Five years ago Canadians, particularly those in Toronto and Vancouver, went on a buying spree for homes. Interest rates were dirt cheap at 2% and homes could be bought with a 5% down payment and 25 year amortization. Heck, if your household income was around $80K to $90K, you’d qualify for buying a house.
Fast forward 5 years. Those homes are now $1.2M. That’s great if you’re a home owner, but the big fat mortgage isn’t gone. Even after 5 years of mortgage payments, only a small dent of the $760K mortgage has been paid off. Owners renewing this year are in for a big shock. Interest rates are no longer 2% (who would have guessed?) and those that thought interest rates would stay at 2% were delusional.
Interest rates from the big banks are now near 3.5% for a 5 year fixed rate mortgage. That’s only a 1.5% increase, but what does it really mean for the final cost of the home. Does anyone really know how much they are paying for that $800K home after 25 years?
Paying The Bank’s Interest
Many people think that when they buy a home they end up better off than someone who is renting because they are paying their own mortgage and not someone else’s. Even though they aren’t paying for someone else’s mortgage, what they do end up doing is renting money from the bank. Just how expensive is renting money or better known as your mortgage:
When the house was bought 5 years ago at $800K, many thought that was all they were going to pay for their house. People dived into the housing market not knowing just how much of their earnings would be tied up in their house. Realtors, the bank, nor their mom and dad told them that there would be so much money thrown away to interest payments. Even if interest rates were to hold at the measely rate of 2% , the final purchase price have ended up just a shade less than $1 million dollars by the end of 25 year mortgage. That’s $200K more than the original purchase price!
Now that interest rates have risen and mortgage rates are now at 3.5%, just what does the cost of the house look like if rates continued at 3.5%. As the green line shows, the projected cost of the house is now closer to $1.07 million. At just a 1.5% increase in interest rates, the house is now going to cost an additional $100K. WTF!!
It’s been well documented by many publications and the Federal Reserve that interest rates are going to keep rising over the next year. In fact, our neighbours to the south have pretty much declared another full percentage point will be added in the coming year. Since Canada generally follows the US in interest rate moves, there’s a high probably that another 5 years from now the renewal rate could be north of 4.5%, and perhaps an even ungodly 6%.
If those scenarios play out, at the end of 25 years, the original house purchased in 2013 for $800K will end up costing $1.1M or even $1.2M!! That means over the lifetime of the mortgage over $400K will be thrown away as interest. That’s 4 Audis, a few trips around the world or even the cost of a condo.
With such high costs associated to interest, a home owner that bought at $800K and sells for $2M in their retirement years may not gain as much as they might have thought. Though on paper it may look like a $1.2M gain on the house, making it a great investment, but after interest is factored in $1.2M growing to $2M over 25 years is only a 2.1% annual gain compounded. That’s exactly like inflation!
Hard to Pay Down
What makes real estate such a poor investment with today’s numbers? Quite simply the amount of money that a home owner needs to pay towards the mortgage, stops them from getting ahead. A report issued by RBC has found that Canada’s real estate affordability has never been as worse as it has ever been.
On average, RBC has found that 53.9% of household income is necessary to pay down a home. In cities like Vancouver and Toronto, the numbers are a staggering 88.4% and 75.9%. This means despite the fact that home prices are rising, people are increasingly feeling the strain of home ownership.
Unlike previous generations who bought homes that required a smaller percentage of their income to pay their mortgage, current Canadians are struggling and house poor. This makes it impossible to pay off mortgages faster than the 25 year amortization period. Previous generations were able to pay off their mortgages in a 7-8 year span and thus have their prime earning years to save for retirement. Current Canadians do not have that same luxury.
So that $400K interest on top of their home is pretty much a given. There’s next to no possibility for Canadians to pay off the mortgage fast enough to lower their borrowing costs.
Not Achieving Financial Independence
This blog is all about achieving financial independence. That means having enough passive income to sustain your everyday life. Unfortunately with a house and a mortgage, this makes it increasingly more difficult for Canadians to reach financial independence.
Not only will a mortgage saddle you with 25 years of grueling monthly payments, it will also decrease your cash flow through other expenses such as maintenance, renovations, taxes and rising interest rates.
For ordinary Canadians believing that their primary residence will help them achieve financial independence, it can’t be classified as a good investment. In fact, it’s an expense. Since a primary home provides no source of cash flow, it provides no benefit to helping achieve financial independence.
What a house does provide is emotional stability. A respectable way to protect your money from inflation and a forced method of saving money.