Changing The Way We Think About Mortgages

I mentioned in my last post about the old adage regarding not spending more than 2-3 times gross salary on a house.  This rule of thumb was not one that was set by the banks, but it was a belief held by many frugal home buyers who did not want to over-extend themselves.  But is it realistic anymore in today’s environment?  Let’s take a look at some numbers:

According to the MLS, the national average home price in Canada was just over $330,000 in September 2010.  In order to purchase the average Canadian house, a family would need to earn $132,000 per year if they only wanted to spend 2.5 times their gross salary.

According to Statistics Canada in a June 2010 report, the average annual income for Canadian families is just over $70,000.  If the average Canadian family only spent 2.5 times their gross salary on a house, they could only spend $175,000 on their home.

If the average Canadian family is earning $70,000 per year and the average Canadian house costs $330,000 that means Canadians are spending 4.7 times their gross salary on their houses.  And it would take $66,000 to make a 20 percent down payment on the average Canadian house and avoid CMHC fees.

Are houses too expensive?  Maybe in certain markets, but the average price across the country still seems reasonable if you look at the growth of real estate over time.  Perhaps it’s wages that have stagnated and not kept up with inflation?  I think there is a case to be made for this point.  And what about the low interest rate environment that we currently live in?  Larger mortgages seem more affordable when you’re only paying 2 percent interest.

Personally I don’t believe that spending only 2.5 times your gross salary on a house is even close to being realistic anymore.  Even 2.5 times gross salary on your mortgage seems like a stretch.  I would feel comfortable with a mortgage as high as 4 times our gross salary, provided that we didn’t have any other debt (including car payments).  And I strongly believe in paying a minimum of 20 percent down payment on your house and amortizing over a maximum of 25 years.

Do you have any rules of thumb when it comes to your housing expenses?  Is it time to change the way we think about mortgages?

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  1. Financial Uproar on November 3, 2010 at 10:38 am

    This sounds an awful lot like “this time is different”, a phrase that never fails to make me nervous.

    In large cities in Canada, 2.5 times gross income is an unrealistic number. There is no doubt about that. Is that because real estate rules have changed? Or is it because real estate is massively overvalued in this country? I vote for the latter.

    You’re responsible financially and I have no doubt that you’ll build a house that you can afford. (You are still thinking of building, right?) Having a substantial down payment will also protect you going forward, as well as only taking a 25 year amortization. You’re a smart guy and you won’t get overextended. I do worry about the masses of people who took out 35 year amortizations and barely qualified at 2% interest rates. Any sort of correction is devastating to them.

    • Echo on November 3, 2010 at 12:51 pm

      @Financial Uproar
      I guess my argument that “things are different” this time is because of the low interest rates that don’t seem to be going away. And wages haven’t kept up with inflation, thus the 2.5 times salary rule of thumb doesn’t apply anymore.

      Maybe the interest rates remain at record lows because houses are over-valued and that is the only way to prevent a massive real-estate collapse. People can afford to spend more than 2.5 times salary because their monthly payments are more manageable due to low interest rates (for now).

      We are still planning on building a house and I will definitely stick to my rules of 20% downpayment and 25 year ammortization, as well as some extra annual payments to speed things up.

      Thanks for your comments!

  2. Balance Junkie on November 3, 2010 at 1:08 pm

    I agree with Financial Uproar. Stretching beyond the limits based on the assumption that interest rates will remain low and housing prices will always rise is what caused the housing collapse in the US. While I have no doubt you’ll keep your risks in check, I’m not so confident about a lot of other folks who might get clobbered if rates rise even a little.

    I guess it depends on your unique situation in terms of your age, income amount and stability, and your ability to stay disciplined with prepayments. We originally took a 25 year mortgage on our home. It will be paid off just before the 10 year mark, but we will still have paid over $50 000 in interest. Ouch!

    • Echo on November 3, 2010 at 2:23 pm

      @Balance Junkie
      My point was that the 2.5 times salary rule of thumb is outdated. That doesn’t change the fact that the lending institutions need to be prudent when it comes to approving loans, taking total income and debt load into consideration.

      Folks who pay 20% down and ammortize over 25 years will unlikely get clobbered if rates rise or if there is a market correction.

      I’m not saying what happened in the US can’t happen here, but our financial institutions have never approved NINJA loans, and they have rules in place to prevent people from getting too far over their heads in debt.

      • Richard on November 3, 2010 at 10:20 pm

        Sorry, Echo, but your last paragraph (in your reply) clearly shows that you are as naive as the majority of the population and simply refuse to believe that Canada, in fact, had a multitude of Sub-Prime mortgages granted. Just because you don’t want to believe that our banks gave mortgages to anybody with a pulse, doesn’t mean that it’s not true. It is. Our banks freely gave these mortgages as they had no way of losing. CMHC backstops the loans, so the banks are not in danger of loss from defaults.

        Here’s a link to CIBC’s website for their “Self-Employed Recognition Mortgage.” Read about this mortgage and you can clearly see that they’ve even ‘highlighted’ “you don’t have to prove your income…” Do you honestly believe that these are higher lending standards?

        You can throw any exaggerated amount of income at them and they won’t even bother to verify it!

        Historically low interest rates have created artificial demand for houses as people with no money can compete for properties against people with large down-payments. Thus, prices have risen well above the standard 3.2 -3.5 X earnings. To simply accept this as “the new norm” is extremely foolhardy. But, hey! It’s your money.

        • Echo on November 3, 2010 at 11:07 pm

          I agree, there were some subprime loans here in Canada before they tightened up the rules further (no 40 year ammortization and no zero down, must be 5% minimum)…but still nowhere near the amount per capita that took place in the US.

          The link that you posted has a disclaimer (as I suspected), stating:
          1 No proof of income is required when all income is from the business and the self-employed applicant has been a principal owner of the same business for at least 2 consecutive years. Conditions and restrictions apply.

          That doesn’t sound like they simply look the other way with regards to proof of income. Their lending rules still apply.

          All that I suggested in writing this post is that with rising housing costs and fairly stagnant wages, does an old rule of thumb still apply when people are house hunting?

  3. Money Smarts Blog on November 3, 2010 at 4:39 pm

    I don’t agree that lack of increased wages means the ratio can go up. The 2.5 (or whatever) ratio has to do with affordability. Getting a larger mortgage means it’s less affordable.

    That said, if interest rates stay low then you won’t have any problems.

    Also – I think the main risk has to do with affordability of payments – not being underwater. It doesn’t matter how much money you put down – if rates increase to the point where the payments are too high, then you have a problem.


    • Echo on November 3, 2010 at 5:07 pm

      @Money Smarts Blog
      “That said, if interest rates stay low then you won’t have any problems”

      Exactly my point Mike. I think the monthly payments were similar on a $85k mortgage at 18% than they would be with a $300k mortgage at 2%. Increased house prices and stagnant wages means that the interest rates will need to stay low in order to prevent a meltdown in the real estate market.

      I think the down payment does matter, if for some reason you need to sell your house, you could be trapped if you find yourself underwater in your mortgage.

      You’re right about affordability. The banks and realtors preach affordability of home ownership over renting, quoting monthly payments that can only be possible from 35 year ammortization schedules. While that will get people into home ownership faster, it can spell disaster for your financial future.

  4. Dr Dale Rathgeber on November 5, 2010 at 10:02 am

    See the recent edition of the Economist magazine which said that Canadian Real Estate prices were about 20% over-valued. Better analysis comes from recent editions of Macleans and MoneySense, both of which call Cdn housing a bubble.

    Nobody has a crystal ball; but housing prices could fall and stagnate for a long period, especially giving the greying of the Boomers, and their increased heallth care costs which will be paid by young Cdns in increased taxes.

  5. Potato on November 6, 2010 at 12:13 am

    Further to Richard’s point, not only is Canada not immune to poor lending (yes, we’re better than the USA, but how much is that really saying?), but subprime lending is not itself a necessary condition for real estate values to overheat and later fall.

    Back to the main point, I think that the deviation from the historical rule of thumb of ~3X earnings is a temporary one that will work itself out. As Mike says, the origin of that rule-of-thumb has to do affordability (i.e., some % of your take-home pay to service the loan at some interest rate translated into some multiple of earnings for the house price, which was easier to figure in your head, and was a more relevant figure for the shopping process), which is interest-rate sensitive. If indeed rates are going to stay low for a long time (where here “long” means decades) then sure, the rule-of-thumb should change to take that into account, and that looks to be exactly what’s happening in the market.

    However, to be conservative I personally wouldn’t aim so high, since rates may indeed go back up in the coming years (plus the plethora of other reasons I have for being a housing bear).

    • Echo on November 6, 2010 at 9:44 am

      I think if I lived in Vancouver I would be a lot more nervous about the housing market, but here in Lethbridge there is more stability in the market (less boom & bust as our economy does not rely on the oil patch directly).

      That being said, I will obviously mitigate our risk by putting 20 percent down, using a 25 year ammortization, and making annual pre-payments on our mortgage.

      Affordability is they key, but I just don’t see 2.5 times earning being realistic in this environment.

  6. Aolis on December 31, 2010 at 10:27 am

    It is an excellent rule of thumb for a mortgage, not the value of the house. Your main point is that many people are not following it, so why should I?

    The rule assumes that you are going to have an average interest rate over a period of 2-3 decades. We have had a low interest rate since 2001, about a decade. I can see why people might push up their mortgages to 4x if they are saving so much in interest.

    Is this still going to be true for the next ten years? It might be the time to start thinking about this rule even more. One way is to have a larger deposit to reduce the size of the mortgage. Or maybe now is not a good time to buy a house with overall prices so high.

    Housing prices were fairly flat until they shot up over the last ten years due to low interest rates. You can’t blame wages for not keeping pace.

    • Echo on December 31, 2010 at 10:50 am

      It’s definitely not my main point to just follow the herd blindly into mortgage hell. I will have a sizable downpayment on my house and keep affordability as a top priority. My point is that the rule of thumb is out of date. Yes the housing market has shot upwards due to low interest rates, but I don’t see the low interest rate environment changing anytime soon (low being less than 6%).

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