First-Time Homebuyers: Guide to the Buyer

First-Time Homebuyers: Guide to the Buyer

 “To rent, or not to rent?”

That is the question facing a lot of young people today. In my position, I have heard just about every consideration and factor people use to make this decision. The overwhelming comment I hear is “I don’t want to pay someone else’s mortgage”. I’ve said it, and to an extent, I still agree with it.

I have to frame my recommendation based on the bigger picture. The decision is often more complicated than people anticipate. Different factors I consider when helping someone decide on whether they should ‘pull the trigger’ on a house purchase are: cash flow, risk exposure, equity, unexpected costs, and liquidity. Cash flow is by far the biggest consideration.

Cash-Flow

When I was starting my career as a paramedic in Sudbury, my wife and I entertained the idea of purchasing a house. My views on paying someone else’s mortgage were set in stone, and I wanted to move away from renting as quickly as I could. What stopped us (and I’m glad it did) was cash flow. We had an awesome renting situation and if we were to jump into a position of ownership, it would have made our financial situation tight. We would have had to pull back on other expenses (mainly luxuries), to accommodate the mortgage. In essence, we would be ‘house-poor’.

Risk Exposure

This has to do with your down payment. If you save $30,000 for a down payment, you may feel prepared for the purchase. What happens if you use all of your savings to buy a house, then lose your job or have an unexpected expense? Are you in a position where buying a house means sacrificing your emergency fund? We can transition the conversation to the use of debt instruments (credit cards, lines of credit, etc.) as a temporary ‘fix’, but I think most people would agree that going into more debt is not an ideal outcome.

Equity

It’s hard to argue against the investment growth attached to real estate. In MOST cases, real estate grows in value, but we are currently living in a ‘bubble’. The unfortunate thing about bubbles is that they eventually burst. We are strolling into a period of time where home owners are statistically making less (compared to the cost of living), saving less, and in more debt. The idea that a 25 year old can be a home owner on a normal income is becoming less appealing (and more unlikely) because it puts them in a large financial obligation that is unsustainable. This becomes even more apparent in bigger cities like Toronto and Ottawa. I was working with a couple a few months ago and their view on their house was that they would ‘keep it as long as they could’. Building equity is great, but sacrificing stability and flexibility is sometimes too high a cost.

Unexpected Costs

If you’re a renter, you may have experienced the inconvenience of having to call your landlord when the hot water tank stops working. Now imagine if you had to pay for the repair yourself? Stack this on the unexpected costs from lawyers, accountants, taxes, etc. and it can make a manageable mortgage seem overwhelming.

Liquidity

Liquidity is simply the ability to get cash from your investment. If you had to sell everything you own and cash in all of your investments, how hard would it be to sell your house? And would you have to sacrifice the equity you were building to sell it quickly? Today in Kingston, we’re in a seller’s market. When the market shifts, the buyer will hold the power to get the most bang for their buck, and it makes it hard to protect the equity you hope to rely on in the future.

Government Help?

New home buyers may have heard of assistance programs like CMHC (Canadian Mortgage and Housing Corporation) and the government’s First Time Homebuyer’s Incentive. These are offered to help young people buy their first house, because even the government realizes that there is a housing bubble. CMHC fees (1.8-4% of your mortgage) are essentially a mortgage insurance that you must pay into unless you can produce a 20% down payment on your first home. This coverage protects both the buyer and the lender in the event that you can’t pay your mortgage.

The First Time Homebuyer’s Incentive is a bit different. The government essentially steps in and funds 5%-10% of the value of your new home with the stipulation that you pay them back the same percentage when you sell. This means that if you buy a house for $300,000 and they give you $15,000 (5%), you’ll owe them 5% of whatever you sell the house for. A few years go by and you sell the house for $350,000. You’ll also be writing a cheque to the government for $17,500.

There’s always a catch, and with this incentive, the catch is that the government gets to participate in the built-up equity within your home without taking any risk. Whether you sell based on your own decision, or the house is forfeited to the lender, they will get their money back. So the question I get asked is, “When would it make sense to do this”? and it’s a great question!

There are two streams of thought in my mind. First, I try to remember that ‘cash flow is king’. If the 5% from the government allows you to have more flexibility with your cash flow to save and invest, you may come out ahead. This way of thinking holds true as long as you don’t actively put money into your house. For example, if you were to buy the house and take the government incentive, you have created some flexibility with your cash flow. If you were to take your excess cash flow, save it, and use it to re-do the kitchen, you’ve increased the value of the house, and in doing so, the value of the government’s return on it’s investment.

Now there’s also the second consideration, and that is CMHC fees. If you have to pay CMHC fees, your mortgage is subject to an insurance cost of at least 1.8%. Currently, on the CMHC mortgage calculator, the rate is 4%. So, you buy your house for $300,000 and you have your 10% down payment. Whether you take the government incentive or not, you’ll be subject to CMHC fees. On the other hand, if you have 15% on your own and use the government incentive to take you to the 20% threshhold, you’ll end up potentially saving money. For example, a $300,000 house with a 15% down payment would result in a mortgage of $255,000 + $10,200 in CMHC fees (4%). A 20% down payment would save you the CMHC fees and in order to forfeit the equivalent amount to the government’s investment return, your home’s value would have to grow to a value of $504,000 ($25,200 = 5% of $504,000). That result is unlikely, and if it happens, you wouldn’t have much to complain about UNLESS the equity in the house was built on costly home improvements.

What’s the Real Return on Investment?

For math students, think about it this way. Every dollar you put into your house, you’ll repay at least 5 cents (but usually more) to the government. A $10,000 renovation may raise the value of the house by $15,000, of which the government will recapture $750. You still make $4250 in equity, but instead of paying back just 5%, you’re siphoning off 7.5% of your additional investment back to the government.

So, my final thoughts on buying a house as a young adult?

Be smart.

Don’t get sucked into the idea that you “have to own a house by the time you’re in your mid 20’s”. Without wanting to sound disrespectful, it’s an idea ingrained in our minds by an older generation who had different considerations to deal with than we have today. If you want/need to buy a house, be prepared for the reality and expect the unexpected costs that are associated with ownership. If you can take part in the housing market without stretching yourself too thin, it can be a good way to build long-term equity, but it’s not the guaranteed investment it’s made out to be. The fact that the government is increasing support for young buyers is a telling sign that they recognize the unsustainable growth that the housing market has been subject to over previous years. If you decide to buy a house, think about how the different programs and incentives will hinder you or benefit you in the long run.

Purchasing Power: The Effect Time Has on Your Money

Purchasing Power: The Effect Time Has on Your Money

The market is a scary place. If you decide to open up the Globe and Mail to check the daily news, you’ll find a stock market ‘ticker’ sitting smack-dab in the middle of the page. This is the equivalent to vending machines putting the most popular candy at eye level. Right now, with the current market situation, the tickers are often red, and from a psychological standpoint, red is a dangerous colour.

So in times of uncertainty like this, a common reaction is to revert to hiding your money under your mattress. Though it’s not a terrible idea to keep some cash on hand for emergencies, did you know that you are actually losing money by doing that?

Most people think they are protecting their wealth by putting it in a shoe box and leaving it alone, but in reality (and in market terms) that money is showing a negative return year after year. The principle is called the ‘Erosion of Purchasing Power’.

What is Purchasing Power?

Imagine your grandparents (or great grandparents) living through World War 1. 1917 was the highest inflation year in Canadian history at ~19%. What does that mean? The loaf of bread or jug of milk that cost $1 at the beginning of the year, cost $1.19 by Christmas. Inflation is the increased (or decreased) cost of goods and services over a period of time (usually a year).

1917 was an anomaly. We had just come out of the World War, the global economic landscape was changing, and a lot of policies were born out of that period of time. More recently, the government has strictly tried to maintain an inflation rate of ~2%/year.

Now, lets go back to the shoe box full of cash in the closet. Let’s assume that there is $10,000 in the box and it was put aside in 1970 as a way to start saving for retirement. Back in the 70’s, you could buy a house in Toronto for ~$30,000, so $10,000 was a substantial amount of money. The yearly income in Canada in the 70’s was averaging between $5,500 and $7,000/year (based on minimum wage being $2.60/hr).

First off, having $10,000 to put in a shoe box for retirement in the 70’s was a big deal. That was almost 2 years worth of salary. At the time, you could buy 1/3 of a home in Toronto, live without going to work for almost 2 years, or achieve a vast number of other objectives usually reserved for the top 1%.

But the box is in your closet collecting dust. Inflation is slowly raising the price of goods and services around you and you forget about the cash. Fast forward to 2020. You are ready to retire. You suddenly remember you stashed this great wealth in your closet and you go to collect it. Sadly, you see just $10,000 in a box.

The loaf of bread that cost $1 now costs $4. The land alone where you could have bought the $30,000 house is worth $800,000+.

Your $10,000 will afford you a nice vacation, but doesn’t come close to the basic income needed for a family to survive. The power that you had to purchase goods with that $10,000 has declined dramatically over the 50 years that it sat in a box.

How do you avoid inflation?

Short answer is that you can’t. Inflation is a result of a variety of factors including currency value, debt load, import/export ratios, interest rates, and taxation. The good news is that it can be counteracted. The new equivalent to a box in the closet is GIC’s (Guaranteed Interest Certificate). They are the ultra-low risk investment that will help your money keep pace with inflation.

But do you want all of your money to keep pace with inflation, or would you rather take some risk and have the land worth $800,000?

The Three Bucket Approach

This is some free advice, and I use this template with a lot of clients because it quenches many of their hesitations and concerns.

Imagine you have 3 buckets, and all of your savings will be in one of those 3 buckets. The first bucket is your bank account or cash in the shoe box. Its purpose is to provide a source of cash that can be accessed quickly in case of emergency. If you need to book a quick flight or get a repair on a car, this is where you turn to first.

Side Note: Many people accept credit cards as their “quick access” solution, but that more often leads to major debt problems.

The second bucket is your short term goals. The goals themselves are dependent on you as an individual, but the idea is to provide quick access (liquidity) while obtaining some growth for the future. often this bucket contains a portion of their emergency fund. It allows your emergency fund to reflect the changes brought on by inflation.

The third bucket is your long term goals. For some people, there would be very little change in how your long term and short term goals are invested, but generically, you can afford to accept more risk when you have a longer period of time. Higher risk should result in higher returns.

This approach is a foundational piece to people’s investment strategy, and a key deterrent to the erosion of purchasing power. For perspective, if the $10,000 from our shoe box simply kept pace with inflation (a non-adventurous goal), it would be worth ~$68,162.86. Back in 1970, $10,000 gave you options. In 2020, $10,000 doesn’t reach as far or present the same opportunity.

Now if we translate the conversation towards the future, what kind of freedom would you have if you let your money’s purchasing power erode? Are you helping your ‘future self’ accomplish their goals? Planning for the future is more than putting money into a box. It’s asking yourself: how will this money impact my family’s quality of life down the road? Do you want to see the opportunities diminish with time, or know that when the time comes, you’ll have to tools available to take advantage of whatever comes your way?

The Novice Investor: Piecing Together Your Investment Vehicle

The Novice Investor: Piecing Together Your Investment Vehicle

Investing… Stocks… Bonds… Mutual Funds… Markets… Internal Rates of Return… Value versus Growth Investing… ESG Investing… Portfolios… ETFs… Savings Rates… Risk Profiles…

There is so much out there when it comes to the parts and principles of investing that it can be hard to digest. On one hand, we are told to invest, and on the other, we are told to not do anything without knowing what we’re doing. That ideology can force a rift in people’s planning and cause them to be idle. I have had clients who sit on tens of thousands of dollars in their bank account, and most often the reason is that they don’t understand their options.

The richest men in the world have built their fortunes by having multiple streams of income. Jeff Bezos, the founder and owner of Amazon, is currently the richest man on earth. If we looked at his income strategy, you would see multiple inflows. First, he has his salary from Amazon. Secondly, he has his Amazon shares that increase in value as the company grows. Third, I imagine we would find that he has money tucked away into shares of other companies, which are also growing. All of these sources accumulate to roughly $2500 per second in income (from “The Registered Citizen”).

Especially with the current ongoing crisis, there are lots of headlines that say you should stay away from the world markets. Oddly enough, you can often find a link nearby that will tell you how to setup a ‘side-gig’ from home to earn more money. Each person has a unique situation, and in this post, I would like to explore how you can design your own secondary income streams. I will be using the analogy of a car, as it makes it easier to conceptualize investment components.

First, I would like to define the difference between ‘Active’ and ‘Passive’ income. It’s pretty self-explanatory, but active income (also known as “earned income”) refers to income you have to physically make. This would include going out to a job and getting paid a wage/salary. Passive income on the other hand is income gained for you by others. Investing falls into the category of passive income.

For the purpose of simplicity, I will speak in terms of mutual funds (which I will define later). Investing can be broken down into two parts: Equity and Fixed Income.

Equity:

Equities, also known as stocks, are the engine of our car. To have ‘equity’ in something is to own it. For example, Jeff Bezos has equity in Amazon because he owns shares (or stock) in the company. As the company increases in value, the market price of your shares increases. This means that every time you purchase something on Amazon, not only does Amazon’s revenue increase (which increases Jeff Bezos’s salary or bonus), it also increases the value of the company, therefore increasing the price of each share.

It doesn’t necessarily have to be companies. There are some investments that hold their equity in other areas, such as gold. In this case, the fund manager will buy gold, and sell ‘shares’ of the gold on the open market. As the value of gold increases, the value of each share also increases and people can sell their shares for a profit. 

Equities can define how fast and how long your car will run. Within equities, you can dive into asset qualities and other specifics that can be as different as the electric engine is to a V8 supercharged sports car’s engine. Equities give us the power and growth potential we need to earn our passive income.

Fixed Income:

Fixed income (also known as ‘bonds’) are the safety features of the car and this form of investment is far simpler than equities. In every sense of the phrase, it is an “IOU”. You, as the investor, are lending money to governments or companies for them to use in their operations. This is a lower risk and lower reward strategy for investing. The company or government gets a loan, and you receive a regular interest payment. For example, if you were to lend Amazon $10,000, they would pay you an interest payment (i.e. 1.5% or $150) either annually or divided monthly and return the $10,000 balance at the end of the term.

One common factor you’ll often hear about bonds is related to the interest rate.

If we paused time and looked at interest rates now, we would see a sharp decline in a new bond compared to 1 year ago. This is because the Bank of Canada (along with other country’s banks) have dropped interest rates in an attempt to stimulate the economy. Interest rates play a large role in the ‘risk’ associated with a bond, but that analysis is for another post.

Traditionally, bonds are a much safer way to invest, as there is little risk of a government or company not honouring and paying that debt back, but it also carries a lower reward. Your $10,000 does not participate in company growth in the same way equities do.

In regards to it’s relationship to our car analogy, with fixed income being the safety system, bonds protect the car as it moves. If there was an event that was cause for concern (for example, the markets dropped in value and you were unable to go to work), the fixed income component would preserve a portion of the investment to limit the damage.

The whole purpose and the relationship between equities and fixed income is to get you from Point A (where you are now financially) to Point B (retirement, first house, education, etc.). This is where mutual funds come into play.

Mutual Funds:

What are mutual funds?

Again, by their name, it is easy to guess that they are a funds designed to be invested by multiple people pooling their money toward a mutual goal. There are lots of different types of mutual funds. For example, there are funds designed for people who want to invest in certain parts of the world, different industries, or even subject to certain moral or ethical standards.

At it’s core, a mutual fund is a makeup of equities and/or bonds that provide growth opportunity while minimizing the downside potential. Since everyone’s risk tolerance and time horizon is different, finding the right mutual fund (or funds) to invest in takes more thought than most people would imagine. If you are considered ‘high-risk’ you may want a mutual fund that holds more equities than bonds. Vice versa, if you were closer to retirement and wanted to preserve your investment, you would lean toward a higher allocation of fixed income and safety.

Common Question: How is this better than buying individual stocks?

Quick answer: it depends. Do you have the time?

A long time advisor once shared an analogy with me that I thought was powerful. Unfortunately, it is highly visual, but I will do my best to paint the scene.

Diversification is one of the main strategies used by mutual funds. Imagine you have a pencil, and that pencil represents a stock. It can be any stock you’d like, but it is one single stock. You have heard that this company has a strong future and will grow in value for you, so you ‘get in at the ground floor’, and invest everything into that company. Now, fast forward in time. We have an event such as the recession of 2008, the tech bubble of 2000, or the current COVID-19 crisis. That company is put under financial stress, as this is an unforeseen position and the world is rapidly changing. Some companies are able to adapt and survive, and others can’t change fast enough and are forced to shut down. A real example of this may be the loss of mega-companies such as Sears. Sears couldn’t adapt to cater to the online shopper and subsequently ‘died out’. Any stock that Sears had is worthless today.

bunch of pencilsSo… take your imaginary pencil and bend it. Imagine that you bending the pencil is the company going through a stressful period. Does it snap? Maybe not, but you, as the share holder, are not protected from the companies failure. The money you invested could be gone.

Now imagine you have a box of 50 pencils, each pencil still representing a single stock. You take them out of the box, you strap an elastic band around them, and you try to bend them all together.

They don’t break so easily.

The difference between trying to buy individual stocks and buying a mutual fund, is that the mutual fund offers greater diversity and protection from market fluctuation. Theoretically, you could go out and buy 50 individual stocks and manually create your own diversification, but most people would find it takes a lot of work to purchase, research, value, sell, re-balance and execute a specific investment strategy while also earning income at their own career. The mutual fund offers a much simpler solution to investors and can create a stream of passive income.

Summary:

The value of not putting all of your eggs in one basket is that you are more protected from a depressed market. A crazy and unexpected event occurs and some of the companies feel the stress, but even if one company falls to the wayside, your portfolio is held together by the remaining mix of equities and fixed income.

Creating passive income can be more than working a 9-to-5 career and investing in mutual funds, but investments are a staple in most successful people’s financial structure.

I want to circle back to my original analogy.

A car has a single purpose. The kind of car, how fast you drive, and where you are going is up to you. But at the end of the day, the car’s role is to transport you from where you are now to where you want to be in the future. If you start your journey without enough gas in the tank or with worn out tires, you are putting yourself at risk of stalling or having problems down the road. Like an investment strategy, a car with proper care and maintenance will ensure you eventually reach your goal.

Proper investment strategies can provide peace of mind when traveling down life’s roads. You never know when there will be an unexpected twist or turn, and being prepared is a key to success.