November 26, 2007
How much should we spend?
For just about everyone, your home will be the cornerstone of your financial future. So it’s no great surprise that, with its barrage of reality television shows devoted to house hunting and home renovation, HGTV has made home ownership into something of a recreational sport. Of course, the cameras conveniently turn off when it comes time for the daunting decisions that seal the deal. Figuring out exactly how much house you can afford, and finding a mortgage that won’t crush you, might be the most important financial decisions you’ll ever make.
The first question obviously has everything to do with how much money financial institutions are willing to lend you. And that, in turn, depends on your income and how much debt you already owe.
In loose terms, the amount of mortgage you can afford will be equal to about four times your gross income. It’s more of a rule of thumb because obviously everyone is different. But an average person with a middle income and $2,000 in outstanding credit card debt will be at the four times mark.
More specifically, mortgage lenders such as the big banks will tally up your potential home ownership costs, like principle and interest payments on your mortgage, property taxes, utilities and any condo fees. Most lenders want to see those costs add up to no more than 32 per cent of your gross monthly income. Next they will add on how much other debt you owe each month, such as credit cards and car payments. Taken all together, your total debt service ratio (TDR) must not be more than 40 per cent of your income. So, for instance, if your gross household monthly income is $5,000, then the amount you owe for your house and other debt must not exceed $2,000. If your TDR comes in high, then you have to either cough up a larger down payment, or consider buying a cheaper house.
But even if you do have enough money to borrow the maximum, that doesn’t necessarily mean you should. A lot depends, of course, on where you are in life. A couple with no kids and few debts will be fine taking out the maximum mortgage. The problem is, lenders don’t always factor in costs associated with raising children. That’s an issue that isn’t looked at by the banks. A couple with children might want to ease back on how much they borrow. That could mean aiming for a total debt ratio in the low 30 per cent range instead.
Before signing your life (savings) away for a roof full of shingles, some bricks and drywall, you may want to plug the pertinent numbers into a mortgage calculator (all the Big Banks have them on their web sites), like this one. At least now you’ll know, when all the paper work is done, if you’ll be able to afford mini-blinds.
Having figured out how much you can borrow, the next big decision is whether to lock in interest rates with a fixed-rate mortgage or opt for one with rates that float. There is no magic answer. Financial advisers will tell you that over the long run variable mortgage rates, which swing over time according to cuts and hikes made by the Bank of Canada, tend to be the cheaper way to go.
But it really depends on how comfortable you are with risk. Say inflation jumps in the coming years, which, with Canada’s overheated economy, is a very real possibility. The central bank will be forced to hike short-term interest rates and that will trigger a rise in variable mortgage rates, meaning it will take you even longer to own your house outright. Are you going to be on the edge of your seat every time the Bank of Canada has a new announcement? That will keep some people up at night. In that case, especially for first-time homebuyers, it makes more sense to lock in mortgage rates for the first five years, and then switch to a variable mortgage later on.
The tough decisions don’t end once you’ve moved into your new home, though. Over the years, you’re likely to add to your brood, and those four walls may start to feel a bit constricting. This brings up a whole new question. Do you renovate or just move into a bigger home? It used to be families spent decades in one house unless they had to move for a job. Now young people think nothing of trading up after barely five years. So what works best for a growing family?
The first thing you have to ask yourself is how much more house you need. Let’s say you’re planning to have a third child and need to upsize. So you get quotes from contractors to see how much it would cost to renovate your home as you would like. Once you know that, you can look around to see if you can get a house that will be as good, or better, for the same price. If your $300,000 house needs $220,000 in work you may be able find a house for half a million that you like much better.
But on top of the sale price new house there are other costs to consider, such as real estate commissions, legal fees, land transfer taxes and possible penalties if you break your existing mortgage. Those can easily add up to more than $20,000. As an added reason to go the reno route, the government offers a GST credit on fees paid to a contractor for a major home renovation.
Having said all that, there are some important things to consider before embarking on that renovation project. Where will your family live while the house is being ripped to pieces, and how much will that accommodation cost? What’s more, can you even find a contractor you trust to do the work? Some of the better contractors in the Toronto area now have a three-year waiting list.
At least that will give you plenty of time to catch up on all those home reno reality TV shows.
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