We’ve all read the homeownership articles that preach the same financial advice: The best move a buyer can make is to save up 20% for a down payment to buy a home. There’s a raft of reasons as to why this is sound advice, such as avoiding mortgage insurance fees and lessening the interest you’ll pay long-term, but for most first-time home buyers saving up 20% can feel like an unachievable goal. So, what if putting 20% down isn’t the smartest move? What if there were intelligent reasons for not saving up a 20% down payment on a home?
As someone who plans to purchase a home within the next few years, I’ve struggled with the sound advice of saving up with the desire to set down roots. As a fairly savvy personal finance nerd, I want to make sure that any action I take is a financially smart action. It’s why I was more than a little surprised to learn that saving up 20% may not be the smartest option. Let me tell you why.
What happens if you put down less than 20% on a house?
Home buyers who are unable to front that hefty 20% down payment are responsible for mortgage insurance fees. Mortgage insurance was actually created by the U.S. government’s Federal Housing Administration during The Great Depression of the 1930s to encourage home buying and protect those who were seen as high-risk. Canada joined in on the idea in 1954, employing rules for homebuyers who put less than 20% down, who are self-employed or who have a poor credit history to purchase mortgage loan insurance. The insurance, which can be purchased from Canada Mortgage and Housing Corporation (CMHC), Genworth or Canada Guarantee Mortgage Insurance Company, is protection for the mortgage lender in case of default or missed mortgage payments.
The premiums for this insurance work on a sliding scale decreasing as you put more of your money in as a down payment. The premiums range from 0.6% to 4.5% of your total mortgage and can be either added to your mortgage or paid in one lump sum by the homebuyer. Keep in mind, home buyers in Ontario, Quebec and Manitoba, will also have to apply provincial sales taxes to the premium. To calculate the premium, mortgage lenders take the price of the home minus your down payment. From there, they multiply the remaining mortgage by the insurance premium.
“There is a huge stigma from our parents and people who have been in the industry for a long time regarding the necessity of paying insurance premiums on high ratio mortgage loans,” says Mike Bricknell, mortgage agent for CanWise Financial. “These fees are seen as a waste of money.”
However, this sentiment doesn’t always translate when you actually look at the financial implications. As a result, Bricknell advises all his clients to do the math with a mortgage professional who has your best interest at heart.
He explains that for the vast majority of lenders, a buyer who puts 20% down can actually be a greater risk for the bank. “The government is no longer backing the loan with the insurance,” says Bricknell. For those who put less than 20% down on a home, this can mean you’re blocked from accessing the lowest rates currently in the mortgage loan market. “Lenders will often take on the mortgage, but may also purchase the insurance in order to minimize their risks. This added cost is then passed down to the borrower.”
Bottom line: Putting less than 20% down can actually save you money in the long term, even after you add in the mortgage insurance premium fees.
For example, let’s assume a Toronto home buyer puts 19% down on a $650,000 home. The lender offers a five-year fixed mortgage at a rate of 3.29% and a mortgage insurance fee of $14,742 is added to the mortgage. Over five years, and assuming no additional monthly payments, this buyer would pay almost $66,500 in interest. What if that same buyer decided to put 20% down. She wouldn’t have any mortgage insurance fees to pay but her lender’s best rate is 3.74%. Over the course of the same five years, this home buyer would spend just under $72,300 in interest.
Bottom line: It cost the buyer more to borrow because they put 20% down on the property rather than 19% — this was true even after factoring in the extra mortgage insurance fees.
So, what’s the sweet spot for anyone looking to put less than 20% down? According to Bricknell, it’s 10%. When a buyer puts down 10%, they get the most significant reduction in mortgage rate premiums.
If you’re worried about putting less than 20% down on a home, there are some perks. “If you go with Genworth for your insurance they have homebuyer privileges that include savings at the movies, car rentals and more,” said Bricknell. Those small advantages can help homeowners save money on their typical monthly expenses and relieve stress.
How do homebuyers make a decision?
For first-time home buyers, the decision seems to be based on timing and the total cost of the property they are interested in buying. Desirae Odjick and her fiance spent more than three years researching and house-hunting for their ideal place. However, getting pre-approval and taking possession of their 4-bedroom detached home in Ottawa took a week. “We only started to really look after we’d saved up 10%. It meant that we could jump on a property at any time, or just wait and continue to save,” says Odjick. The couple had considered tapping into her RRSP and taking advantage of the first-time Home Buyers’ Plan (HBP) on top of their cash savings but felt it was more responsible to put less down and leave her retirement savings intact.
Another reason they felt 10% was appropriate for them was that they’d have more money available for closing costs as well as any future financial emergencies. It was a smart move. When all was said and done their total cost to purchase, including down payment, closing costs and miscellaneous fees were about 25% of the total cost of the home.
But what about those fees? Paying the mortgage insurance costs didn’t scare Odjick or her fiance away. After rolling this extra cost into their mortgage, Odjick said that “over the longer period or a 25-year pay off period, the cost is really marginal in terms of what your monthly payments are.”
On the flip side, there are some who are less privy to the idea of spending extra money on mortgage insurance, when they could be putting that money towards their mortgage. Miranda Russell and her husband took possession of their Calgary home in April 2017. The couple put 23% down on their suburban new-build — their primary reason was to avoid having to pay mortgage default insurance. “When you looked at how much it would have cost, the extra insurance totalled a full year of mortgage payments,” says Russell.
Don’t be afraid of the high-ratio insurance premium
The reality is that many first-time homebuyers are left with few options when trying to break into the market. If you’re plagued by this fear, Bricknell suggests “speaking to a mortgage professional to determine the best option.” While online calculators are great, they don’t always give you every detail that matters.
Armed with this new knowledge, I’m pleased to readjust my down payment expectations. While my husband and I continue to save (with a goal of 20% down) we are no longer tied to the idea that we cannot make a move if we have less than a fifth of the property purchase price as a down payment. Turns out we’re already in that 10% sweet spot — a place I once considered a danger zone.