Home buyers: How large should your down payment be?
Is it best to maximize your down payment on a house or condo purchase, or keep some money to invest?
Is it best to maximize your down payment on a house or condo purchase, or keep some money to invest?
When you buy a house or a condo, there are minimum down payment requirements to consider as you make your financial arrangements. If the purchase price is $500,000 or less, you need a 5% down payment. For properties between $500,000 and $999,999, there is a 5% minimum on the first $500,000 and 10% on the remainder. For properties worth $1 million or more, you need a 20% down payment.
If you are buying a property with the intention to rent it out to tenants, you need a 20% down payment regardless of purchase price.
Borrowers who are self-employed or who have poor credit may require a down payment that’s larger than the minimum.
For those purchasing with a down payment of less than 20%, Canada Mortgage and Housing Corporation (CMHC) mortgage default insurance is required, in order to protect the lender from the higher potential for default in a high-ratio mortgage. The premium (the amount you pay) for this insurance ranges from 2.8% to 4% of the total mortgage. Premiums in Saskatchewan, Ontario and Quebec are subject to provincial sales tax as well. The premium is rolled into your mortgage amount.
If you can put together a 20% down payment, you’ll save that CMHC insurance premium, as well as the interest you’ll pay on that premium over the life of your mortgage. However, for some aspiring home buyers, saving 20% could take many years to achieve—and it’s not required, unless they are required to in order to buy a home valued at $1 million-plus, or to buy a rental property. Purchasing with less than 20% down could make financial sense, especially for buyers who expect to live in their home for five or more years, who are borrowing less than what they are approved to borrow, or who live in neighbourhoods with high rents.
If someone needs to put all their savings into a down payment to qualify for a mortgage on a home, this is a potential yellow flag. Buying under these conditions could leave them with no emergency fund for unexpected home repairs or just life’s everyday surprises. Putting all of their savings into a down payment also increases the likelihood they will not be able to save each month after making their mortgage payments, paying other home ownership costs and covering other their basic living expenses.
However, if you have enough savings to buy a home with a down payment larger than 20%, you might qualify for a home equity line of credit that can act as an emergency fund.
If a home buyer is questioning whether it’s best to leave some of their savings invested instead of putting down a larger down payment, especially if they have more than 20% down, the answer is—it depends.
A first-time home buyer may be able to take up to a $35,000 Registered Retirement Savings Plan (RRSP) withdrawal under the Canadian federal Home Buyers’ Plan (HBP). A first-time home buyer is someone who has not occupied a home that they owned, or one that their current spouse or common-law partner owned, for the four years prior to the home purchase. That four-year period begins on January 1 of the fourth year prior to the year the RRSP withdrawal is taken.
Whether using the HBP is advantageous or not is difficult to calculate. A home buyer who does use it is losing tax-deferred growth inside their RRSP; how much depends on the return their investments may have otherwise generaated. RRSP withdrawals are eventually taxable on withdrawal, no later than age 72, and future tax implications may be difficult to determine. If an HBP withdrawal allows a home buyer to get into a home of their own or reduce or avoid CMHC insurance premiums, a withdrawal can be worth considering.
If a home buyer has a tax-free savings account (TFSA), the decision about whether to use the TFSA to put down a larger down payment depends in part on the expected TFSA return. Over the long run, the stock market may return 6% to 7% before fees. If someone pays 1% to 2% in investment fees, an all-stock portfolio may generate 4% to 6% per year. If an investor is conservative and holds cash, bonds or other fixed-income investments, their return expectation may be lower. Consider that current mortgage rates are in the 2% range; some conservative investors may not earn much more than 2%, making it likely worthwhile for them to put their TFSA funds toward their home purchases. However, as interest rates rise, the potential to earn more on a TFSA may make staying put inside the investment account a better deal than putting those funds toward a mortgage.
Even if the rate of return is similar to a borrower’s interest rate, a TFSA can also serve as a potential emergency fund.
If a home buyer has non-registered savings, the rate of return required to justify keeping the funds invested instead of putting down a larger down payment becomes higher. This is because, unlike TFSAs, non-registered investments are taxable, with interest, dividends and realized capital gains reported on an investor’s tax return. An investor may need to earn a 3% to 4% preturn just to break even if their mortgage rate is 2% (depending on their tax rate and the type of investment income). As rates rise, so too does the required return.
An homebuyer with non-registered investments can tilt things in their favour by making their debt tax-deductible: They may be able to use their non-registered savings to put down a larger down payment and then borrow back to replenish their investment account. This will generally allow them to deduct the interest on the borrowed funds used for investment. Their required return to break even may then be comparable to their mortgage rate. But, again, as rates rise, the potential return delta may become smaller. If mortgage rates rise to 4% and their investment returns are 5%, the $1,000 of profit per $100,000 of leverage may not be worth the risk and complexity.
Keep in mind that interest on money borrowed to invest in RRSP or TFSA accounts is not tax deductible—only money used for non-registered investment accounts.
Putting down a large down payment is a good thing. It means you have a stronger balance sheet, less debt and less risk as rates rise. You may also be able to avoid CMHC insurance premiums if you put more than 20% down. Keeping money invested instead of using it for a down payment may or may not help you come out ahead. A priority with any real estate purchase should be to make sure you still have room in your budget for emergencies and, most importantly, to save for the future.
Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.
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You made no mention of the fact that if you get mortgage insurance because you put less than 20% down you get a lower mortgage rate which can over the life of the mortgage save you more than the cost of the insurance.
A friend told me a mortgage provider told him it would be better not to put a 20 percent down payment on his house because then he would get a lower interest rate. The idea is that the lender can provide a better interest rate since they would not be liable for the loan, mortgage insurer would be. Can this be true? Wouldn’t this affect your calculation?
I agree with your last sentence.
So many options but some important things people should consider are all the associated costs especially if they are putting just about every spare $ into the down payment. Not just the down payment but Legal fees, land titles, prepaid municipal taxes, HOUSE INSURANCE (this seems to be ignored and then in Calgary new owners expected the government to cover hail damage. The City did in the end to buy votes of the predominantly immigrant community in the NE area. The Mayor who lives in the area and Area Councillor are both ‘visible minorities’.), furnishing (blinds etc), and then unexpected pregnancies, damages and write-off of vehicles and other unplanned emergencies.
We did put every spare $ into our first house down payment but based payments on just 1 salary not 2 that the bank and real estate agent were suggesting. This was many years ago and expectations and wants have changed.
Keep in mind that mortgage interest on a principal residence in Canada is not income deductible for tax purposes. The same goes for personal debt where the borrowed funds are not used for investment. Use the formula “The effective annualized interest rate, divided by the product of 1 minus your Marginal Income Tax Rate expressed as a decimal” to arrive at the actual pre-tax equivalent rate that you would have to earn on a taxable investment to break even. For example, if your mortgage interest rate is 2% but you are an Ontario, Canada resident with a marginal tax rate of 53.53%, you would have to earn 2%/(1-0.5353)=4.30385% pre-tax on taxable investment returns to just break even. The effective annualized financing charge that is most common on life insurance premiums in Canada to pay the premiums in monthly installments instead of annually is a whopping 18.594% – personal credit card interest territory. In terms of pre-tax investment returns necessary to break even, the formula is the same. Hence, the “convenience” of paying for your life insurance premiums monthly instead of annually if your marginal tax rate is 53.53% necessitates a whopping 18.594%/(1-0.5353)=40.013% (rounded to the 3rd decimal) equivalent return on taxable investment returns…expensive indeed, but rarely if ever disclosed by insurance companies or sales agents.
Each case and scenario has its own unique characteristics and deserves consultation with qualified and adequately equipped financial consultants; however, and in general, I’d recommend that you setup a strict and monitored budget to reduce non-deductible debt and financing expenses to free up convenient and stress-free funds for mortgage payments and other expenses related to the prospective home purchase and ownership (don’t forget property taxes that rarely decrease and often increase over time as well as tax implications of using RRSP funds under the HBP for “first time home buyers”. Last but not least, consider the risk of “closed” Variable Rate Mortgages. These may apper attractive at first but can push you over the edge with the inevitable general interest rate hikes (made even more likely and sooner due to the enormous government debt piled up during the pandemic).
Yes, that is why some would argue it makes financial sense not to put 20 percent down. Following this strategy, you would get a lower interest rate for the life of the mortgage and would be better off than if you did have a 20 percent down payment. I still hate the thought of paying for insurance and then waiting years to recoup the insurance fees. Would be interested in getting a professional opinion on this; it seems counter-intuitive.