This attitude or preconceived notion is surprisingly prevalent in the minds of many home-buyers. In fact, it motivates potential home-buyers to consider purchasing a home because a 5% down payment is not only the most attractive down payment option, but also easier to come up with (it goes without saying!).
So what’s the problem? To understand this we must look at the process involved in qualifying for a mortgage of 95% LTV(loan to value) coupled with a 5% down payment to satisfy the full purchase price of the home. Keep in mind this process is not exclusive to the 5% down payment option, but is also applicable to any down payment option between 5%-20%:
As mentioned in our previous blog, in Canada, a “conventional mortgage” is a loan of up to 80% to the value of the property. Any mortgage loan above 80% is considered to be a “high-ratio mortgage” loan. In accordance with the Canada Bank Act, all high-ratio mortgage loans must be insured with what is commonly known as “default insurance”. But why?…This is because, in a situation where a borrower defaults on their mortgage payments, the insurance would protect the lender from any loss incurred by them as a result.
Now you may ask “what loss?… My home is still worth more than the loan that was issued to me, so this isn’t adding up!”… Well let’s take a closer look!. If you had received a loan of 95% and later defaulted on you mortgage payments, your lender is in a position to issue a “power of sale”. The lender is not interested in holding on to the property, and would begin taking steps to put the home up on the market. Often times, lenders don’t want to have the home on the market for long periods of time, and to increase the chances of a quick sale, they may list the property slightly below market value. If you combine this undervalued sale with miscellanies costs (real estate commissions, legal, etc.), the lender runs the risk of incurring a loss on the property because they didn’t have a large enough buffer to recover their investment. This is why conventional mortgages (80% or lower) don’t need to be insured; there is enough equity to act as a buffer for the lender to recover their investment in a power of sale situation.
Now that we understand why the insurance is necessary, let’s discuss the insurance itself and the process of obtaining it. Like any insurance company, the CMHC wants to keep claims low. In other words, it is undesirable to the CMHC for the following to occur: the borrower defaults on their mortgage, whereby the lender incurs a loss, to which the insurer will have to pay out the lender’s claim. To avoid this scenario, the CMHC has to be very careful when assessing the risk of the individuals applying for a high-ratio mortgage.
By now you may probably begin to understand why the 5% down payment option isn’t a realistic option for everyone. But in any case, I will continue…
The CMHC considers several things, often identical (if not always identical) to that of your mortgage application to the lender. For example, employment history, annual income, debt ratios and the credit report of the applicant/s are just a few things that are taken into account when assessing the risk of insuring the funds. The property itself is also a part of the risk assessment when determining whether default insurance will be issued or not.
You may now be able to see more clearly the process involved in being “worthy enough” to carry a mortgage of 95% LTV or qualify for a 5% down payment option. To summarize, borrowers must demonstrate that they are a low enough risk for lenders, who in-turn must demonstrate to the insurer that the likelihood of a claim is low. In a way, CMHC guidelines of approval may be more stringent than that of the lender (lenders are protected if insurance is granted, but who protects the CMHC?)
This is why we always advise our clients to avoid the “I only need 5% down” attitude, since this is an ideal option but not always realistic. Instead we advise our clients to go the conventional route with a 20% (or more) down payment, that way if you are not approved as a high-ratio borrow, you’re not out of luck. So remember, avoid the pitfalls of disappointment; if you have 20% for a down payment and it turns out that you qualify for a lesser down payment option (during the application process), at least by then you can exercise choice in considering which route to take.