You are young and have scrimped and saved $100,000.00 between you and your partner (or maybe just you). You want a home, a beautiful home! You found just the right one and it is going to cost you $500,000.00. Your parents say you should put 20% down.. but should you empty your nest egg and put it all into a house?
Canada Mortgage Housing Corporation (CMHC) insurance in Canada enables homeowners to buy homes with less than 20% down (our nation’s banks’ now standard minimum). However, this service has a cost. If you put only 5% down you need to pay a fee of 3.6% on the entire mortgage balance, eating up most your down payment. For 10% down the fee is 2.4% and for 15% down it is 1.8%.
This government service begs the question – If you put less than 20% down, what investing return do I need to get to get ahead of that fee with interest rates being so low? Or, alternatively, should I use the government to leverage my portfolio by investing part of that 20% down payment?
Our test: What is the required break-even annual return needed to be “worth more” at the end of five years after CMHC fees? A key point here is after only five years. We are assuming a five-year fixed rate mortgage, Canada’s favorite term, and assume you would re-evaluate your decision after five years based on prevailing interest rates. Also, if you assume a longer timeframe to beat the CMHC fee then you must make assumptions about interest rates in five years and have a whole bunch of other issues beyond the scope of this article. Let’s keep it simple.
Assumptions: 1) All scenarios assume the value of the house doesn’t increase. House prices do not matter for this as you own the same house regardless of how much you put down. What matters is your portfolio size and mortgage balance, i.e. your net worth. 2) All scenarios assume monthly mortgage payments. 3) Five-year fixed rate mortgage of 2.44% is based on current post-Trump mortgage rates, your mileage may vary. 4) For less than 20% scenarios, it is assumed that you withdraw from the portfolio to meet your higher mortgage payments (i.e. the higher payment minus the 20% mortgage payment every month). This creates an apples to apples comparison on a cash flow/monthly budget basis. 5) We assume you take out this additional amount needed for mortgage payments from the portfolio at the start of each year.
Here's the math:
Conclusion: If a young Canadian Warren Buffett was buying a home in Canada today he/she should definitely put only 5% down. You only require a 7.73% return after tax to match the 20% down payment scenario and Mr. B has done quite a bit better than that. Heck, if you are a couple that has worked for a few years you might even be able to tax shelter the entire portfolio between RRSP’s and TFSA’s and only require 7.73% annual return before tax over five years. On the other hand, if you are a conservative index investor that has a healthy allocation of bonds, you are much more likely to be better off putting 20% down from both a financial and emotional standpoint. And, of course, you could lose it all.
There are other important considerations. If you put less down your mortgage payments are obviously higher making your monthly cash burn rate higher. However, on the other side (and we think this is often ignored), if the family in this scenario really only has $100,000 saved and put the entire amount into the down payment they then have absolutely no financial cushion. Only putting 5% down would leave the family with a portfolio that could cover approximately 34 months of mortgage payments on day 1. With some engineers in Alberta we personally know past the 1.5 year mark of unemployment, that might not be such a bad thing.
Curiously, the 15% down payment requires the highest return, requiring a 9.37% return to beat the 20% down scenario. This is due to the jump where a 15% down payment requires a 1.8% CMHC fee while 10% requires "only" an additional 0.6% fee (2.4% total) while you have 2X the money to invest. Although the 5% scenario technically requires a slightly higher return than 10%, you would also be much better off if the portfolio is very successful as you would have a larger investment base. In turn, this is a go big or go home scenario where you either play it safe or only put 5% down.
Happy house hunting!