Yes, I ripped this title off of “The Real Housewives of Beverly Hills”, but instead of being filled with fake lips and double-digit IQs, this piece of literature will hopefully be filled with value.
It seems like people are having a harder time saving enough money to purchase their first home nowadays than ever before, and also taking more time to do so. This is happening during a time of historically low interest rates, but also during a time where housing markets in larger cities are continuing to grow and housing prices continue to climb. While this post isn’t about whether or not the claim from younger adults having inadequate purchasing power to buy a home compared to 30 years ago has any merit, it does address the challenges of not putting enough equity down when purchasing real estate that could leave one in an unfortunate position during ownership or upon selling of the asset.
For most people, the ownership of a house is the most capital-intensive endeavor over one’s lifetime. Mortgage payments, renovations, maintenance costs, property taxes, and utilities expenses are typically seen over the lifetime of home ownership. Owning equity and taking on debt to do so is a very common thing. It is quite rare that people are out there buying equity in cash, unless they are real estate billionaire moguls from China inflating asset prices in major cities. But for the majority of cases, all of us will end up taking a mortgage to purchase a home. A mortgage is considered as long-term debt, or good debt, because you are using leverage to own an asset that will likely appreciate over time. The major component of a house’s value is its land value, not the actual structure itself. The house “structure” actually does depreciate over time, but it’s the land that appreciates in value over time (land asset value is never depreciated on a balance sheet). As the owner, you experience this rise in asset value while paying back a mortgage over time that is based on the initial purchase price of the asset. This is contrary to financing a vehicle which involves paying back borrowed money, with interest, used to purchase a quickly depreciating asset. Not smart. Lesson 11 goes into more detail about this.
To increase purchasing power when it comes to buying a home, banks will allow buyers to put down as little as 5% down of the total purchase price of the home. Now, this of course depends on whether the buyer is pre approved for the purchase in the first place. Pre approval of a mortgage heavily depends on the buyer’s income, net worth, credit score, and collateral. In other words, banks want to protect themselves and ensure that the borrower (the buyer) can afford to carry this cost of capital over the course of the mortgage term, as well as provide the appropriate levels of collateral in the event of mortgage default. “Can you afford your monthly mortgage payments” is ultimately the question that the banks are trying to answer here.
Having to only put down 5% makes it easier for buyers, especially younger first home buyers, to purchase a home, and to call something as “home” for that matter. While this may trigger larger volumes of home purchases given the low minimum down payment requirements, it does come with added costs and risks as opposed to putting down 20% of equity upon purchase. There are three categories I created organize these costs and risks under:
1) Mortgage Insurance
2) Cost of Capital on Increased Leverage
3) Liquidation
Mortgage Insurance
If you have a down payment less than 20% at the time of purchase, you are required to purchase mortgage insurance. This insurance essentially protects the lender, aka the bank, against mortgage default. This is an added cost that is typically worked into the monthly mortgage payment. Mortgage insurance rates change depending on the down payment amount (or loan to value more specifically), and will range from anywhere between 2.5% of purchase price to 5%, in addition to the mortgage payments based on the amortization period chosen. Your original mortgage has just increased by 5%. A $500,000 mortgage has just become $525,000. Was that worth trying to rush into an equity purchase with only 5% down?
Cost of Capital on Increased Leverage
By increased leverage, I mean taking on a larger mortgage instead of putting down a larger down payment. Increased leverage means higher mortgage payments. Not only will this mean higher principal payments because you borrowed more, but it means more interest cost. Increased leverage usually comes with higher interest rates. The bank wants to protect themselves and make sure that they receive their money back that they lent out to the buyer. The more someone borrows, the more the bank will charge on interest to make sure they receive their money back. So not only is the buyer owing more to the bank because their down payment was small, but now they are required to pay higher interest costs because of the higher leverage they decided to take on.
Let’s look at two home purchase scenarios. For simplicity, I will fix interest rates at 2.75% effective annual rate. Both scenarios involve a buyer purchasing a $500,000 home. Buyer 1 puts down 20% of the purchase price, so $100,000, while Buyer 2 puts down 5%, so $25,000. Monthly mortgage payments are based on a 25-year amortization. Let’s compare the first 5 years of mortgage payments since a 5-year fixed interest rate mortgage term is quite common.
Table 1: Buyer 1 and Buyer 2 Scenario Data
Table 2: Buyer 1 First Five Years Amortization Schedule
Table 3: Buyer 2 First Nine Years Amortization Schedule
I’ve highlighted the last row in Year 5 for Buyer 1 to show the remaining principal balance on this mortgage, as well as to show the amount of interest that Buyer 1 has paid over this 5-year time frame. For Buyer 2, putting down 5% will require an additional 4 years, and an additional $50,000 in interest, to achieve the same remaining principal balance as Buyer 1 had achieved by the end of year 5. The results are even more interesting when looking over the entire amortization period.
Table 4: Buyer 1 Condensed Amortization Schedule
Table 5: Buyer 2 Condensed Amortization Schedule
You can see that the interest paid in scenario 2 is much larger compared to scenario 1, albeit the gap in interest paid over the amortization period actually closes between the two scenarios. These two scenarios are assuming a lot of other factors as well, such as fixed interest rates over 25 years, fixed amortization period upon refinancing, the same interest for both scenarios, no consideration for CMHC mortgage insurance for Buyer 2, and no accelerated payments or lump sum principal payments in either scenario.
In summary, cost of capital will be much higher in the case of smaller down payments, and the buyer must be certain that they can continuously afford this high mortgage while making other ends meet at the same time. No one should be a slave to their home, and the rule of thumb is that mortgage payments shouldn’t exceed 30% of one’s gross income. Any higher of a ratio and one’s ability to pay their mortgage is ever more sensitive to changes in variables expenses. Can a person handle a sudden expense such as a new furnace or something as basic as new car tires?
Liquidation
So, you’ve made the big decision to buy a house, and a few years after purchase, you decide to sell your house. However, over the past few years, the housing market in Defactoville has been quite soft and asset prices have actually come down. Your home is worth about 10% less than what you paid.
This is a very common scenario for people looking to sell their home in a weak real estate market. Over the long term, real estate value does increase, but over short term periods, value trends can go up or down. Increases or decreases to a home value is directly realised to the owner upon selling of the home. If a house sold for $20,000 more than it was purchased for, the seller realises a direct addition of $20,000 extra dollars in their pocket after paying the bank back for the outstanding mortgage balance. However, the opposite is true too. If Ted buys a house for $300,000, and sells it years later for $270,000, Ted has to pay the bank back his outstanding principal balance before any money goes into his pocket. If he still owes $270,000 on his house, he will net zero dollars after the sale of his house because all of it was needed to pay the bank back. Now what happens when this scenario worsens?
Well this is how it can get worse. It can get worse if either the sale price was lower, or the buyer’s initial down payment was so low upon purchase that the outstanding principal owed on the house at the time of the sale actually exceeds the sale price. Table 6 illustrates this. Let’s say Buyer 2 decides to sell their house in year 3 because they are being relocated for work. Remember that Buyer 2 purchased a $500,000 house with a 5% down payment of $25,000. Over the past 3 years, the local real estate market in Defactoville has been going through a recessionary period, and asset values have dropped 15% over this time. In this market, Buyer 2 can likely sell their house for $425,000.
Table 6: Buyer 2 First Three Years Amortization Schedule
However, upon sale of the house, Buyer 2 still owes the bank $433,669.20. Buyer 2 will actually still owe the bank money after they’ve sold their house for $425,000! This scenario doesn’t even account for realtor fees and lawyer fees, which can easily be another $15,000 in this case. What does Buyer 2 do now? Do they have an extra $13,000 lying around to pay back the bank? Do they sell their car to make this payment? Do they need to take out another loan to repay this mortgage loan?
This is a very scary and real risk that people face who are extremely leveraged in owning their home, and it’s the situation many unfortunate people found themselves in during the 2008 US financial crisis. Individuals were forced to liquidate other assets to cover the outstanding principal balance owed to the bank on their extremely leveraged real estate purchases that had severely dropped in value during the financial crisis.
If you are considering purchasing a home with a very small down payment like 5%, it’s important to be mindful of the potential risks associated with this decision. Ensure that you as the buyer are aware of the added costs upon origination of the mortgage contract, the added costs over the term of the mortgage, and the potential added costs upon selling of the real estate asset. Proper financial planning and budgeting can help avoid these risks. Waiting a little longer before purchasing a house in order to save up for a larger down payment is never a bad idea, and can put you in a much more comfortable situation financially over the long term, while ensuring you are able to meet your other short term financial obligations and not having to become a slave to your house.
Realistically, is it reasonable to say that you are a homeowner with only 5% down, or is the bank the real home owner here?