Remember the song “If I Had $1,000,000” by the Barenaked Ladies? When the artists released that song in 1992, $1 million was some serious purchasing power. Fast forward a couple decades and it’s a different story in the Canadian real estate market.
Average prices for fully detached homes in Toronto and Vancouver continued to hover above the $1-million mark last month. That $1 million just doesn’t buy what it used to 25 years ago (consider this Toronto home that recently fetched $2.32 million, which sold for $275,000 in 1992).
So who can afford a $1-million home and are you one of these lucky Canadians? Let’s take a look at the factors that will determine if you can afford a seven-figure home.
Your down payment
Your down payment will be the first factor that’ll disqualify most buyers from purchasing a $1-million home. This is difficult to meet because all homes with a purchase price above $1 million require a down payment of 20% or more.
Typically, if you’re buying a home with less than a 20% down payment, your mortgage is considered a high-ratio mortgage and you’re required to purchase mortgage default insurance. Mortgage default insurance protects the lender in the event you default on your mortgage.
Usually, you can buy mortgage default insurance from the Canada Mortgage and Housing Corporation (CMHC), but it won’t provide insurance for homes valued at more than $1 million.
Since a high-ratio mortgage is out of the question, you’ll need at least 20% for a down payment or at least $200,000. But that’s not all. You’ll also need to pay closing costs. Closing costs usually amount to 1.5% to 4% of a home’s value and include expenses like a home inspection fee, legal fees, title insurance, and the land transfer tax (LTT).
The LTT is by far the most expensive closing cost and in Toronto you have to pay LTT twice: once to the province and once to the municipality. Use the land transfer tax calculator to determine how much you’ll owe at closing.
Depending on your location, you should expect to pay between $15,000 and $40,000 in closing costs. To be on the safe side, you should have your down payment of $200,000 plus an additional $40,000 for closing costs to buy a $1 million home.
It’s easy to see why I called this factor the one that will disqualify the most homebuyers: Not many homebuyers have nearly $250,000 sitting around for a purchase like this!
If you’re one of the few Canadians with a large enough down payment, congratulations! Now let’s look at whether you can afford the monthly payments comfortably. We’ll determine this by calculating your debt service ratios.
Debt service ratios
Whether or not you can afford the monthly mortgage payments on a $1-million home is determined by your debt service ratios. Your debt service ratios are two formulas set out by the CMHC that lenders must use to determine the maximum mortgage you can afford. Your maximum mortgage is then added to your down payment to determine your maximum purchase price. Let’s look at the first of the two formulas: The gross debt service ratio.
Your gross debt service ratio determines whether you can afford the monthly carrying costs associated with your home. The ratio is calculated using the following formula:
Mortgage payments + property taxes + heating costs ÷ annual income
This ratio must be less than 32%. To calculate your gross debt service ratio, let’s use the following housing costs for your $1-million home.
If you put 20% down on a $1-million home, you’ll have an $800,000 mortgage. Using RateHub.ca’s mortgage payment calculator and today’s best five-year fixed mortgage rate of 2.64%, we can determine that this mortgage rate would leave you with a monthly mortgage payment of $3,640.
|Expenses||Monthly expenses||Yearly expenses|
Your gross debt service ratio needs to be less than 32% for you afford this home. That means you (or your and your partner) will need an income of at least $189,337 per year to qualify: $60,588 ÷ $189,337 = 32%
Now let’s look at the next debt service ratio: your total debt service ratio. This ratio takes the factors above into account but also adds in any debt obligations you may have. Let’s add in a car loan at $600 a month and student loans at $600 a month. The formula will then be:
Mortgage payments + property taxes + heating costs + car payments + student loan payments ÷ annual income
|Expenses||Monthly expenses||Yearly expenses|
In this case, your ratio cannot be more than 40%. That means you’ll need an income of at least $187,470 to afford your mortgage and your other debt obligations: $74,988 ÷ $187,470 = 40%
To satisfy both debt service ratios, you’ll need an annual income of at least $189,337 to afford a home worth $1 million.
Be cautious about borrowing to your maximum affordability
According to these ratios, you can afford a home worth $1 million on an income of $189,337 but that doesn’t mean this is the wisest financial decision. When deciding how much to spend on a home, you should consider the following variables:
Saving for retirement—The debt service ratios above don’t take into consideration saving for retirement. You should make sure there is enough room in your budget to save for your retirement. Some experts recommend saving at least 10% of your gross salary for retirement.
Rising interest rates—While you may be able to afford a $1-million home at today’s interest rates, keep in mind that interest rates are near historical lows. Make sure you can still afford your $1-million home if you have to renew at higher rates. For example, if you had to renew your mortgage at historical interest rate norms of 3.89%, your monthly mortgage payment would rise to $4,161. Can you still afford your home? Run the numbers through our mortgage affordability calculator to be sure.
Life events—While you may be able to afford a $1-million home right now, make sure that you’ll still be able to afford your home if major life events happen. Some examples may include sending a child to college or university, retirement, or purchasing a summer home. These life events will change your budget, but it’s important that they don’t change whether you can afford your home.
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Flickr: Jay Woodworth