In 2023, and the ever-evolving real estate market, it’s crucial to address common misconceptions that can impact home buyers’ decisions. While we touched on this topic in a previous blog, recent conversations with our clients have highlighted the need to revisit the “I only need 5% down” attitude. In this updated article, we aim to provide a refreshed understanding of the challenges associated with a minimal down payment and shed light on the industry dynamics that affect mortgage qualifications.
The Down Payment Dilemma: The allure of a 5% down payment option persists among potential home buyers due to its attractiveness and perceived ease of affordability. However, it is crucial to recognize the underlying complications involved in qualifying for a mortgage with a 95% loan-to-value (LTV) ratio, irrespective of the down payment amount (ranging from 5% to 20%).
Understanding Conventional and High-Ratio Mortgages: In Canada, a “conventional mortgage” refers to a loan covering up to 80% of the property’s value, while anything above 80% falls into the category of a “high-ratio mortgage.” According to the Canada Bank Act, all high-ratio mortgage loans require “default insurance” to protect lenders from potential losses in case of borrower default. This is even more important today, given home prices in Canada (May, 2023).
Why Default Insurance? To comprehend the need for default insurance, it’s essential to consider the consequences of mortgage default. If a borrower defaults on their payments, the lender has the authority to initiate a “power of sale” process, whereby they seek to sell the property to recover their investment. To facilitate a swift sale, lenders may list the property below market value, leading to potential losses when combined with additional costs such as real estate commissions and legal fees. Conventional mortgages, with their lower loan-to-value ratios, eliminate the need for insurance as there is sufficient equity to serve as a buffer for the lender.
The Role of Default Insurance: Now that we understand the necessity of default insurance, let’s delve into the process of obtaining it. Just like any insurance company, the Canada Mortgage and Housing Corporation (CMHC) aims to minimize claims. Consequently, the CMHC evaluates the risk associated with individuals applying for a high-ratio mortgage meticulously.
Risk Assessment Factors: When assessing the risk of insuring a mortgage, the CMHC considers factors like those evaluated by lenders during the mortgage application process. Employment history, annual income, debt ratios, and credit reports are just a few examples of the criteria used to assess the likelihood of default. Furthermore, the property itself is also scrutinized as part of the risk assessment process.
The Reality of the 5% Down Payment: By now, it should be evident that the 5% down payment option is not a viable choice for everyone. The stringent guidelines set by the CMHC make it challenging for individuals to qualify for a mortgage with a 95% LTV ratio. It is vital for borrowers to demonstrate low risk to lenders, who, in turn, must prove to the insurer that the chances of a claim are minimal. This dynamic often results in CMHC approval criteria being more rigorous than those of the lenders.
A Smarter Approach: Instead of fixating on the “I only need 5% down” mindset, we encourage our clients to pursue the conventional route with a 20% or higher down payment. This approach ensures that even if they don’t qualify for a high-ratio mortgage, they still have viable alternatives. By having a 20% down payment, individuals retain the flexibility to consider different options during the application process, mitigating the risk of disappointment. Also, with 20% down, banks can introduce a little more leniency to underwriting making it more likely to be given exceptions where needed.
Having said all that, some people will face the challenge of savings 20% down, especially when trying to buy a home in 2023 and onward. Let’s face it… 20% of a $1,000,000 home today is just not easy. And, even if you don’t have 20% down, there are options that we’re happy to explore for you.
Let’s talk through it and figure or what your maximum affordability is under multiple scenarios. Call us today at 905-455-5005