If you plan to buy a home, you know that it comes with more than a few steps, including the ones you’ll walk up to get to that dream master bedroom with ensuite. First and final dad joke. Pinky swear.
The most important step to achieving homeownership is saving up that big lump sum down payment fund. Not only is this five-figure savings goal the only thing standing between you and your future house, but it’s daunting — particularly when the sum is somewhat comparable to your annual salary, if not more.
It takes the average Canadian five to seven years to save enough money for their down payment. Of those savers, 42% keep their money in a high-interest savings account. This conservative option isn’t a bad place to store your down payment fund, but that doesn’t mean it’s a good option, either. True, it all depends on your personal situation, but after years of discussing, researching and thinking about this topic, I’d argue that a high-interest savings account is one of the least-best options when saving for a down payment on a home. I’ll tell you why.
How much money do you need to save for your down payment?
Saving up to buy a property is far from an easy task. Saving your money can be a frustrating and time-consuming activity. To help, you need to set a realistic goal — a sum of money that will allow you to purchase a home and qualify for a mortgage.
To calculate how much you need to save for your down payment fund, it’s a good idea to take a look at the minimum amount of money required to achieve your goal of homeownership.
Based on these numbers, it’s always smart to check out the average cost of homes in your city (and even in specific neighbourhoods). To get a realistic sense, target homes that align with what you desire as far as wants and needs. From there, you can estimate how much you might need for a down payment.
But that quick calculation isn’t enough, says financial expert, Kelley Keehn. While not having a large-enough down payment is a common problem, other issues include a desire to buy more home than a person can afford, and not having a substantial enough net worth. So, remember to be realistic in your homeownership goals.
Most financial experts will tell you to put 20% down on your mortgage because if you don’t, you are required to pay mortgage default insurance fees as a lump sum or add these extra fees to the mortgage debt from your lender (and pay it off as part of your monthly mortgage payments). The insurance, which can be purchased from Canada Mortgage and Housing Corporation (CMHC), Genworth or Canada Guarantee Mortgage Insurance Company, protects the mortgage lender in case of default or missed mortgage payments. That means your lender is protected if you default, not you. Lenders are required by federal laws to purchase mortgage default insurance whenever a home buyer puts down less than 20% on a property purchase — and your lender will pass those costs on to you, the home buyer.
Mortgage insurance is only available when the purchase price is below the $1-million mark, which is why you can no longer put less than 20% down on those higher-priced properties. If homebuyers don’t have mortgage default insurance, they typically aren’t willing to take the risk.
Mortgage default insurance premiums are calculated based on the amount of money you decide to put down, from 5% to 19.99%, in addition to the amortization period you choose.
Where can you save your down payment fund?
Great. Now that you know how much to save, you’ll have to figure out where to put the money. The options should be different depending on where you are in the saving process. If you are just starting your plan to buy a home, your options should be more aggressive. This way, you sit on a lump sum and are ready to buy as soon as the right home comes along. The key is to maximize the growth of your down payment fund without taking unnecessary risks. So, what are the options?
1. High-Interest Savings Account
This type of savings account pays more interest than your typical savings account from the bank. Typically, these accounts offer a return of 2% to 3%. Remember to review a variety of banks to see which offers the highest rates, and to verify the different fees and features of each account.
Pro: Guaranteed investment, easily accessible
Con: Low rate of return
2. Registered Retirement Savings Plan (RRSP)
The Canadian government started the RRSP Home Buyers’ Plan (HBP) in 1992. Those who contribute to their RRSP — and never owned property or lived with a partner who owned property anywhere in the world — can apply for an interest-free loan under the federal government’s Home Buyers’ Plan. The advantage of an RRSP is that you can invest your money in stocks, ETFs and bonds — there is a large list of qualified investments that can be held inside an RRSP. As of 2019, the withdrawal limit is $35,000 for each person, which means that couples can potentially withdraw $70,000 to help with their down payment fund. Once you withdraw this money, you have 15 years to repay the loan from yourself, interest-free.
Pro: Borrow money tax-free with no penalty
Con: Potential loss of up to 15 years of tax-sheltered growth
3. Guaranteed Investment Certificate (GIC)
A GIC is similar to a savings account in that you deposit money and earn interest. Money in a GIC must be left in the product for a specified amount of time. Typically, financial institutions hold GICs between one and five years, and in exchange, you will earn interest. In the end, you get the entire amount you deposited plus the interest. The average rate of return on this type of investment is between 2% and 4%.
Pro: Low-risk short-term investment
Con: Low rate of return
4. Tax-Free Savings Account (TFSA)
The TFSA was introduced by the Canadian government in 2009. A TFSA is a place for you to earn money from the places you invest within the account tax-free. Because a TFSA is an investment account, you can choose the type of investment product you want to hold, including (but not limited to): GICs, mutual funds, ETFs, stocks, even high-interest savings accounts. As of 2019, the annual contribution limit for this account is $6,000. Unused room within the TFSA can be carried forward, which means if you don’t currently have a TFSA, you can contribute up to $63,500 in 2019. Money can be withdrawn from this account at any time with no penalty.
Pro: Flexible and tax-sheltered growth on investments
Con: Once the money is withdrawn, you cannot replace those funds until the following year
5. Money Market Fund
Money market funds are similar to that of a mutual fund. A money market fund is invested in short-term instruments such as cash and cash equivalents. With a timeframe of less than one year, this type of fund offers very liquid money available for spending, with little risk. Although money market funds offer slightly better interest rates than financial institutions, they are also sensitive to interest rate fluctuations. It’s best to use this type of account as a short-term home to hold the money before investing elsewhere.
Pro: Low risk, liquid investment
Con: Low rate of return and rates vary
To decide between each of these investment vehicles or products, it’s best to understand your goals, your timeline and your risk. Understand that accounts allow you to store a variety of investments, whereas products are a single savings vehicle.
“There are thousands of savings options for Canadians and “safe” is a relative term,” says Keehn. “Even low-risk investment options like GICs have risk.” In other words, what works for one person may not work for you. So how can you decide? I’ll tell you.
How can you assess your risk tolerance for short and long term saving goals?
When you plan to buy a home, it’s crucial to sort out your timeline. Typically, short-term savings are money that will be spent in the near future, whereas long-term savings are money you won’t touch for greater than three years.
Both of these types of financial goals are important to have, but it’s even more important to identify these goals to determine how you can passively maximize your return on this money. In other words, how can you put that money away and then pretend it doesn’t exist but have complete confidence that it’s earning interest?
For a down payment fund, a good approach is the five-year-rule. In short, if you plan to purchase in the short term — less than five years from now — you should have your money easily-accessible. If you plan to purchase in the long term — greater than five years from now — you should invest your money for the highest possible return.
Your timeline will dictate where you save your down payment fund. A good self-assessment of whether or not your timeline allows for you to save your down payment fund into investment accounts will make the process much simpler.
If you have less than five years until you plan to buy a home, you should be more conservative with your money. While earning a return on your savings sounds great, it may not be worth the risk if it means eroding the money you’ll need for a down payment. You need to have the right amount of cash available and the ability to access that money at any time, which means it’s quite the risk to keep this fund in stocks.
“A simple guideline is to stick to guaranteed investments, shop around, Google the highest savings account rate and find out about financial institutions with the best offerings,” says Talbot Stevens, financial educator and author.
The best options to save your down payment fund if you plan to buy a home within the next five years are high-interest savings accounts, a GIC, your TFSA and your RRSP. Do your research to find a financial institution that has a higher rate of return if you still want to maximize your earning potential.
If you have more than five years until you plan to buy a home, you have a lot more flexibility with where you can store your down payment fund. Most financial experts would share that you should have some of your money in that equity building investments.
Places like individual stocks, ETFs, mutual funds, pooled funds and accredited investments are great options. But, something important to consider in this situation is your personal risk tolerance. If you invest this money, the market cycle is typically seven to nine years, and in that time you should anticipate one major dip and one major run-up and you cannot anticipate when these fluctuations will occur.
“In the long-term, these markets should give a higher return than the 2% or 3% you’ll get in guaranteed rates,” says Stevens. “On the flip side, be prepared for the reality that It might be less. Part of investing is that you have to be able to come to terms with that.”
At the start of my financial journey to save a down payment fund, I had a majority of my funds invested in stocks within a TFSA. As we got one to two years out from buying a home, we moved most of our down payment fund into high-interest savings account for safe-keeping.
Luckily, when our money was invested, we didn’t take any big hits. Although it was a risk to invest our savings, it also helped us get closer to achieving our goal of homeownership at a faster rate than it may have if we didn’t choose this option.
Even before you buy, homeownership takes a ton of financial preparation and planning. For me, money that sits stagnant is never the best way to make the most of your hard-earned money. If you are aware of your timeline, it’s always a good idea to use that time to your advantage.