With Ontario home prices rising considerably over the past year, many homebuyers are pursuing new and creative ways to get into the real estate market.
Many have left big metros in favour of more affordable towns — sometimes 3-4 hours away — while others have discovered fractional ownership, which allows them to purchase a portion of a property.
The big hurdle for many buyers, however, remains the down payment. Typically between 5% to 20% of the purchase price — which, on a $500,000 home, amounts to $25,000 to $100,000 — a down payment often takes years to save.
But what if you didn’t need to pay this lump sum all at once and out of your personal savings? Below, we’ll take a look at the alternative methods to fund your down payment, when it may make sense, and what to consider before taking this route.
The Alternatives
There are a few creative ways to finance your down payment:
Gift Letter
In a previous article, we talked about how homebuyers, to beef up their down payment and avoid the stress test, borrowed from the “Bank of Mom and Dad.” This means that their parents did two things: 1) gave them money and 2) provided a written statement to the bank stating that these funds DO NOT need to be repaid. A financial gift from an immediate family member accompanied by such a letter allows you to cover part or all of your down payment without impacting your purchasing power (debt-to-income ratio).
RRSP
Through the Government of Canada’s Home Buyer’s Plan (HBP), first-time buyers can leverage up to $35,000 of their RRSP contributions ($70,000 for a couple) tax-free for a down payment. More details here.
Line of Credit
You may be able to use funds from your line of credit (either personal or home equity) to subsidize your down payment as long as your debt ratios remain in check.
Personal Loan
This involves borrowing from a lender — or possibly friends or family who may offer more favourable interest and payment terms (though borrowing money from friends can lead to uncomfortable situations).
Credit Card
This is last on the list for a reason. While possible, this is not ideal as your interest rates will be sky-high.
Requirements
As you can see, your down payment doesn’t vanish in any of these scenarios; you’re simply borrowing the funds to pay for it. Aside from a financial gift, these options equate to increased debt and, thus, more payments you’ll need to make.
You’ll want to make sure of the following before taking on added debt:
- Your income is solid, stable, and substantial enough to handle more debt comfortably
- You have great credit: a score above 680, but ideally 750. Mortgage lenders will look at this very carefully during the approval process.
Should You Do It?
Let’s assume you’ve checked all the boxes and are able to subsidize your down payment by borrowing. The next question is “should you do it?”
Here are some pros and cons to consider:
Pros
Equity Gains: Mortgage Paydown
When renting, 100% of your money goes to the landlord. By owning, and paying down your mortgage, you’re putting money back into your pocket in the form of home equity. There are additional costs of homeownership you’ll need to add to your calculations, but mortgage paydown alone may be worth entering the market earlier than later.
Equity Gains: Appreciation
In addition to making equity gains by paying down your mortgage, you’ll likely gain equity through home value increases. While many homeowners gained up to 30% or more over the past year, that’s far from normal. We recommend using a much more conservative multiplier, between 3-5%, to gauge your potential appreciation earnings. Even at that pace, your gains would be substantial.
Avoiding Mortgage Default Insurance
This needs to be paid on all mortgages with a down payment under 20% (in the form of added mortgage payments + PST which needs to be paid upfront). If you need to borrow a bit to escape the premium, that alone could be worth the cost of borrowing. You can calculate your potential savings here.
Cons
Increased Exposure
Any time you take on more debt to invest, you’re increasing your exposure in the event that you encounter unforeseen financial hardships — something you should ALWAYS factor into your calculations and decision making.
Higher Monthly Payments
If you’ve increased your debt through alternative funding, you’re likely paying a higher interest rate than that of your mortgage. Even if the rates are the same, added debt will equate to higher payments each month. Can you stomach it?
Weakened Equity Position
By financing most or all of your home, you will — and for an extended period of time under normal market conditions — have relatively little ownership of your home. This leaves you little in the way of flexibility if you, for example, need to draw funds from a home equity line of credit.
Other Considerations
When evaluating any investment, it’s important to understand not only your ability to invest and your risk tolerance, but also the opportunity costs involved:
- What equity and appreciation gains could I miss out on if I wait five years to enter the market?
- Down payments will keep rising as home prices rise. Will my savings keep pace with the market?
And, within the context of this conversation, you may also want to consider alternatives that require LESS debt. This could mean purchasing a smaller home, like a condo, instead of maxing out your budget on a townhouse, semi, or detached home, and enjoy some more financial flexibility while reaping equity gains.
Or, if you’re looking for an investment property, you may wish to partner with a like-minded and financially stable family member or friend.
In any case, taking on additional debt should never be taken lightly. While this article highlights some of the possibilities and considerations, the best way to clearly understand your options and what makes the most sense is to consult with an experienced Realtor as well as a mortgage advisor.
