There was a lot of criticism over B.C.’s announcement to offer interest-free loans for first-time home buyers.
A. Lot. Of. Criticism. And rightly so.
Starting in February 2017, B.C’s government will offer a subsidized loan to any first-time home buyer that can match the interest-free loan (for the first five years), up to a maximum of $37,500. The new program is known as the B.C. Home Owner Mortgage and Equity Partnership, or HOME for short.
To qualify for the program, buyers must have lived in B.C. for at least a year (and been a Canadian citizen or permanent resident for at least five years). The household income must be below $150,000 per year, plus each household must prove that they’ve filed their tax return and paid taxes for the last two years. The loan will be amortized over 25 years, with interest set at prime plus 0.5% after five years.
Premier Christy Clark’s rationale for the program was summed up in her comments during the press announcement for this new loan:
“I firmly believe that the dream of home ownership must remain within the reach of the middle class here in British Columbia,” Christy Clark said Thursday in an announcement made at a townhouse sales centre in Surrey.
“We must make sure it is easier for first time homebuyers to find their way into a really tough housing market right here,” she said. “People need a partner in scraping up that first down payment and our B.C. government wants to be your partner if you want to buy your first home.”
Clark’s government expects about 42,000 households to take advantage of this new house-buying incentive.
Criticism of the new loan program
Almost immediately, the criticism over B.C.’s first-time buyer loan started pouring in.
“While this attempt to help B.C. residents with their housing situation is well-intentioned, it will not work,” wrote Andrey Pavlov, professor of finance, Beedie School of Business at Simon Fraser University, in a recent Globe and Mail column. He adds: “In a market with highly constrained new supply, any financial subsidy for buyers would get reflected in higher sale prices. Therefore, the benefits of the new program will flow to current owners and developers, not to the buyers.”
Bryan Yu, senior economist at Central 1 Credit Union, pointed out that while this new loan will help first-time buyers get into the market soon, it will do little to address affordability issues in the Lower Mainland.
While, Joshua Gottlieb, assistant professor at the Vancouver School of Economics, told the Canadian Press:
“The program could end up boosting demand — and therefore prices — by encouraging even more people to compete over the same number of homes.
‘It seems like a policy that does not reflect an understanding of the current markets or basic economics,’ he said in an interview.”
Others criticized the B.C. government’s timing; offering a financial incentive just as new debt numbers were released, which show how Canadians have reached new levels of consumer debt.
Still others made comparisons about how this new loan will re-create the conditions of the U.S. subprime crisis—creating a situation where over-leveraged buyers take on too much housing debt.
How could you not make this cognitive leap? Particularly after a last summer’s report from Moody’s Investor Services that pointed out “systemic vulnerabilities” in the Canadian mortgage market that would be exposed should the country be hit by a U.S.-style housing meltdown. The resulting losses, according to Moody’s, would be more than $17 billion spread out between banks, mortgage lenders and mortgage insurers. At the same time, home prices would fall by 35%.
But here’s the thing. Moody’s assumptions require a trigger for a Canadian-brand if subprime failure. The B.C. government’s new loan isn’t that trigger.
HOME loan won’t re-create the U.S. subprime crisis
Allowing high-risk buyers to take on more housing debt—a situation that eventually led to the 2008/2009 housing crisis in the United States—is, of course, a big concern in Canada. Home prices keep escalating in the Greater Toronto and Greater Vancouver areas, despite attempts by various governments to slow these markets. So, the idea of allowing buyers to borrow even greater amounts just seems foolish. But cause our own Canadian-brand of subprime crisis? It’s unlikely.
This new loan options impacts too small of a population—just over 40,000 households will take advantage of this program, according to B.C. government predictions. That’s less than 2% of B.C.’s population (according to BCStats’ 2015 numbers) and less than 0.15% of Canada’s population. (To put this in perspective, just before the 2007/2008 housing crunch, about 20% of mortgages in the U.S. were lower-quality subprime loans up from the historical 8%.)
Yes, an increase in loan incentives, such as easy initial terms, are worrisome. It was one of the factors of the U.S. housing collapse. But so were the loose regulations and the anticipation that a homeowner could quickly refinance in the future. It’s an expectation that few, if any, Canadian homeowners hold, as we’ve all been told time and time again that rates will rise—probably soon. We also know that housing prices are starting to level off, and even if they haven’t, the writing is on the wall.
There’s another major difference between the U.S. and Canada: We do not have formal policies to increase homeownership. Yes. There are many stakeholders that are invested in housing transactions, but there’s a big difference between a formal policy—as seen in the U.S., when Freddie and Fannie created policies that incentivized banks to write mortgage loans—and an informal motivation.
As the Canada Mortgage Housing Corporation states: “Canada, unlike the U.S., does not have a policy goal of increasing the rate of homeownership. Rather, we encourage the availability of housing across a variety of tenure types—homeownership, rental housing, supportive housing and transitional housing.”
Smart way to use the HOME loan
Now, if a B.C. first-time buyer were to use the loan there is certainly a smart way to do it.
Don’t increase the purchase price of your house
Almost immediately after hearing the B.C. government’s announcement, I went to a mortgage calculator. I wanted to know how this interest-free loan would impact a buyer’s maximum purchase price. I was shocked.
For example, let’s say buyer Bob and Betty want to buy a home. They have an annual household income of $150,000 and savings of $30,000. Without the new B.C. HOME loan, the maximum purchase price they can afford is $550,000 (assuming 25 year amortization at a five-year fixed rate of 2.85%, and not including condo fees, heating costs or property taxes. It also assumes the couple has no other debts.) Since this first-time buyer couple is only putting a little over 5% down, they’d also have to tack on another $18,720 in mortgage loan insurance fees (further eroding their equity in the property).
With the new B.C. Home Loan, buyers Bob and Betty now have $60,000 as a down payment. (Remember: This new loan will match whatever money a buyer has saved for a down payment, up to maximum of $37,500.) Since, this new debt does not come with monthly debt obligations, their debt ratios don’t change all that much. As a result, Bob and Betty could increase their purchase price to just a bit over $770,000—a more than $200,000 increase in purchasing power.
But to do this, Bob and Betty are only increasing their down payment by about 2.5%, which means they’d have to pay mortgage default insurance fees of just over $25,600. In five years, they’ll have a mortgage balance of just under $550,000. Rates will have gone up (or so we predict!) and they’ll also need to start paying back that $30,000 HOME loan.
Or have a really, really good reason
If, however, Bob and Betty were to avoid increasing their purchase price. Settling for a $600,000 home, with $60,000 down, they’d be further ahead in five years, when they’d have to start paying back that HOME loan and renew their mortgage, which would have a balance of about $405,000.
Now, a decision to increase the purchase price of a home should be taken for only reason: To avoid having to move in a relatively short period of time. If increasing your purchase price bumps you up from an entry-level condo to a two-bedroom unit or something similar, then it might be a wise choice. That’s because real estate transactional costs are costly.
A general rule of thumb is that it takes about two or three years of owning a property to build up enough equity to justify these high transactional costs. Buy an entry-level condo and be forced to move within a couple of years and you could watch your equity diminish quite quickly.
The better plan is still 20% down
But all this assumes that the first-time buyer has less than 20% for a down payment. An even better strategy is to buy a home that allows you to put 20% down. This way you avoid adding on mortgage loan insurance fees and you have a much better chance of keeping your current monthly expenses manageable and absorbing future increases in the cost of living.
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