If you had $100K in your bank account and you could afford a home in expensive cities in Canada like Toronto and Vancouver, would you be better off buying a $1050K home with a 2.5% mortgage interest rate or buying a $830K home with a 5% mortgage interest rate given both are on a 5 year fixed-term 25 year amortization schedule?
You might be wondering why the heck I randomly pulled values of $1050M and $830K as my comparison. Well average detached home prices in Toronto are $1050M, as released in the latest CREA report as reported by the Financial Post. If someone were to put a $100K downpayment on such a house and finance it using a 2.5% 5 year fixed mortgage rate with a 25 year amortization you would be looking at a $4250 monthly payment. (You can’t really do this because the house exceeds $1M, but this is theoretical)
Similarly, if you were to buy a house costing $830K at 5% using a 5 year fixed mortgage rate over 25 years, you would also pay $4250 a month in mortgage payments. (This you can do because it’s under $1M, which qualifies for CMHC insurance)
Why compare the two? Simple. Most individuals or couples negotiate the price of their home not by the final price they pay, but on the monthly payment of their mortgage. Yes, it sounds somewhat stupid, but let me tell you this is exactly how most people approach buying a home.
I actually had the benefit of hearing a conversation between a realtor and a client while running on the treadmill at the gym. The realtor was talking while working out on the bicycle (yeah, she wasn’t really working out). “It’s only twenty thousand more. You can afford it. It’s maybe only a hundred more per month… Think of the baby! Your mother-in-law will be so proud!”
Yes, I’m not joking. That’s exactly how the series of exchanges went between the potential buyer and realtor. You can see why salespeople sell you based on monthly mortgage payments versus the overall price. It’s always about monthly cash flow and using your emotions against you really sticks the point to the gut. That’s why I put so much emphasis on cash flow because cash flow sets your standard of living.
The Final Cost
We get so fixated on monthly costs that most of the time we don’t realized just how expensive something is when we buy it. Take for instance the house that is $1.05M. You may end up with the winning bid on the house for that amount, but by no means is that the final price you end up paying for it if you finance. In fact, with interest rates being as low as it is, the cheapest price one might expect to pay for that house, should they pay the monthly mortgage rate of 2.5% over 25 years is $1.375M. This assumes no extra payments or rising interest rates.
If you were to buy the same home for $830K at a higher interest rate of 5% then you would also end up paying $1.375M if the interest rate stayed the same and no additional payments were made. There are so many arguments against buying a home in a high interest rate environment because more your money, in this case $270K, goes to paying the bank interest rather than your principal. That’s a good argument, but let’s see why this might not hold up.
Mortgage rates in Canada are currently at an all time low. It’s not hard to find a lender who is willing to give a mortgage rate of 2.5% over 5 years. After the 5 years, with the US itching to raise rates, it will most likely be very difficult to find rock bottom interest rates that we have now. Most likely the rates will get closer to the 5% mark.
So if in those 5 years one were to save the difference between rent and the mortgage payment, you could figure that your downpayment for the home would be bigger. Just how much bigger? Well for a the price of a $1M home, it’s not unfathomable to rent it for less than $2000 a month. Yes, it’s possible even in Toronto, as I have done it. So yes, you’ll be throwing $24K a year renting, but also you’ll have an additional $2250 in cash flow to save for your downpayment. Let’s see what happens.
So in 5 years instead of a $100K downpayment you might be able to make a $235K downpayment. This means the mortgage would drop down to $595K and the monthly payment at a 5% interest rate would become $3460 a month rather than $4250 a month. If we did the same math and figured out how much you would have to pay in total for the house it would come out to $1.27M. But wait! We threw out 120K in rent so really that cost would be closer to $1.39M. Slightly more than what we would pay had we not waited, but there’s more.
The decrease in the mortgage amount might not offset the paid rent, but now there is an increase of almost $800 a month in cash flow by delaying the purchase. Remember just how important cash flow is in maintaining your standard of living. You can’t eat the drywall in your house, right? All of these numbers are hypothetical and assumes that the price of the house drops because people are focused on how much they can pay on a per month basis.
Paying Down Faster
One of the overlooked benefits of having a smaller mortgage is the fact that it can be paid off faster through the use of additional payments. Many home owners hate having a large mortgage and will try to pay it down faster by doing double payments on some months or doing a one time payment at the end of the year. Regardless of the approach that is taken, using this method can really decrease the number of years required to pay off a house.
The fact that the smaller mortgage frees up an additional $800 a month means that theoretically an additional $9600 could be used at the end of the year to pay off the principal. That’s huge! Over the 5 year term of the mortgage almost an additional $50000 could be paid off on the principal thus reducing the mortgage amount at renewal. This more than offsets the additional cost in renting for the first 5 years.
If the scenario outlined in this article actually played out, then the buyer who buys at the low interest rate with a higher price would be surprised to find out just how much more they would have to pay if interest rates rise to 5%.
At the end of a 5 year term, the outstanding balance on a $950K mortgage would sit at $804K. To renew at the new 5% rate would mean that the original mortgage would now balloon up to $5283 per month. That’s an increase of 24% in monthly payments for only a 2.5% rise in the mortgage rate! This would represent a cash flow difference of almost $1800 per month had the house been bought with a larger downpayment and a higher interest rate. Imagine what you could do with an extra $1800 a month in your pocket. That’s like renting a second home.
Don’t Go Beyond Your Means
The real key message to buying a home is to not stretch yourself too thin. Home buying is a very emotional adventure and it’s very likely that a realtor or even the seller of the home will entice you by showcasing the things you don’t need but make that house “special”.
When buying a home, try to determine how much you will ultimately pay for the home. Prices in popular cities like Toronto and Vancouver have approached such stratospheric levels that it will literally take you a lifetime worth of salary to pay off the mortgage. If common sense tells you that $1.5M for a house after interest is too much, then perhaps it is. Even if it only costs you $4000 a month in mortgage payments, don’t get suckered into paying more for a house just because you can make the monthly payments.
Make sure your cash flow after buying a home still allows you to sustain the standard of living that you want. You shouldn’t have to live like a hermit just to pay off your house.