Housing prices are ticking up again, with the average price for homes sold in September in the GTA reaching $843,115, according to the latest report.
Rising prices present prospective home buyers with a dilemma when it comes to saving for a down payment. Putting down the minimum five per cent on a $500,000 home gets you into the housing market for a reasonable $25,000. Saving up a 20 per cent down payment, on the other hand, avoids costly mortgage default insurance premiums (mortgage loan insurance from Canada Mortgage and Housing Corporation).
Note that the minimum amount required for a down payment depends on the purchase price of your home. Homes valued at $500,000 or less need a down payment of five per cent, while homes valued between $500,000 and $999,999 require five per cent on the first $500,000 and 10 per cent for the portion above $500,000. Home buyers need to put down 20 per cent on homes valued at $1 million or more.
There are pros and cons putting down more or less on your home purchase. I reached out to Robert McLister, mortgage expert and founder of RateSpy.com, to discuss house down payment options.
Five Per Cent Down
Pros: The obvious advantage to making the minimum five per cent down payment is there’s less capital required to become a homeowner and reaching that threshold requires less time to save.
“So many young buyers stay on the sidelines scrimping for a bigger down payment only to see home prices run away from them,” says McLister.
He points to the past two decades of price growth as evidence that getting into the market quicker can pay off, “provided homebuyers don’t overextend themselves.”
Putting down less than 20 per cent requires the buyer to purchase mortgage loan insurance to protect the lender against default. While the borrower must pay those insurance premiums, McLister says an advantage to having an insured mortgage is that it gives purchasers access to the lowest interest rates available.
A five per cent down payment is also compatible with the First Time Home Buyers’ Incentive – the shared equity mortgage with the Government of Canada – and other governmental home subsidies.
A deliberately smaller down payment can leave a borrower with a larger cash cushion, saving for more immediate closing costs and furnishings, or simply retaining more money for emergencies and other needs.
Another advantage is that automatic monthly mortgage payments create a forced savings plan for those who might otherwise squander that money as a renter.
Cons: The financial impact of putting the minimum amount down on your home is that it comes with a four per cent default insurance premium. While this amount can be rolled into the mortgage, it creates a highly leveraged situation with risk of negative equity should home prices fall.
“On Day One you’re almost 99 per cent financed. It doesn’t take much of a home price selloff to trap you in your home, preventing a sale,” said McLister.
A five per cent down payment also means more interest expense over the life of your mortgage, compared to a larger down payment.
Note that the amortization for buyers with five per cent down is limited to 25 years. The property also cannot be a non-owner-occupied rental property.
Another caveat to consider: Prospective home buyers can borrow the five per cent down payment (even from a credit card) so long as they meet the lender’s debt limit ratio. The big red flag on this means, “they can essentially owe more than their home price on Day One,” said McLister.
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20 Per Cent Down
Pros: The primary advantage of putting down 20 per cent or more on a home is to avoid default insurance premiums, saving thousands of dollars over the life of the mortgage.
A larger down payment offers more flexibility, giving buyers the ability to purchase a home priced at $1 million or more, and allowing for amortizations over 25 years, along with refinancing.
Putting 20 per cent down gives buyers more product choices, such as re-advanceable mortgages, standalone home equity lines of credit, interest-only mortgages and non-prime financing.
Buyers with 20 per cent down also avoid the federal mortgage stress tests if they use a credit union or alternative lender.
Cons: A 20 per cent down payment ties up more of an investor’s capital, which comes with an opportunity cost — there will be less money for moving costs or renovations.
It also subjects most borrowers to a stricter stress test if they use a bank, since the mortgage would be uninsured.
“The uninsured stress test equals the greater of the (Bank of Canada’s) benchmark rate or your contract rate plus two per cent, whereas the insured stress test is just the benchmark rate,” said McLister.
Finally, a 20 per cent deposit is typically required for many new build properties.
In summary, McLister said, the size of the down payment shouldn’t only be dictated by available resources, but by investment alternatives.
“Often times it makes more sense to put less down so you can allocate cash to purposes with a higher return on investment.”