In Canada, if you buy a house and have less than a 20% down payment, you have to pay a CMHC (Canada Mortgage and Housing Corporation) fee to insure the mortgage. It should be the goal of all home buyers to have a larger down payment, but it’s not always possible.
One scenario is where someone has enough money to make a 20% down payment and is wondering if they should use all the money for the down payment or put down a smaller down payment and use the extra cash for other things. Another scenario is where a buyer is close to reaching 20% down payment and only has to borrow a small amount of money to reach 20%. Should they do it?
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I can think of three examples where a person bought a house with a smaller down payment, even though they had enough money or means (via borrowing) to reach the 20% necessary in order to avoid the CMHC fee. One blogger shall remain nameless, the other person was me (12 years ago) and the third person is a blogger at Moneyville, which is owned by the Toronto Star. I’m going to use Madhavi (the Moneyville blogger) as my example, only because she is the most recent.
Madhavi and her family owned a condo, which they sold and bought a family house. They netted $115,000 from the condo sale and bought a house for $560,000. 20% of $560,000 is $112,000, which means she could have put down a 20% down payment and avoided the CMHC fee.
Instead she decided to use roughly half of the money to pay down debts ( a worthy use ) and only put down a 10% down payment.
The problem with only paying a 10% down payment is that you have to pay the CMHC fee. Does that mean she paid a big fee just to consolidate some unsecured debts?
She mentioned in the article that the CMHC fee was $12,000 including tax. Had she put down $115,000 down, the CMHC fee would have been zero since mortgages with a 20% down payment or higher do not require insurance.
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By using a smaller down payment, Madhavi was able to reduce the interest rate on $59,000 of debt. If we’re going to analyze the wisdom of paying a $12,000 fee, we have to include the interest cost benefits as well.
The average interest rate of the unsecured debt that was paid down was not mentioned, but she did say that $45,000 of it had interest rates from 6% to 10%. For argument sake, let’s assume that the average interest rate of all the $59,000 debt she paid off was 4% higher than her mortgage rate.
In other words, she paid $12,000 to decrease the interest rate of $59,000 of debt by 4%.
As to whether this was a good move or not – we have to consider how long she would have taken to pay off the $59,000 of unsecured debt, had she not used part of her down payment money to pay it off.
4% interest on $59,000 for one year is $2,360. If she doesn’t pay the principal down at all – it will take five years for the interest saved to equal the CMCH fee. After that, she will have saved money by using a smaller down payment.
If she would have paid down the $59,000 quick enough to keep the total excess interest (4%) cost below $12,000, then she would have been better using 20% down and avoiding the CMHC fee.
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Of course, it’s impossible to know what the future holds, but I would suggest that in Madhavi’s case, it’s likely that paying a smaller down payment and paying the CMCH will have a neutral or positive outcome.
The reason I say that is because if you buy a house when you have a lot of unsecured debt (at least $59,000 in Madhavi’s case) and it appears that the house cost itself is a stretch – I don’t think it’s likely that they would be in a position to pay off extra debt very quickly.
Had they put 20% down and saved the CMHC fee, they would have had higher monthly payments, probably would have taken quite a while to pay down the unsecured debt and would have paid more in extra interest than the CMCH fee cost.
What if I don’t have any or much unsecured debt and have to borrow to reach 20%?
Madhavi bought a house with a huge amount of unsecured debt. I suspect it is more common for people to buy houses who have little or no debt (other than an existing mortgage). For this scenario, the numbers change quite a bit and it is a lot more likely that if you can borrow enough money at a reasonable rate to make the 20% down payment, you will come out ahead.
Related: 11 things to think about when buying a house
What if I have the 20% down payment, no debt, but need some money for other things?
If you have the cash for 20% down payment already and little or no debts – it’s a no brainer. You must use the cash for the down payment and then just borrow any money you need for closing costs, furniture etc.
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I have always been a firm believer in putting a good chunk down to avoid cmhc, but at the same time it’s nice that people starting out have that option.
Can someone explain to me how that 20% limit works. From my understanding there are laws for minimum down payment on a mortgage that force borrowers to take government insurance if they don’t meet the minimum. However, banks seem to circumvent these laws by allowing borrowers to put the down payment on a credit line. As a borrower, it doesn’t make much of a difference if I have mortgage vs credit line debt. What is the point of this law if it is so easily circumvented?
You can chalk up a fourth example to your list Mike, although I have some fairly unique circumstances I think. In order to secure a teaching job I moved to a rural area in Manitoba. The rent in the areas was consistently at around $500, and I found a great house for $95K (gotta love rural MB prices). As I was just coming out of school, I could only squeeze out 5% since I had various other costs. Because of the low purchase price the CMHC was just over 2K I believe. The house has since shot up in value due to a recent surge in natural resource-related jobs in the area, so that alone has made me look smart. Even if that hadn’t happened, the costs of moving if I had rented for a year or two (while building up my homebuying fund), in addition to the capital I have built up through my mortgage, and the benefit of having a higher standard of living has been well worth it. The ironic part is that I routinely advise people (albeit in much different circumstances) that they should probably save to avoid CMHC when I myself crossed this infamous personal finance line.
I think a few key things were missed here:
1. Either way, the debt she has to pay down (whether the personal or the mortgage) collects interest. The personal is over a shorter period, but a higher rate. The mortgage is a longer period, but most likely a lower rate. Paying off the personal versus the mortgage doesn’t change her total debt, it just changes the piles of debt.
Then she added $12,000 of CMHC to her debt by not putting 20% down on her residence. She probably looked at the $12k as $6 a week for 25 years (whatever the amount is) and thought of it as trivial rather than looking at it as a whole.
2. The interest calculation doesn’t taken into account time value of money. She needelesly increased her debt by $12,000 now to save interest over a future period, and the payback would be more than 5 years. Doesn’t make sense to me.
TM @ Y&T – That’s a great example. In lower priced real estate areas, or “eras” as the case may be, the CMHC fee might not be enough to worry about.
@Stephen – It makes sense to pay the $12,000 fee if the extra interest from the unsecured debt she doesn’t pay off (because she uses all her cash for the down payment) exceeds the $12,000 fee. And yes, I did ignore the time value of money for simplicity. This financial model is so rough, it’s not worth worrying about the details.
When I bought my condo in late 2010, I did the opposite of Madhavi… to avoid paying CMHC fees, I actually added $12K to my credit card debt (uh, I mean, I “chose not to pay down my credit cards,” just in case the bank is listening). Hitting 20% down saved me about $1600 in mortgage insurance fees. I figured I’d pay off the $12K over two years, at a 9% spread over my mortgage rate. About a thousand bucks. But then I kept getting balance transfer come-ons on the CC, so in practice it’s only costing me about $400 (i.e., I’m saving $1200). I would do it again. Or I’d get smart and not shop until I had the 20% in hand…
I agree with Stephen, you didn’t take into account the fact that the portion that was taken off of the $59000 would have been added to the mortgage at a rate of at least 3% interest.
My family(husband and kids) saw our dream home. we all love it. It has been on the marketS(on and off for a few years) During this time, it was up for sale twice, but the families were not approved for their loans. We gave our preapproval offer for 150,000 Then our realtor told us that they had a couple that saw the house and was going to put up a preapproval offer next week. They told us to submit our final bid on sunday. Then they will let us know. What are they doing? My husband thinks the realtor just wants us to increase our bid. Call me gullable, but i want this house. we can afford it. Tomorrow is sunday and I am scared. My husband only wanted to bid 158,000. I Wanted to bid 160,000. So we put in 158,000. The listed price was 169,000. I know I do not want another house if I do not get this one………… I guess they will let us know . Has anyone had this done to them?
@Marc – Yes, I did take that into account. That’s why I only looked at the “extra” interest which is the difference between the interest rate charged on the $59k and the interest rate of the mortgage.
@Gerard – Sounds like you saved some decent money with that strategy – kudos!
@nessie – Yes, that happens all the time. It’s possible that the realtor is making up stories, but it’s also very likely that there are other potential buyers who wait until someone else is making an offer to make an offer themselves.
Here’s one thing that you did not take into account. Several lenders will only give you the deep discounted interest rate if the mortgage is insured. For instance , a 5 year fixed rate mortgage would be 3.09% if it was insured. Conventional mortgages with the same lenders have an interest rate of 3.19% . Why? the investors who buy the mortgages see uninsured mortgages as being riskier and demand a higher interest rate. If she was using a mortgage company she may have saved money on the interest rate. However, over a 5 year term she would only have saved $1440. by getting the lower rate.