The Canadian dream remains one of home ownership. No matter how many personal finance experts tell you how much money you can save renting and how much money you’re really spending on maintenance and property taxes and the closing fees that most conveniently leave out of their buy/sell profit equation, Canadians are still firmly emotionally tethered to owning a home. No matter how many articles come out on how happy Germans are as long-term rentals.
So fine. Buy a home if you want to. Go forth and live your dreams! But before you do, make sure you can afford it. Like really afford it. Not just afford it now, but afford it in the future should interest rates rise.
What happens if rates rise to 7.23%, the average 5-year fixed rates of 1990-2000? You’ll mortgage will get thousands of dollars more expensive! That’s unlikely to happen so rapidly, but it’s almost certain they’ll rise at least a few percentage points.
Just like what goes up, must come down, what goes down, must also go up. Those are the laws of physics. And by physics, we mean “the laws of the economy”.
So will you still be able to afford your home when interest rates rise?
The government doesn’t think so. That’s why the feds now force lenders to perform a “stress-test”. In order to qualify for a loan your income has to be able to support the Bank of Canada’s 5-year fixed posted rate, currently 4.64%. The loan you actually get though, can be as low as 2%.
We think this is a good idea. We’ve been a long-time fan of stress-testing here at New School. We, like the government, don’t want to see anyone default, over-extend themselves or become house poor. In the rush to get on the property ladders, too many Canadians ignore their interest rate risk.
Let’s look at an example of what a small hike in interest rates could look like for your budget:
Robin and Jamie buy a $550,000 house (about the country’s average) and after 20% down have a mortgage of $440,000.
They take home a combined $5000, and so their housing costs are about 39% of their income, an acceptable range they think. (Of course, that doesn’t include property taxes, utilities, landscaping, bed bug extermination if they live in Toronto, etc., which brings their total housing costs closer to 50%, but we’ll put a pin in that for now.)
They snag at pretty good interest rate of 2.24%, which leaves their monthly mortgage payments at $1,932.
At the end of 5 years, Robin and Jamie are left with $373,806 owing on their mortgage. But the only rate they can now get is 4.64%. Their monthly payments now rise to $2,098
Robin and Jamie are surprised.
When they first calculated their budget, they assumed that after 5 years of paying down their mortgage, their monthly costs would go down, not up. They expected to only be paying $1,627 a month now, and having an extra $482 to save.
They’ve recently had a baby, and so are spending $1300 a month on daycare, and another few hundred dollars on associated expenses. They also bought a car a few years ago, and now have car payments to contend with. That $5000 they bring home has also actually shrunk to $4000, since Robin reduced his hours to part-time to help with the child.
They aren’t going to sell their home or go into default. If they have no choice, they’ll somehow manage to dig deep and pay the extra $166. But it’s not going to be easy. They’re not sure what else they can cut and any planned vacations, savings, and renovations are out the window. They start putting some daily expenses, like diapers on a line-of-credit.
AND SO THE DEBT SPIRAL BEGINS.
So what’s the lesson here?
Housing affordability is so much more than what a financial institution will lend you.
If you’re a young, first-time home buyer, your lifestyle is likely to get more expensive in the upcoming years, not less. And interest rates are almost guaranteed to rise. So stress-test your budget now make sure that you can comfortably afford your home now, with a lot of breathing room.
Need help? OF COURSE YOU DO THIS STUFF IS CONFUSING.
Take our “Can you afford a home” course
This course is a First Time Home Buyers Survival Kit. Whether you’re buying in 3 months or 3 years from now, this course will help you understand how much you can afford to you can plan accordingly.
WHEN YOU TAKE THIS COURSE YOU WILL:
•Understand how to use your money wisely for your down payment (and how much you should be aiming for – realistically)
•Know how your mortgage works, what you need to do and how to get the lowest rate
•Test your dream home to see if you’ll be house poor!
•Know the max mortgage amount that wouldn’t raise any of our HousePoor Red Flags
•Come up with a plan of attack. If you’re not there yet, find out what you need to do to get there!