The Globe and Mail reported just this week that a large drop in housing would have a devastating effect on young individuals who just recently purchased homes. The CBC followed that story the next day with the same headline stating facts from the same report. People who bought homes in their 20’s and 30’s stand to lose the most because of the small amount of equity that are currently in their homes and the popular use of extreme leverage such as 5% downpayments and 30 year amortizations.
Over the past two decades, Canada has experienced the largest run up of real estate prices in perhaps the entire world. Most people that are buying their homes today can’t even remember the last time home prices fell (it was in the 1980’s). Those that bought a home a decade would declare that they don’t care even if their homes fell 50% because home prices have increased greater than 100% for them. All these facts are true, but it doesn’t mean that real estate goes up forever and we should be aware of the risk factors for taking on a large mortgage. Like any large purchase where you have to borrow money, there is always a risk.
Mortgages are the only form of borrowing where someone can ask for up to 20 times the money they actually have on hand. With just a 5% down payment and a decent job that provides a monthly income, almost anyone can purchase a home in Canada. The fact that we can leverage our money to buy such an expensive asset means that any little movement in price can create large capital gains. It only takes a 5% appreciation in the price of our homes to double our original capital. When prices are moving up it’s a quick and easy way to make gains.
This phenomenon is what makes housing such a great investment in the eyes of the regular investor. You provide a roof under your head, your net worth is increasing quickly, and there also comes a sense of pride through home ownership that you can’t get with renting. With all the positives, the negatives are overlooked simply because over the last quarter century Canadians haven’t experienced any kind of housing correction, as had happened in the United States.
Using extreme leverage to purchase homes carries a large risk when prices drop. Similar to a 5% gain in prices, a 5% drop in prices could wipe out someone’s equity completely. The scariest part of owning a home isn’t when the price of the home drops, but what happens when it comes time to sell or refinance the property.
A house that is worth less than what is outstanding on the mortgage creates a difficult dilemma. Selling would mean the owner would have to cover the shortfall on the outstanding mortgage using savings. It’s highly unlikely that individuals would have that much money sitting in their bank accounts to cover such a windfall if such a situation were to happen.
Unlike America, where homeowners walked away from mortgages that were worth more than their homes, Canada doesn’t have that same privilege. Borrowers are required to carry that loan until it is paid off and the only other alternative is through personal bankruptcy, which is devastating for anyone’s personal finances.
With the recent flux of new home buyers in the last 5 years, very few have actually had to refinance or renew their mortgages. The wave of refinancing will most likely happen in the next 3 to 5 years when the crop of new home owners’ mortgage term ends.
In a period of inflating home prices, it hasn’t been difficult at all for home owners to get good rates and renew or refinance with really good terms on their mortgages. That’s because the risk for the banks are lower when home prices are rising. If at any point home prices start falling, as they have in Alberta, then it becomes a bit more complicated.
If you let your mortgage renew with the latest 5 year rate and don’t change the length of amortization, the bank will most likely have no problems renewing the mortgage. So long as you can make the payments for the new interest rate at renewal, there should be no problems to maintaining finances on your own home.
If, however, there is a need to renew your mortgage with different terms, then it becomes a lot more difficult to renew if the price of the home has fallen. This happens because banks are reluctant to refinance a mortgage where the price of the home is less than the outstanding mortgage amount. Additionally, banks are required to keep a loan-to-value ratio on their mortgages. This means that during refinancing, banks are required to lend at most 80% of the value of the house. In the past this used to be 95%. What does this mean? If your house was originally worth $500 000 and it dropped 10% to a price of $450 000, the bank at this point will only refinance the house for a maximum of $360 000. If for any reason you need to borrow more than that, you’re out of luck. You might be forced to sell or renew with unfavourable terms rather than refinance.
My House, My ATM
One of the downsides of owning a home is that it’s not a liquid asset. What I mean from that is that the value of the home can go up, but it’s hard to get at that money to use. Short of selling it and reaping the gains, there is no way to get money out of the equity of your home except by using HELOCs. HELOCs are lines of credit where where your home becomes the collateral. I’m a firm disbeliever of this practice, and I’ve written about this before.
Home equity lines of credit have become so popular in Canada because most of our equity is locked in our homes. People have been withdrawing money from their homes to renovate, go on vacations, buy cars, buy fancy electronics with little regard to what effects it may have on their future finances.
Similar to refinancing, so long as home prices go up, there is nothing to fear, but if you’ve been doing this practice of borrowing against your home and home prices drop. Look out!
The greatest fear might not even be in the mortgages themselves, but how many loans have been taken out against homes as collateral. Banks are required to only lend out at most 65% of a home’s equity in the form of a line of credit. Those that have been stretching their lifestyles by using rising home values may be in for a rude awakening should home prices fall. That’s because banks have the right to start calling in loans if they feel that there is a risk to their financial portfolios. This isn’t much different from someone buying stocks on margin and having the price of their stocks fall. When things go up, it’s all great and dandy, but remember what happened before the Great Depression when people bought stocks on margin? Yeah, it didn’t end well.
Home owners could get stuck in a bind if refinancing is required or if home values fall low enough such that they are required to make lump sum payments back to the bank in order to get back to the required loan-to-value ratios. These are some of the risks that most people don’t even think about because rising home values masks all these issues. Ironically enough, many people didn’t think of the risks associated with subprime mortgage assets in the United States when home prices were rising either.
Know The Risks, Play Within It
Buying a home will always be an emotional decision. There is always that urge within us to achieve home ownership because that’s what the North American dream is. To own a piece of land to call our own. I’m not here to write about why you shouldn’t strive to be home owners, but what I am writing about is that you should be aware of the risks that are involved by using extreme leverage to buy a home. Before making any rash decisions, you should realize the amount of debt that you will be taking out and whether or not that should be manageable. Don’t assume that just because the nice salesman at the bank says you can afford it that you should actually buy it. Do your own research and calculations to make sure you can still sustain your lifestyle while paying off the mortgage.
Home ownership isn’t without risks. It just seems that way because of long term trends, but the same argument could be made with stocks and bonds in the long term. The difference between the two really comes down to the fact that with extreme leverage there are greater risks in the shorter term.
I’ve always been against the practice of issuing loans against a home to pay for other things. I honestly feel this practice should be stopped. It doesn’t make sense to be paying interest on a home mortgage, and then having to pay even more interest to take money out of the gains. It’s stupid. Stop doing it. Not only is it detrimental to the long term growth of your house equity, it adds more risk to your financial situation. The next time you feel the urge to splurge. Just save up for it rather than taking out a loan on your home. The new kitchen appliances can wait, so can the new hardwood floors.
I’ve written many times before, home ownership is great, but it might not be for everyone. Learn the risks before you jump head first. Keep your emotions in check. And most important make sure you stay diversified. Don’t make your home your retirement strategy.