First time home buyers are a driver for the housing market. Typically, young people are anxious to realize the dream of home ownership, are compelled by the pressures of low borrowing rates, and motivated with a common belief that ‘prices will only go up’.
The First Time Home Buyer
To purchase a home a first time home buy is required to save a 5% down payment. And, once they meet all the borrowing criteria they receive the mortgage. Naturally, it will be subject to a hefty mortgage loan insurance premium because it is a high ratio mortgage.
First Time Home Buyer Option #1
We will take a $400k home as an example. Our first-time buyer has $20,000 down and with a 5% down payment. They will be charged an insurance premium of $15,200.
In addition to the insurance premium our first-time home buyer may incur expenses for legal fees, land transfer tax and other miscellaneous closing costs.
On this $400,000 home, $20,000 down, $15,200 insurance premium the homeowner will end up with a first mortgage of $395,200. Owing 98.8% of the value of the home to the bank.
No need to worry, housing prices only go up.
Monthly payments would be $1,768.40 at 2.49% over 25 years.
With recent incentives for first time home buyers, having the government share the risk of future property valuation makes it that much more attractive to borrow. For the dream of home ownership. This incentive is essentially a second mortgage on your home. Of course, only for those of us who have never had a first mortgage.
First Time Home-Buyer Option #2
Again, we will take a $400k home as an example.
To purchase this home and apply for the incentive the new home buyer will need a minimum income of $100k per year income with no other borrowing.
This buyer chooses to purchase New Construction. Subsequently, this first-time buyer can maximize their incentive amount at 10% toward the down-payment.
The buyer has a mortgage pre-approval (the first mortgage) and meets all other eligibility requirements including the buyer having $20,000 for down payment. Or, 5%.
Our first-time buyer now receives $40,000 in incentives. This incentive is a shared equity mortgage (the second mortgage). Now, with a total down payment of $60,000. Or, 15% down.
The Catch
However, there is a catch. The first mortgage is subject to mortgage loan insurance premium and the incentive does not reduce this premium.
On this $400,000 home, $60,000 down which includes $20,000 cash from the home owner, with $40,000 incentive from the shared equity mortgage; and, $15,200 insurance premium.
So, the homeowner will end up with a first mortgage of $355,200; and, a second mortgage of $40,000 due at some point in the future. For total borrowing of $395,200 or 98.8% of the value of the home.
Monthly payments would be $1,589.41 per month at 2.49% over 25 years.
The Benefit
The main benefit of this incentive to the homeowner is the short-term reduction of monthly payments by $178.99 per month. The lower monthly cost is due to the lower first mortgage amount. Of course, no payments are due on the second mortgage until the home sells. Or, the mortgage is collected for some other reason.
The Long-Term Scenarios for Option #2
Three scenarios are required to see how this works over the 25-year life of the mortgage.
Hence, we will assume no changes in interest rates. Additionally, no fees are collected due to mortgage refinancing in this time period.
Scenario 1
At the time the home sells, 25 years after purchase with no mortgage owing, the home is appraised at a value of $400,000. The second mortgage is now due at $40,000.
Therefore, the homeowner walks away with $360,000 in equity.
The total mortgage interest paid over 25 years was $135,319.
Scenario 2
At the time the home sells, 25 years after purchase with no mortgage owing, the home is appraised at a value of $300,000. The second mortgage is now due at 10% of the appraised value. Or, $30,000.
Therefore, the homeowner walks away with $270,000 in equity.
The total mortgage interest paid over 25 years was $135,319.
Scenario 3
At the time the home sells, 25 years after purchase with no mortgage owing, the home is appraised at a value of $500,000. The second mortgage is now due at 10% of the appraised value. Or, $50,000.
Therefore, the homeowner walks away with $450,000 in equity.
The mortgage interest paid over 25 years was $135,319 on the first mortgage plus $10,000 in increased equity owed for the second mortgage.
Thus, for a total mortgage cost of $145,319.
Home Ownership vs Rental Comparison
For comparison, we will look at the option of renting.
Assuming rent is $1200 per month, which is extremely low on price-to-rent ratio. And so, a renter will pay $360,000 to live in this home for 25 years. Additionally, the renter walks away with no equity.
Market Variable Impact
Interest rate increases would change the cost of borrowing vs. renting.
Interest rates would need to reach and remain at 5.90% for the 25-year mortgage term for the mortgage interest to be comparable to the cost of rent.
However, the renter never realizes the benefit of equity.
Out Of This World Option Home Purchase With Cash
For an out of this world comparison let us look at another option.
Mr. and Mrs. Thrifty, earning a combined income of $100,000, decide they are going to own a home without borrowing.
Above all, they have managed their expenses, budget and have no debt. Additionally, they are currently renting for $1,200 per month including utilities. Finally, their landlord can increase their rent by 2.5% once every twelve months.
Our Thrifty couple set a goal to purchase a $400,000 home with cash in 7 years. To do this they will put away a total of $4,761.90 each month into their TFSA. A self-managed TSFA where they purchase a low-fee stock index fund.
Assumptions
While, for this example we will not calculate the total they could potentially earn with investments. So, we will assume after 7 years of savings there was no loss of principle and a slight return on investment. This gives them enough to cover closing costs and land transfer tax on their $400,000 home. Additionally, we will also assume the home has not appreciated in value.
Mr. and Mrs. Thrifty see the 2.5% rent increases each year from their landlord. And, spend a total of $108,683 on rent in the 7-year period. The time it takes them so save the $400,000 to purchase their new home.
Thrifty Wins
Mr. and Mrs. Thrifty spend a total of $108,683 in rent while they saved to purchase their home. However, no interest expenses were incurred. In contrast, after only 3 years living in their first home. Even more, while continuing to save $4,761.90 per month, they sell their first home for $400,000.
Mr. and Mrs. Thrifty end up walking away with $400,000 in equity.
In fact, Mr. and Mrs. Thrifty purchase a much larger house with cash from a combination of savings and equity. Naturally, the couple continue to save monthly.
Feeling At Home?
Being a first-time home buyer has never looked better for the borrower. With a little patience and discipline there are other options.
We encourage you to make choices that create options. See this post.
Other items to note: The lawyer closing on a second home is closing 2 mortgages. As a result, fees may increase.
Further, (buyer be warned) there may be additional fees incurred through home ownership when switching to a new lender or refinancing a first mortgage.
Whatever happens, if you are a single income household you should have life insurance to protect your family home. In the event that, there is an unexpected life event.
Additionally, all of our posts in the Personal Finance Series can be found here.
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