros: more downpayment, nicer house, better neighborhood and/or less mortgage.

Cons: Little reserve. Investments seem to do well now. My wife feels it's insane to get rid of investments and it makes her nervous. She may be right.And related: given your feeling about the market, if you had the cash to buy a house now (we're looking east van) would you? Or does it make sense to keep money in the market until things turn...if they turn (about which I am somewhat doubtful, given what it looks like in our current neighborhood, Kits.)

What should this person do?

How Should I Invest My Down Payment?

I have had numerous questions about how one should invest a down payment if one is waiting for the real estate market to go through a correction or if one just needs to save more money before making a purchase.

I have a few thoughts about the subject and the answer largely depends on a person's risk tolerance and time horizon, as with all investments. Here are a couple of scenarios for us to consider:

1) For less than one year until purchase and/or low risk tolerance, this person should not have any equities in the portfolio to be used for the down payment. A money market mutual fund, cashable GIC, high-interest savings account, or short term bond fund would all be suitable selections. The major considerations I would have in this situation are first, liquidity, and second, the highest rate possible over such a short time horizon. Some good money market funds are the TD or RBC Premium Money Market and National Bank Corporate Cash Management funds.

2) For more than one year but less than five years and/or medium risk tolerance, this person should have 20% to 40% of the portfolio in large-cap and dividend paying equities plus a combination of GICs, bonds, and/or bond mutual funds. Some great 'all-in-one' passive solutions would be the TD Income Advantage Portfolio at the more conservative end, or the CI Portfolio Series Income Fund at the more aggressive end. Alternatively, you could buy a cashable GIC or money market fund with 60% to 80% of the money and buy 1 or 2 of the top ten Large Cap Dividend mutual funds in Canada with the rest and for some spice you could add a Global Dividend fund. Most of these funds offer low volatility and great track records.

3) For longer time horizons or for higher risk tolerance, this person could have up to 80% equity depending on the risk tolerance level and the investment opportunities available are very wide and I would just direct you to stay conservative with a focus on Large Cap Dividend investments.

In general, avoiding income taxes on the portfolio should be pursued, and a focus on dividends and capital growth is very advantageous. Some mutual fund companies offer funds that shelter interest income from the full rate of taxation and these funds are widely available through any investment dealer. They are sometimes referred to by a series letter or as a corporate class fund.