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adrw // Andrew Alexander

Buying a House?

Finance11 min read

When wrestling with the question of whether to buy or rent my primary residence in Ontario, Canada, this has served as a living document frequently updated with latest resources and thoughts. Keeping them public and open to discussion has sharpened my thinking and kept me sane as I've hashed out different ideas and approaches with others.

Some of the notes below are out of date, and some will not be my final conclusions in a couple years, so come along for the ride and clarify with me any questions!

For my 2019 rough notes application of the Principles for Navigating Big Debt Crises to the Canadian Real Estate market, see The State of Canadian Real Estate in 2019. It probably deserves fresh guidance given the changing winds from COVID-19 in 2020 but alas, I have not yet.

Rent vs Buy

Early in my investigation, I noted some pros/cons that immediately came to mind. Eventually, we landed on buying given the much more comparable rent vs buy dynamics in Kitchener (houses renting for $2000-2500, mortgage payment for similar house at $1800-2500) in contrast to other cities like Montreal where it can be strictly better to rent given larger rent supply and less rates.

Pros

  • Housing is a highly subsidized and incentivized investment (RRSP withdrawal program, no capital gains on primary residence, various homebuyer and renovations tax credits...)
  • In wilder markets in Canadian cities, RE price index has been increasing at >5% for the past 20 years. Recent years (2020) has seen year over year price index increase by 8-10% in Toronto and Kitchener-Waterloo. (Index link below). Locking in prices before they continue to go up could make sense.
  • Interest rates are extremely low and will likely be for the next 5-10 years. Rates haven't been this low since the 1920s making this an optimal time for a mortgage.
  • Cities like Kitchener-Waterloo outside of Toronto haven't been exposed to the same extent to the frenzied RE run up that GTA and Vancouver have faced meaning ownership prices could be closer to rent/buy breakeven price (see The 5% Rule in calculators below). For example, a $600,000 house in Kitchener, by the 5% rule, would make sense if a comparable house can't be found long term for rent of $2500 or less. If your registered investment accounts are maxed out, then expected opportunity cost of your ownership sunk cost if you had invested in stocks is lower (since stock gains in non-registered accounts are taxable) so 4% can end up being more accurate. Rent equivalent for $600,000 house with the 4% rule is $2500. The bulk of houses on Kijiji are renting in KW for \$2000-2800, meaning that the rent/buy difference that is much more clear cut in the condo market or in Toronto housing market, is a bit more of a tossup in KW right now.
  • They ain’t making more land
  • You eventually own where you live which could ideally drop your monthly costs to utilities, maintenance, and property tax
  • Forced savings vehicle (won’t ever not make a mortgage payment, might skip savings some months if not disciplined)

Cons

  • Responsible for maintenance
  • Almost certainly higher cash cost for just the mortgage let alone taxes, renovations, utilities on a per month basis
  • Locked into a single location (every move drastically drops ROI of owning)
  • Opportunity cost of the reduced cash flow per month ($300/month put into investments starting at age 25 grows to $1 million by 65, \$600/month starting at age 35) especially at young age
  • Opportunity cost of kingdom and charity projects that are funded out of cash flows and from maintaining lower living standards
  • Accustoms children to higher living standards than in an apartment or rented house
  • Reduces patience with annoyances of rental properties when as an owner there is power in your hands to continually fix annoyances
  • Home equity is not liquid unless a loan is taken out against it
  • Retirement can’t be funded from the equity value increase in a house unless loan taken out against the value
  • Owning encourages upgrades and renovations to improve it (it’ll pay off and add value to the home when we sell)
  • Owning can cause unrelated lifestyle increases: living far away => more commuting / second car; spend more on renovations per year ($5-10k vs $0 renting)
  • Reduced job mobility (moving is much harder)
  • Reduced willingness to travel and leave house vacant for long periods of time
  • Reduced cash flow / increased % spent on housing leads to higher income requirement and tighter margin of error if either person loses employment or wants to take leave for a period of time
  • 30+ year bull Canadian RE housing market, willing to bet it will continue another 40 to cover our lifetime (I’m not sure...)
  • Near peak for short term and long term debt cycle (Ray Dalio), thus deleveraging of some sort is coming, likely leading to reduction or pause in growth in house prices as most over leveraged sell houses and others decide not to buy or upgrade because of overextended debt levels.

Indexes

Analysis

Calculators

Videos

  • Rent vs Buy Matt McKeever (Rental Real Estate Investor) 2017, 2018, 2019
    • YouTube videos updated each year reviewing how purchasing a house can often not be the best financial decision compared to renting for primary residence
  • Renting vs. Buying a Home: The 5% Rule YouTube
    • Take house price * 5% (total unrecoverable annual cost: 1% property tax + 1% maintenance + 3% cost of interest) / 12 to find the monthly break even of home ownership compared to rent at equivalent location.
    • Video notes that if individual will be investing rent / own difference in a taxable investment account (ie. RRSP and TFSA room are maxed) then the rule may be closer to 4% because of the reduced difference between investing in stocks and home ownership from the taxation of investment gains.
  • Three Common Mortgage Mistakes (higher cost of breaking for 5 year fixed, not checking terms so that future refinance or other may be off the table, not using broker to shop around banks, rates, terms) YouTube
  • The Real cost of DIY Home Renovations YouTube
    • Be realistic in estimating costs and tactics ahead of a big renovation or taking on a fixer-upper house. Costs and stress can be higher than expected, certain tactics and doing certain tasks yourself can reduce both.
  • IKEA Kitchen Cabinets YouTube Great step-by-step instructions on instal of these cost efficient cabinets
  • Second Story Additions YouTube

Investigations

  • What if you rent part of your primary residence, still eligible for primary residence capital gains exemption on sale? You will encounter a "deemed disposition that normally arises on a partial change in use of property", aka you loss exemption status on the % of the house that you're now renting. CRA
  • Isn't buying real estate the best way to maximize leverage? Couldn't you then use that leverage for stock investing or other purposes?
    • Leverage, yes! Usable for non-real estate, no. After research into HELOCs, readvanceable mortgages, and all sorts of other strategies, it's become clear that it's nearly impossible to use the leverage available in a mortgage outside of the specific real estate property that the mortgage is for.
    • How do you maximize leverage?
      • At best, you can get a 5% down mortgage and then once 20+% has been paid down in principle (usually past year 10 with a 25 year amortization), you can get a HELOC to keep pulling equity out and maintaining leverage long term. Some HELOCs have a loan limit set on setup based on assessment of the house.
      • At the other end of the spectrum, you could pay for the house in cash and then withdraw up to 80% in a HELOC. The terms are important because some have payment plans similar to a mortgage so you lack the flexibility (that you get with a Line of Credit) that you need to put the money long term in stocks for example. Additionally the interest rate on HELOCs are often 1-2% higher than the rates you get with a mortgage, so it's difficult to see how the house purchase, which locks up 20% minimum in down payment / minimum HELOC equity, can provide any additional leverage than simply using the full 100% (used to initially pay the house).
      • Other HELOCs, sometimes packaged as readvanceable mortgages (Scotiabank/BMO offers them), will automatically increase in credit room based on the principal parts of the continued regular mortgage payments. For example, if $1000 of your $2200 mortgage payment is going towards principle and you already have over 20% home equity, your HELOC will expand in room each month by \$1000. In this case, you could maintain high leverage on your house by withdrawing from HELOC the principle part of your payment and investing in stocks for example. Some readvanceable mortgages have lower limits than normal HELOCs only allowing borrowing up to 65% (vs HELOC normal 80%) of house value.
    • Can you refinance every year to maximize ongoing leverage?
      • Nope, refinancing essentially results in a brand new mortgage and thus new paperwork and closing costs. You can get a Home Equity Line of Credit (HELOC) but only of an amount surplus to 20% of the mortgage value. For example, for a $500k mortgage, you can't get a HELOC until $100k of principle has been paid down, and then your HELOC is only in the best case the amount above that. So if you've paid down $150k of principle, you can get a $50k HELOC to flexibly withdraw equity out of the house at slightly above prime rates, and less than an unsecured line of credit.

Mortgages

  • RateHub: Note, it is owned by CanWise a mortgage lender who they happen to often show as the best rate. Good educational articles and overview of rates from other banks.
  • RateSpy
  • IntelliMortgage
  • Mortgage Broker Regulator Search: Though not related to rates, this tool lets you see if your broker has had any regulatory infractions
  • Canadian Bankers Association Mortgages Information: Overview of different aspects of a mortgage
  • Government of Canada Mortgages Information: Overview of different aspects of a mortgage
  • r/PersonalFinanceCanada What should I know before going to a mortgage broker: Lots of great tips
  • Standard vs Collateral Charge Mortgage: You'll need collateral charge if you want a re-advanceable mortgage, with certain lenders, or for a HELOC but it does come with some consequences.
  • Open vs Closed
    • Open mortgages cost a high interest rate premium to allow flexible repayment of principle with no additional conditions.
    • Closed have strict rules, non-negotiable, around any additional payment of principle outside of the traditional mortgage payments. Many though have allowances for 10-20% of balance owing or total original mortgage (note the difference) which over a few years would allow significant pay down of principle if so desired (for example if rates went up). Private mortgage broker studies have shown less than 2% of Canadians across their entire lifetime exercise use of these 10-20% principle pre-payment options, so any push towards an open mortgage ("in case you want to pay back more") is usually motivated by a bank wanting you to pay a premium for the flexibility that, even in a much more limited scope with closed mortgages, most people do not use.
  • X-Year Terms
    • Mortgage terms (rate, open vs closed, fixed vs variable) are negotiated and agreed to for a certain length of time when the mortgage is then renegotiated. This practice reduces paperwork from having terms be up for change every few months or every year. It also grants the ability to change your approach when the term is complete and you choose the terms of renewal.
    • Breaking the mortgage in the middle of a term can have serious consequences as many mortgages (specifically fixed interest rate) have interest penalty and other breakage fees to compensate the banks for the lost interest resulting from you breaking the mortgage mid-term. Understanding these terms ahead of time will reduce surprises if unforeseen circumstances cause you to break your mortgage mid-term. Reasons to break mid-term could include selling your house to pay off the mortgage or wanting a lower interest rate if rates have dropped.
  • Fixed vs Variable
    • Fixed rate mortgages grant a constant interest rate for the length of the X-Year term. Mortgage brokers studies have shown that over 70% of people with fixed rate mortgages break the mortgage mid-term for one reason or another. Breaking a fixed rate mortgage mid-term often carries significant interest rate penalties which tend to negate the supposed benefit of locking in a low interest rate.
    • Variable rate mortgages change the interest rate charged based on the fluctuating bank prime rate which often changes in lock step with the Bank of Canada rate and can be impacted by economic conditions such as recessions (pushing rates down) or inflation (pushing rates up). Changing rates will reduce or increase your mortgage payment accordingly, unless you choose mortgage terms that keeps constant payments at the cost pushing back your amortization if interest ends up taking up more of your mortgage payment.
  • Conventional vs Collateral Mortgage
    • Conventional mortgages set the lending institution as the priority entity on title for the property. For example, in the case of you defaulting on your mortgage, the top entity will take title deed to the property to cover losses from the mortgage default. A conventional mortgage is exclusively concerned about the property, and does not wrap in any other debts. If you skip credit card payments, the Bank can send collections after you and take you to small claims court but they can't go after your house.
    • Collateral mortgages have the lending institution fully hold the house as collateral for the mortgage, and in addition, tend to use the collateral to backstop other debts such as Home Equity Lines of Credit (HELOC), credit cards debt, auto loans, and other forms of credit. This is a requirement for most HELOCs but has the unintuitive impact on other credit lines such that a credit card in default ends up getting wrapped into the mortgage and thus the lending institution can use your house to force your repayment of the credit card (or take your house). This added risk of having all your debts with one institution and collateralized against your house is something to keep in mind, though shouldn't be a hard blocker since it can open up many expanded credit capabilities such as readvanceable mortgages (mortgage with expanding HELOC based on principle portion of your mortgage payment).
  • Readvanceable Mortgages
    • Readvanceable mortgages are more complex instruments that combine a mortgage with an expanding HELOC based on principle portion of your mortgage payment. This means that every mortgage payment (which consists of principle + interest) expands your HELOC credit room by the amount of the principle.
    • An expanding HELOC contribution room grants more flexible use of the home equity such as to maximize tax deductible interest using the Smith Maneuver or to fund home renovations or other investments at generally a lower, closer to prime interest rate than unsecured lines of credit.
    • The cons (Globe & Mail) for some borrowers will be more credit than they know what to wisely do with, increased lender lock-in since the mortgage is a collateral mortgage and switching lenders after a term will carry ~\$1k in legal fees, and often a slightly higher interest rate to compensate for the complexity and flexibility of the instrument.
  • Manulife One
    • Manulife has an account they advertise merges your banking account, mortgage, and line of credit where interest owed is calculated daily and you can end up better off by using your banking balances to on a daily basis reduce your interest owing.
    • Unfortunately, their rates are much higher than other mortgages and they have surprise monthly fees that make it more of a trap for unsophisticated borrowers enticed by paying down their mortgage faster.
    • One Reddit user writes of how he was able to copy the pattern at a much lower rate using a TD HELOC for all of his regular banking and segmenting out his mortgage into different length fixed interest terms (r/PersonalFinanceCanada)

The Smith Manoeuvre

How to make mortgage interest deductible? With the Smith Manoeuvre.

Not natively part of Canadian tax code, it is possible with a readvanceable mortgage where increasing HELOC room is borrowed and invested in dividend paying stocks (which pay more than the HELOC or mortgage interest rate) to make mortgage interest tax deductible (like it is in the United States).

Read more about the Smith Manoeuvre here:

Referrals

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