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Down Payment Size & a Housing Bear Market

Housing-Correction“The housing market will eventually correct.”

That’s a quote from economist Ben Tal in this CIBC report from last week.

There’s nothing earth shattering about that because corrections are to be expected. The more interesting question is: how big will the next selloff be?

Tal’s conclusion was that the next downturn “is likely to be gradual.”

Values are “overshooting” fundamentals but that doesn’t presage a crash, says Tal. He says a crash requires one of two things:

  1. A “significant and quick rise in interest rates…akin to the one that led to the 1991 recession and housing market correction,” and/or
  2. A “high-risk mortgage market that is highly sensitive to any changes in economic realities, including hikes in interest rates.”

#1 is unlikely because, among other things, the Bank of Canada keeps a tight leash on inflation (which is the biggest catalyst for rising rates). Moreover, economic growth is widely projected to remain near or below the long-term average.

#2 has never been a serious threat in Canada and vigilant regulators are dead-set on ensuring it never will be.

From a numbers standpoint, Tal identifies “risky” borrowers as those individuals with total debt service ratios over 40% and equity under 20%. Those people comprise 3.2% of total mortgages, a number he says would grow to 4.5% if rates soared 300 basis points.

Yet, even in this high-debt/low-equity group, defaults have been “well below 1%,” Tal adds (which is a positive reflection of Canadian lending standards). By comparison, 8.1% of U.S. mortgages are 90 days delinquent or in foreclosure.

“Thus, short of a huge macro shock,” says Tal, “there does not appear to be the risk of large scale forced selling that would typically be the trigger for a precipitous plunge in the national average house price.”

CIBC’s report aside, most analysts seem to be projecting a minimum 5-15% price drop in the next housing downturn. Consider that if you’re putting only 5-10% down on a home purchase. Here’s why:

  • After five years, a household putting down only 5% on a $300,000 house (with a thirty-year mortgage at 3.75%) would be left with a $264,166 mortgage balance.
  • If prices dropped 10% and they paid 5% in Realtor commissions to sell (commissions vary by province), they’d owe over $9,000 more than their proceeds from selling—assuming $1,500 for legal and discharge costs.

But who cares if you don’t sell, right?

Well, even if you’re planning to buy with a long-term time horizon, life does throw us curveballs (job relocation, unemployment, a growing family, disability, divorce, etc.). When you have to sell, you need equity as a buffer and falling prices can quickly eat that up.

Notwithstanding a “gradual” home price correction, it therefore makes little sense to rush into buying if your financial outlook isn’t rock solid. For tens of thousands of Canadians who haven’t been able to sock away a 3-6 month emergency fund and a decent-sized down payment, renting is economically superior to buying…..crash or no crash.


Sidebar: “Not surprisingly,” says Tal, Vancouver and Toronto have the highest percentage of mortgagors with debt ratios over 40% and less than 20% equity.


Rob McLister, CMT