Make Sure you can afford your Dream Home

January 11, 2010
By Jim Adair

For first-time buyers in particular, it s a confusing time. Canada is just coming out of a tough recession that cost a lot of jobs and hurt consumer confidence. Everyone is aware of the troubled real estate market in the U.S. But since the spring, Canada s resale housing market has been booming, thanks to rock-bottom mortgage interest rates. So is now the time to buy and take advantage of the low rates?

While today s ultra-low borrowing costs represent a unique opportunity to purchase a property, home buyers need to proceed with caution and keep in mind that renewal rates will likely be substantially higher in coming years, says Sal Guatieri, senior economist with BMO Capital Markets.

Jan Yuen, a senior manager at BMO Capital Markets, adds: Stretching the limits of your budget by choosing the maximum amortization period and a minimum downpayment leaves you little wiggle room to deal with an unexpected financial challenge. A meaningful downpayment and shortening your amortization by making extra payments on your mortgage will save you tens of thousands of dollars in interest costs.

For example, Benjamin Tal of CIBC World Markets says that on a $250,000 mortgage with a five per cent rate amortized over 30 years, adding a full month of extra payments each year works out to a de facto shortening of the mortgage amortization period by five years. If interest rates have gone up, translating years into basis points means that by simply switching from an accelerated payment plan to a regular one means borrowers would be able to absorb the first 75 basic points on a rate increase, says Tal.

BMO advises borrowers to do a stress test on their budget to see if they can afford rate increases. For example, customers looking to renew a $250,000 mortgage currently priced at 2.25 per cent would see their monthly payment to increase by $260 a month if rates were to increase by two percentage points, says BMO.

BMO also suggests that mortgage holders make weekly or bi-weekly mortgage payments if possible. They should also take a close look at fixed versus variable-rate mortgages. While variable-rate mortgages have been a winning strategy over the long term, fixed-rate mortgages (currently at historic lows) come with the peace of mind of being insulated against rate increases and knowing how much of your mortgage you will have paid down at the end of your term.

It says total household costs, including mortgage payments, property taxes, heating and utilities, should not be more than one-third of household income.

The Bank of Canada says that 5.9 per cent of Canadian households are vulnerable to rising interest rates because their debt-service ratio is more than 40 per cent. It says that if rates rise by 300 basis points by 2012, that percentage of vulnerable households would rise to 8.5 per cent.

But in a recent report, Tal says that focusing on a borrower s debt-service ratio with no reference to the underlying asset (the equity in the house) can be misleading. He says when equity is added to the equation, the number of households that would be vulnerable to a rate shock is less than four per cent.

Another potential buffer to rate shock, says Tal, is the fact that most Canadian financial institutions limit their variable-rate customers to a mortgage that they would qualify for at today s three-year fixed-term rate, well above current variable rates. While all borrowers will face the impact of higher rates, most of them will therefore be able to absorb a 300 basis point rate hike and still remain within the qualification threshold.

Tal adds: Also note that in general, low-income Canadians tend to rely more heavily on fixed-rate mortgages -- the complete opposite of the situation south of the border where low-income Americans were heavy users of variable-rate mortgages. While even fixed-term mortgages will eventually be reset, the longer time frame for any hikes in their borrowing rates leaves them with more time to pay down principal and benefit from rising incomes before that hits.

Many analysts believe the housing market will slow down during the coming year, and that house prices will not appreciate as rapidly as in 2009. In the housing industry, everyone from the Mortgage Brokers Association of British Columbia to the president of the Building Industry and Land Development Association of Toronto is urging Flaherty to let the market settle down on its own before taking regulatory steps.

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