It’s the question that confronts every 20- or 30-something with homeownership dreams: is it better to wait and save for a larger down payment or buy a home with what you have and get going on saving for retirement?
That’s the query Global News recently received from a millennial reader, and we’ve put it to the test.
There are intuitive arguments in favour of both approaches. On the one hand, all else being equal, having a bigger down payment and smaller mortgage means less debt, lower fixed costs and more cash-flow flexibility. On the other hand, the sooner you start saving for retirement, the more time there is for compound interest to work its magic.
But what do the numbers show when you do the math? We came up with two hypothetical scenarios. In the first one, a made-up 30-year-old buyer we’ll call Sally is making $50,000 a year and buys a $200,000 home with a 10 per cent down payment of $20,000. Sally is able to squirrel away between $5,000 and $6,000 a year for long-term savings, and once she is a homeowner, she starts putting that money into a Registered Retirement Savings Plan (RRSP).
In the second scenario, Sally waits another four years to buy the same home, this time with a 20 per cent down payment. This means that she won’t have to pay for mortgage default insurance but also that she won’t be able to start contributing to her RRSP until closer to her mid-30s.
We put Sally’s case to financial planner Jason Heath of Objective Financial Partners and asked him to run with it.
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Buy now and save for retirement or buy later with a bigger down payment?
The first thing Heath pointed out is that, in the first scenario, a 10 per cent down payment on a $200,000 home would require Sally to pay $5,580 worth of mortgage insurance. The premium is equivalent to almost 28 per cent of the $20,000 Sally paid up front for the house — a steep price to pay for not coming up with a larger down payment, Heath noted.
With a 10 per cent down payment on a $200,000 property, Sally would pay $1,028 for her mortgage, assuming a four per cent fixed interest rate amortized over 25 years. After 20 years, assuming her mortgage rate remains the same, she’d have a mortgage balance of $55,908. And assuming her home appreciated by three per cent per year, which is a good estimate of the long-term average annualized rate of return for housing, she would own a property worth $361,222.
But what if Sally had kept renting for four more years and socked away enough for a 20 per cent down payment instead?
“The quick math would suggest she’d need $20,000 more, or $5,000 per year,” Heath said. But while Sally works on her $40,000 down payment, home prices would likely keep rising. By the fourth year, the home would be worth $225,102, and she’d need $45,020 for a 20 per cent down payment. She would need to save $6,255 per year to add $25,020 to her initial $20,000.
If Sally was able to squeeze that amount of savings out of her yearly income, she’d be able to buy the house in the fifth year. By the end of Year 20, assuming she has the same $1,028.79 mortgage payment, she’d still have $64,103 on her mortgage. On the flip side, she’d have less then two years to go to be mortgage-free.
But what about saving for retirement?
Let’s assume that Sally from Scenario 1 can also save up $6,255 a year for those first four years. Since she’s a homeowner, now she starts putting the money into an RRSP. If you assume she’s using her RRSP tax refund every year to make a lump-sum payment on her mortgage, by Year 20, her balance would actually be down to only $42,880. Meanwhile, her RRSP would be $51,739 bigger by the end of the two decades.
Is it always better to buy sooner rather than later?
The answer is no. The numbers in our example show that Sally could do well by buying a home sooner rather than later, but those results were based on a very specific set of assumptions.
The numbers could tell a different story based on a number of factors, according to Heath.
“Cheap rent, low real-estate price growth, high mortgage rates or high potential investment account returns could support waiting until a 20 per cent down payment,” if one is also saving for retirement at the same time, he said.
By the same token, high rent, high real-estate appreciation, low mortgage interest rates or low savings-account interest rates may make buying now with 10 per cent down a better choice, Heath said.
He cautioned homebuyers against borrowing as much as the banks will let them — even with tighter federal mortgage rules that have lowered the size of the mortgage a Canadian can take on given their income and other debts.
WATCH: Is too much of your money tied up in real estate?
Your own lifestyle and risk tolerance are also factors to take into consideration, according to Heath.
“Two borrowers with the same incomes and same mortgage pre-approvals may well have differing abilities to cover the cost of owning a home,” he said. “A two-latte-a-day-drinking world traveller may spend more and have less cash flow to fund their homeownership costs than someone who has embraced (extreme) frugality.”
Similarly, if Sally felt comfortable placing, say, 90 per cent of her RRSP investments in stocks, she might expect long-term returns considerably higher than the interest she would pay on her mortgage. That would be an argument in favour of starting to save for retirement earlier.
Still, Bridget Casey, founder and CEO of the financial literacy website Money After Graduation, argues a 10 per cent down payment is often a solid option for millennial buyers.
There is a big difference between a five per cent down payment — the least Canadians can put down for homes under $500,000 — and a 10 per cent initial lump sum, Casey said.
For one, the cost of mortgage default insurance is considerably lower if you can get to 10 per cent down or more, she said. Second, a 10 per cent down payment is enough to keep your equity in positive territory through small dips in housing prices, she noted.
WATCH: Why deferring emptying your RRSP just before retirement may make sense
With a five per cent down payment, a homeowner would also have to borrow the amount necessary to cover a chunky mortgage-default insurance premium, which would leave the borrower with the equivalent of less than two per cent equity.
“For example, I’m in Alberta and (the real estate market) is actually down in Edmonton and Calgary right now, and it’s down more than two per cent (from a year ago),” Casey said.
By contrast, even having to borrow money to cover mortgage default insurance, a borrower with a 10 per cent down payment would have an initial equity stake of 7.2 per cent, Casey noted.
On the other hand, the advantages of getting from a 10 per cent to a 20 per cent down payment aren’t always compelling, she added. When you spread a mortgage over 25 years, the difference in the monthly mortgage payments may be small, she added.
For example, on a mortgage for a $200,000 home with a four per cent interest rate, a 20 per cent down payment would lower the monthly payment by less than $150, according to the online mortgage calculator provided by rate-comparisons site RateHub.
However, for an $800,000 home, the difference becomes a more substantial $538 a month.
Casey also stressed the importance of starting to save for retirement sooner rather than later. Because of compounding interest, a dollar saved and invested in your 20s and 30s is worth a lot more in retirement than a dollar saved in your 50s and 60s, she noted.
“Cash invested in the stock market works far harder than cash tied up in residential real estate,” she said.