The Million Dollar Dilemma

Today’s online edition of the National Post looks at a home finance issue that may be most relevant in areas like Vancouver, Toronto or Montreal, but that demonstrates the importance of looking beyond interest rates and quick-qualifications when setting out to buy real estate. Although the article focuses on million dollar purchases, any home buyer should consider that strong cash flow may not offset a large downpayment – particularly if you plan to do work on the property, or are in a situation where you’ll be running into heavy land transfer taxes (or, as the article notes, if you are financing mortgage insurance AND a 12% second private mortgage to make up the 20% minimum on a million-dollar-plus home).

Read the article HERE.

Concerns about Appraisals, Home Values

Residential real estate appraisals have become the latest flashpoint in the ongoing debate about the health and value of Canada’s housing market. An article in the Globe and Mail, published on October 11th, indicated that “Documents obtained by The Globe and Mail detailing confidential statements from banks, appraisers and mortgage insurers show rising worry over the use of a database operated by the Canada Mortgage and Housing Corporation (CMHC). The documents suggest the data are flawed and help push home prices up.”

The focus of the unnamed parties’ concern is Emili, an automated appraisal system introduced in 1996 to help expedite the approval process of CMHC mortgage insurance. The system “uses figures such as recent sales of nearby homes to gauge values, without sending an actual appraiser to the address” to validate the value of the property as submitted by the lender. If a property auto-approves on Emili, it means that the purchase price (or the estimated market value, if refinancing) is at or below the existing CMHC-acceptable value of similar homes in the area.

The “rising worry” suggested in the article was addressed by CMHC in a statement that read, in part, that Emili “does not use property value averages, but uses the specific characteristics of the property being assessed. The database and models are continually updated and independently reviewed by a third party.”

So, has Emili been over-estimating house values, leading to a real estate bubble on the verge of bursting? Hardly – because lenders are not obliged to lend anyone anything if they don’t think it’s in their best interests.

The home values CMHC evaluates have already gone through a lender review, and many lenders – particularly if they are risk-averse – will force refinance borrowers to accept a lower value before submitting the deal to CMHC. A lender is not obliged to honour an appraisal, and we are hearing that in an increasing number of cases, bank underwriters are openly questioning the values provided by appraisers and instead LOWERING the value being used for the loan. Homes that are purchased through bidding wars are particularly vulnerable to these under-appraisals, and you can read about that dynamic HERE and HERE.

Secondly, while automated, data-driven appraisals may seem detached from the realities of the market or specific homes, even full appraisals are not in any way 100% accurate. Appraisers not familiar with a particular neighborhood can dramatically underestimate the value of a property because the same home in a less appealing area would be worth 10 or 20% less. In-person appraisals are subjective at best and biased at worst. Drive-by appraisals – where an appraiser doesn’t enter the property – have become more prevalent as fewer appraisers are given less money per appraisal, and have to do more jobs in a day in order to make a decent living. Drive-by appraisals might not take any interior modifications or renovations into account, and (in our experience) almost always underestimate the value of the home.

We also need to recognize that there are TWO sets of values: One value – the market value – is determined by what someone is willing to pay for a home. The second value – the lender’s tolerance value, if you wish – is determined by what a bank or individual is willing to LEND on it. These can be dramatically different (see the current state of US home values, where lenders over-estimated values compared to the market’s ability to purchase the homes, allowing ‘underwater borrowers’ leveraged to 120% of market value, and leading to the dramatic crash of 2007-2008).

So long as the lender-based values remain at or below the market values, our market should remain relatively safe. Here in Canada, banks err on the side of caution; they treat all appraisals as suspect, have done away with appraisal “cushions”, and have made it increasingly less appetizing for mortgage specialists or clients to challenge appraisal values. The “cushions” were dollar or percentage values that provided a small increase in value should a client need it to make a deal work – for example, if a client was trying to consolidate debts and needed their home to be worth $400,000, a lower-than-expected appraisal of $380,000 could be bumped up to $390,000 to get the math closer. Similarly, if the mortgage specialist felt that a home was undervalued for financing purposes, they used to be able to request a new appraisal – free of charge – to ‘challenge’ the value and (hopefully) move it up; now, there is a financial charge that discourages these challenges.

The comparisons to the US bubble are, to our mind, very unfair and irrelevant. US lenders WANTED homes over-valued, factoring in 10% year-over-year appreciation and financing clients to 100% and more of the purchase price so they could build up their book of loans and generate more interest income. In Canada, lenders want as little risk as possible on their books.

What does all this say about the Canadian housing market, and whether appraisals have helped create a “bubble” in cities like Toronto and Vancouver? Two forces are at play. First, the buyers who need to execute transactions set the market values of real estate, and if it has become harder for them to qualify for financing, or if transfer taxes and commission fees make the purchase unpalatable, the market will slow and sellers will eventually need to drop prices to make the deals work. Appraisals impact the purchase transaction if they are considered to be overpaying for a home compared to what the lender is willing to recognize as a value. On the other hand, lenders have been trying to protect profits and mitigate risk by questioning home valuations at every turn.

With delinquency and default rates at stable low levels, it’s pretty clear that lenders have valued real estate relatively well from a client affordability standpoint. It will either take a large drop in purchase transactions, or significant numbers of buyers having problems getting mortgage financing, to indicate that the real estate market is, in fact, “over valued”. Until then, the role of appraisals, in our minds, has had very little to do with driving up real estate prices…

The Globe and Mail article can be found HERE.

You can read about CMHC’s response HERE.

Downpayment Dilemma

Today’s National Post features an article that looks at whether a smaller downpayment could get you better rate (you can read the piece HERE). Besides being somewhat misleading (nearly all mortgages in Canada are funded either directly or via brokers by one of the Big Six banks, who generally price high-ratio mortgages the same or more expensive than conventional deals, and not the other way around) it focuses on a bad idea – that saving on an interest rate is an important consideration for a borrower when deciding on a down payment. Your down payment decision may be decided for you, but in the end it’s about what you are able to do with your actual cash resources, and what risks you are willing to take by tying up all or some of them in a piece of real estate.

The article points out that a .15% saving in interest over 25 years on a $500k mortgage would save a borrower $3,500. They neglect to mention that putting 5% down instead of 20% would COST $13,750!! If you had to pay it out of hand, you would avoid it at all costs!

To be fair, there are a few potential benefits to making a smaller down payment even if you have enough to avoid CMHC altogether. Since CMHC fees are added on to the mortgage and amortized the same way, taking on the charge can be attractive to those with little cash savings. Instead of using all your savings for a downpayment, using a portion to pay for moving, closing legal costs, cosmetic updates to the property or minor renovations could prevent accumulation of unsecured or credit card debt and higher interest costs.

Other borrowers may need to improve their credit score before qualifying for a mortgage. In this case, using a portion of your savings to pay off outstanding debts or bills can qualify you for a mortgage but, again, result in a smaller downpayment and a requirement to incur CMHC fees. Same goes for emergency savings; incuring CMHC premiums allows borrowers to maintain liquid cash savings for the unexpected, a sensible decision given our current economy and all the talk of a housing market correction.

Those benefits aside, the fact remains that a CMHC insured mortgage costs the borrower thousands of unrecoverable dollars in premiums and results in a higher debt load and mortgage payment. There are no additional protections for you personally – remember, CMHC protects the lender’s interest, not yours. You’d still lose the house if you couldn’t pay for it, but the bank’s losses would be offset.

There is also an “equity erosion” factor that comes into play for borrowers with a small down payment. If you only put 5% down on a house, then tack on CMHC fees to the mortgage, you are leveraged to more than 95% of the value. Should you need to sell or want to upgrade in the next few years, your equity position will not be as large as you may think: taking into account realtor fees to sell (assume 3 to 5%), land transfer taxes (2.5 to 5%, depending on where you live), and existing mortgages (including the CMHC fee-added-on mortgage) you could be underwater unless your home has dramatically appreciated in value or you have aggressively repaid your loans. If you lose your job, get transferred, or decide to get pregnant, you may not be able to make the move that you want or have to do – and that’s assuming home prices staying flat or rising; if prices go down, these buyers could be in serious trouble.

We advocate mitigating equity erosion risks by minimizing reliance on CMHC. Even increasing a downpayment from 5% to 10% saves thousands of dollars in fees and insulates homeowners a little bit more against possible market corrections. In other words, interest rates should be the least important factor in deciding how much of a down payment you are going to make. The nature of the purchase (is this short term or long? investment or primary residence?), the status of your existing debts, your ability to qualify for financing, the amount of savings you have for closing, moving and other costs, the state of the property and upgrade/repair requirements, and the security of your employment are far more important considerations.

Speak to a qualified mortgage specialist before you make any borrowing decision, and if at all possible, don’t incur CMHC fees unless you absolutely need to. Oh, and it’s just our opinion, BUT if anyone quotes you a higher rate for a conventional deal (i.e. 20% down mortgage) and suggests you go the insured/CMHC route because you can save a bit on the rate, turn around and walk away…