Thanks so much to our guest blogger this month, Elijah Kirchmaier, co-founder of Up Financial. He’s exploring home ownership within the framework of your whole financial picture. Owning a home and/or rental properties can be a great part of an investment portfolio but shouldn’t be the only part – for all the rest, go see Elijah and his team!
While many Canadians consider home ownership a goal, almost every homeowner will tell you that the pride of home ownership comes with a considerable financial responsibility beyond your down payment and monthly mortgage costs.
Disclosure: I have no incentive whether you buy a home or keep renting. The following is written to highlight the pros and cons of each alternative and share some examples of what I’ve seen our own clients deal with over the years so that you may make a well-informed decision.
In order to figure out which option is better for you it’s important you take into consideration your own goals, budget, lifestyle and the current real estate market.
As a founder of a Wealth Management and Financial planning firm I deal with the disparate parts of a clients financial life and have seen many extreme cases on either side of real estate investments. To be specific, this post is focused on being a first time home buyer and I will steer clear of revenue properties and real estate as a short or long term investment.
Your personal home is much different than your other investments. You live there, you’ll make memories there and you’ll be far more attached to it than the investments you’ll make within your RRSP or Tax Free Savings Accounts for example. Because of the unique nature of this type of investment, there are a number of things to be aware of.
The following is broken into 2 sections:
Section 1: Benefits and Downsides of Renting/Owning
Section 2: The Process of First Time Home Ownership
Section 1: Benefits and Downsides of Renting/Owning
Benefits of Renting:
1) LIQUIDITY (CASH FLOW)
Not having monthly mortgage payments, property taxes, utilities, upkeep and surprise expenses allows you to focus on building up your assets like your Registered Retirement Savings Plans, Tax Free Savings Plans or to save for a larger down payment in the future.
2) FLEXIBILITY TO MOVE WITH EASE
When you don’t own your home you can move easily and for considerably cheaper. Career changes or relocating cities no longer come with the large price tag of selling your home and breaking your mortgage early.
3) CONSISTENTLY CHEAPER
Don’t let anyone convince you that owning a home is cheaper than renting; especially in the beginning. Over your lifetime you will likely save considerably more money by owning your home but in the first 10 to 20 years you will likely spend considerably more money than if you rented. Renters have far less costs to contend with than owners do. Monthly maintenance, property insurance and surprise repairs are all the responsibility of your landlord when you rent, meaning you don’t have to shoulder that burden.
Downsides of Renting:
1) NO FORCED SAVINGS OR EQUITY BUILDING
Your monthly rent is not building any long term value. When you stop renting, you have no equity built up in the property unlike your landlord who was using your rent to help pay their expenses and their mortgage.
2) YOU COULD BE FORCED TO LEAVE
Renting leaves you at the potential mercy of your landlord in being forced to relocate if the property is sold, or your lease isn’t renewed. If your landlord decides to increase your rent significantly when renewing, you may also find yourself forced to relocate.
3) NO RELIEF LATER IN LIFE
Downsizing, reverse mortgages etc are some of the many options once you’ve retired to withdraw equity in your home to help fund retirement. Having a home paid off can be significantly more profitable in the long run, especially in retirement when you’re living on a fixed income.
Benefits of Home Ownership
1) FORCED SAVINGS
When you make your mortgage payment a portion of that payment goes towards the principle. Every month you’re forced to make your mortgage payment and while initially most of that payment is interest, over time a larger and larger portion will go to the principle of home which will benefit you over the long run. For many Canadian families that struggle with saving, their home is often their largest asset and can be a significant source of their income in retirement. For others, the forced savings may make up an additional piece of their investment portfolio.
2) TAX SHELTERED GROWTH
Historically real estate tends to increase in value over long periods of time (IE: 10+ years). For Canadians, the increase in the value of your principle residence isn’t taxed. This means that if you purchase a home for $500,000 and sell it 10 years later for $550,000 you have earned $50,000 tax free.
3) FLEXIBILITY OF USE (REMODELING & RENTING)
When you own your home you can remodel and renovate as you please. Often lease agreements will have restrictions on what you can renovate and change. You can also decide to rent your home or a room in your home. A lease may restrict you from sub-letting a room or from earning revenue from sources like Airbnb.
Downsides of Ownership
1) HIGHER CASH FLOW NEEDS
Owning a home requires you to manage and pay more expenses. Between a Mortgage, Property Taxes, Home Insurance, Water & Sewage, Gas, Electricity, Condo or Homeowners Association fees, upkeep, renovations and an emergency fund for unexpected repairs, you should expect both higher and more variable monthly costs for owning a home than if you rent.
2) EXPENSIVE TO MOVE
Land-transfer tax, real estate agent fees, legal fees, mortgage fees for breaking a mortgage early can all add up very quickly.
3) LESS FLEXIBILITY (MOVING)
If you find yourself relocating to a new city or working at a company in a different part of the city you may need to sell your property. Depending on how long you’ve been in the home and how the real estate market has performed you may be taking losses on a property in both the form of market losses or losses as a result of the fees involved in a transaction.
In many circumstances how easily you can access the value of an investment in very important. An uninsured loss, a car breaking down or a medical expense are just some of the many times Canadians need access to assets they would otherwise leave untouched. If you have equity in your home, you may not be able to access it if markets are unfavorable or you may have to accept a substantial loss if push comes to shove.
Section 2: The Process of First Time Home Ownership
So you want to buy a home? Where do you start?
The first thing you need to do when you purchase a home is come up with the down payment. A minimum 5% down is generally required however putting less than 20% down forces you to get high-ratio mortgage insurance. After the 2007-2008 Mortgage Crisis all mortgages with less than 20% down require additional insurance to protect the lender. The reason for the insurance is to protect the lender as you pose a potential risk to the mortgage company to default on your payments because you don’t have enough invested in a property.
For example: if you buy a home for $500,000 and put $25,000 (5%) down, the mortgage company is afraid that if your home drops in value you’ll walk away from your investment. You’ll be forced to purchase insurance through CMHC or GENWORTH which can add up quickly.
I AM CURRENTLY WORKING WITH A CLIENT WHO IS PURCHASING HIS FIRST HOUSE AND ONLY PUTTING 5% DOWN COMES WITH AN ADDITIONAL COST OF $17,500 IN INSURANCE COSTS FOR HAVING A HIGH RATIO MORTGAGE. IF HE WERE TO WAIT AND PUT 20% DOWN, HE WOULD SAVE HIMSELF $17,500!!!
You may need to decide whether you are better off waiting and saving more money for a down payment. If you feel that the property is under priced today by more than the amount of this added insurance, you may be able to justify the extra cost to act on the opportunity.
So I have a down payment, now what?
The next important factor to look at is what the housing market is doing. Are house prices at all time highs? Are there a considerable amount of homes for sale? Can I find someone who is motivated to sell? We saw clients who purchased homes in Calgary at the peak of 2007 who are still underwater on their properties 12 years later.
FOR EXAMPLE ONE OF MY CLIENTS BOUGHT HIS FIRST HOUSE FOR $550,000 IN 2007 AND 12 YEARS LATER IN 2019 IT’S ONLY WORTH AROUND $495,000.
I HAVE ALSO SEEN CLIENTS WHO PURCHASED PROPERTIES IN VEGAS, PHOENIX AND PALM SPRINGS IN 2008-2010 WHO HAVE TRIPLED THEIR INVESTMENT OR MORE.
Over the past few years some of my clients in Vancouver, Toronto and Ottawa have seen considerable gains on their properties. However, those who bought in the last year and a bit in Vancouver have seen negative returns on their investments as they purchased during the foreign buyer craze.
While it’s impossible to know what future real estate markets look like, in general house prices in major cities like Calgary have always risen over the long run. Housing prices ebb and flow with the economy and when the economy is contracting house prices drop and create the potential for really good deals.
My main point here is that Real Estate is not a linear investment and with how often people move and relocate in their 20’s and 30’s there are risks involved in sinking hundreds of thousands of borrowed (leveraged) dollars into an investment that may dip in the medium to short term.
So I feel like Calgary is a great market to buy in right now. Real estate prices are very low compared to where they were a few years ago.
Great! Now let’s add up all the additional expenses that come with owning a home and compare it to your budget. From this we’ll be able to establish how much you can afford to spend on a home. Additional costs such as Condo Fees, Home Insurance, Gas, Electric, Sewage & Water, Property Taxes, Renovations and Furnishing your home should all be taken into consideration.
When factoring in all of your expenses you want to ensure you’re leaving enough room to still save a minimum 10-20% of your income each month for investments. Being house poor is a quick way to stagnate your financial growth. Make sure to understand your budget BEFORE you start looking at homes. It’s real easy for emotion to take over and “treat-yo-self” because “yolo”.
So I was approved for a mortgage at X hundred thousand, that means I can afford to buy a house at that price, right?
Unlikely. Mortgage companies have rules and limitations they set in place to avoid individuals defaulting on their loans. The issue is that they don’t care whether you have money left over for savings and discretionary spending. They just want to make sure you can pay your mortgage every month. That’s why it’s so important to figure out your budget. If you come up with a mortgage budget that includes continuing to put money into savings and cover all your discretionary income, I pretty well guarantee the mortgage company will approve you for the loan. By setting your budget first you control your emotions and won’t be swayed by what the mortgage approval “says” you can afford.
ONE OF MY CLIENTS DID THEIR BUDGET FOR A MORTGAGE AND DETERMINED THAT HE COULD SAFELY ALLOCATE $2,400 FOR MONTHLY MORTGAGE COSTS AFTER CONSIDERING ALL OTHER BUDGET NEEDS LIKE SAVINGS, INSURANCE AND COSTS OF LIVING. THIS CORRESPONDED TO A $500,000 MORTGAGE. WHEN HE WAS APPROVED BY HIS LENDER, HE WAS ABLE TO SHOP UP TO $750,000. HAD HE PURCHASED AT THAT PRICE, HIS MONTHLY COST WOULD HAVE BEEN CLOSER TO $3,600/MO; AN AMOUNT THAT WOULD HAVE DEVASTATED HIS BUDGET IN SHORT ORDER.
Do I have any other options to help me afford the house I really want?
While in a perfect world we could all afford our dream homes right away, there are many ways you can help ‘bump’ your income when you own a property. By renting out a basement suite or even a single room, you can help take some of the stress off your mortgage. I once stayed at a house in Boston where the owner used the smallest room for himself and rented the other 4 rooms on Airbnb at rates between $150-$250 per night per room. It was way cheaper than staying in a hotel for me and he was fully booked for months at a time allowing him to mroe than meet his needs as a homeowner. Just be aware that there are certain tax implications on rental income and that this income is not guaranteed.
You sound really cynical about home ownership?
Not in the least. My job is to prepare clients so that they fully understand what they’re getting involved in and to bring awareness to emotional decision making. I personally purchased my first home at 21 on December 1st, 2011 with 20% down to avoid CMHC. I sacrificed my summers and saved 40-60% of my income each year to save enough to do this. I purchased during that time period because the Calgary housing market was still recovering and I could get a house for well below market value from a number of years previous. I also found a seller who had relocated to Texas and the house was sitting empty; I purchased in late November knowing that the seller wouldn’t want to sit on a property until the following Spring when home sales picked up again. I was able to bid low during a time when homes weren’t moving and got a great price. I sold the home 5 years later on December 1st, 2016 because I could end my mortgage without penalties and purchase a home that had dropped more in value as Oil Prices had fallen throughout the year.
In 5 years my home value appreciation increased my net worth by around $46,000 (increase in value minus closing costs and realtor fees) which works out to a rate of 2.26% per year (not including all the additional expenses to owning a home). My RRSP and TFSA portfolio over the same period earned 14.88% per year. Real estate does not behave like traditional fixed income or equity investments, but has it’s own unique characteristics and risks. This is why I believe it should make up part of your portfolio but not the entire portfolio. My equity portfolio won’t always produce that and neither will my house.
By understanding all the costs involved in owning a new home you can make an informed, logical decision and experience the pride of owning your own space. Home ownership is a wonderful thing and it’s great to have a place of your own and not stress about moving and finding leases every couple years. Just make sure that when you do make the jump, you’re doing it because it makes sense for your situation and not because you feel pressure to “adult”. There’s nothing wrong with renting, savings your money, giving yourself flexibility and being able to make the better purchase over the long run.
Onwards and Upwards!
– Elijah C Kirchmaier