The interest may run you the equivalent of a latte a day, but the opportunity costs — like missing out on vacations and RRSP savings — can be even greaterAuthor of the article:Jason HeathPublishing date:
The average home price in Canada rose from $544,284 in March 2020 to $716,828 in March 2021 according to the Canadian Real Estate Association (CREA), a $172,544 increase. Prices in places like Greater Vancouver and Greater Toronto rose $96,100 and $143,000, respectively. Many Canadians are spending an extra $100,000 to buy than they were a year ago, raising an important question: just what is the impact of dropping an extra hundred grand on a home?
In the short run, there are the obvious transaction and financing costs. Land transfer tax and mortgage insurance costs are higher. Mortgage payments are higher as well, mind you, with interest rates at such low levels, most of your payment goes to the principal.
Assuming a two per cent mortgage amortized over 25 years, the monthly payments are an additional $423 on $100,000. The interest costs are only $166 of the first monthly payment, and just $9,177 in total over a five-year term. That is an average of $1,835 per year or $153 per month of interest — the equivalent of a $5 latte a day in exchange for an extra $100,000 of real estate.
If the mortgage renews at 4.5 per cent after five years, the payments need to rise about 25 per cent to maintain the same amortization and pay the mortgage off after 25 years in total. If the mortgage payments stay the same, the amortization would have to increase by almost 10 years, taking an extra decade to repay the mortgage.
The extra mortgage payments on that additional $100,000 reduce the ability to do other things — such as saving for retirement. Investing the equivalent of the extra mortgage payments over the 25-year mortgage into an RRSP at a 4.5 per return, including the tax refunds from making the contributions, would result in about a $418,000 RRSP balance after 25 years. This assumes a 35 per cent middle class marginal tax rate.
If you withdrew the same amount from the RRSP every year for the next 25 years in retirement, assuming the investments continued to earn 4.5 per cent annually, you could take out about $27,000 per year.
Spending an extra $100,000 on a home may cost you 25 years of retirement income at $27,000 per year based on the assumptions. This is a very simple example holding a lot of factors constant, and $27,000 in 25 years will only be worth about the same as $15,000 in today’s dollars (assuming two per inflation).
Obviously, if someone spent $100,000 more on their home, they would have more home equity in retirement despite forgoing RRSP contributions. If their home value grew at 5.9 percent per year, they would have more than $418,000 in extra home equity and be better off than the RRSP investor. Their home equity — assuming tax rules do not change in the future — would be tax-free to access, unlike the taxable RRSP withdrawals. If real estate values keep growing at double-digit returns, no doubt the more expensive home will be the better financial choice.
The thing is, real estate cannot keep growing at the same pace. It is not possible for real estate to grow in the long run at the same rate it has been growing. Double-digit real estate price growth and low single-digit wage growth cannot happen forever unless interest rates go negative or millions of millionaires from other parts of the world move to Canada. Both could happen, but both are unlikely, especially for an extended period.
Residential real estate in the U.S. has grown by 0.4 per cent in excess of inflation since 1890 and the Bank of Canada maintains a 2 per cent inflation target. I am not saying real estate prices are going to fall, but I am saying it is hard to imagine real estate prices growing at the same pace over the next 10 years as they have over the past decade.
There are other considerations that make a more expensive house less appealing. More expensive homes have higher property taxes, insurance premiums, and other costs over time. We also assumed a 35 per cent marginal tax rate and some people have periods in their careers where their tax rate is higher (seven provinces have marginal rates in the mid-40 per cent range at $100,000 of income). Some employers offer matching contributions for retirement savings programs like group RRSPs and DC pension plans. Higher mortgage payments would inhibit a saver’s opportunity to take advantage of tax refunds and company benefits.
The higher carrying costs of a more expensive house may cause a homeowner to forgo other expenses like life or disability insurance premiums to protect them and their family. This can have significant risks and financial repercussions in the event of a death or disability. They may have to forgo lifestyle opportunities like vacations which have non-financial benefits that are hard to quantify.
The point here is not to talk people out of buying homes. It is to cause people to think about the short and long-term implications of stretching to buy more home than they can afford. Given the potential changing work environment as work-from-home continues for many employees, there may be opportunities to live somewhere different than you do now or than you thought you might live in the future.
People who have other mobility opportunities that allow them to consider a move to another town, city, or even province may be able to spend more on living in the short-term and more in retirement 2021 in the long-term if they can shave a little off their mortgage.
- May 06, 2021