Tuesday, February 17, 2009

First Time Home Buyers

Based on this Sunday's Reflection post Steve asked:

"If I have a very short term investment horizon (1-2 years before buying a house) do you think I would benefit from meeting with a financial adviser?

Or does it make sense for me to just hang onto cash until I'm ready to take on home ownership?"

What a fantastic question. I was writing the answer when I realized that so many of us are in this exact position and there were so many dimensions to his question that I thought it warranted its own post. (Also note: The older you are, the more relevant this becomes).

The short answer is a resounding "Yes!", and here's the process and reasoning as to why (and what you should look for from the adviser):

Step 1 - You want to buy a house
Buying a house is the single largest purchase you will ever make. A mortgage will be the largest expense from your pay cheque and will longest lasting recurring payment.

Whether you're married, engaged, dating or single, you've probably done your homework with regards to what you want, need and can compromise on with regards to your houses location / size / features to come up with a price range.

This price range determines what deposit you need, your monthly mortgage payments and pay back period. Ok. So far pretty basic stuff.

Step 2 - Making your money work harder for you
Steve makes a good observation that he has a short investing horizon which implies high liquidity needs. He expects to be buying his house within a year or two (not sure if that means he is A. passively looking for a house while building his deposit B. waiting for the market to cool a bit more to get a better price or C. Has everything in place and is actively looking for his dream house).

Either way, this is a *textbook* example of what the Home Buyers' Plan (HBP) was designed for. It allows you to take up to $20k from your RRSP to buy a house for the first time. Also remember that RRSPs are funded with your *PRE*-tax income, giving you another reason to consider using this savings vehicle (As is a Tax Free Savings Account - TFSA, another new pre-tax savings vehicle started in 2008). Those of you with company sponsored RRSPs have another dimension of financing to consider (but check your vesting period). With a short time horizon, his adviser could help him use an RRSP that has conservative growth and low risk as part of his saving strategy for home financing (RRSP's don't have to be made up of aggressive growth stocks. Some RRSP qualified mutual funds are made up of less risky instruments like bonds or GICs and can be liquidated with relative ease - although you need to be aware of all performance, front or rear loaded management fees). These are just some of the solution strategies that a good financial adviser should be able to provide you with.

Aside: At most major banks or funds, if you have *any* type of investment: RRSP, RESP, RSP, discount brokerage etc you probably already have an adviser assigned to you. You should go meet them.

This also brings up another important and relevant topic... RRSPs in and of themselves and how they are affected by house purchases.

Step 3 - Retirement.
It may *seem* far away, but you have to think about it now. Ask your parents. One of their biggest regrets (unless they were born incredibly wealthy) is that they felt like they should have started thinking about their retirement sooner. Needless to say, the impact of buying a house has a *huge* effect on your retirement planning. On top of your mortgage, you have to pay for maintenance (you're the owner now), property tax and a host of other expenses.

Do you remember those adverts which compare a 22 year old person straight out of university who starts saving money versus a 30 year old saving money for retirement? The point they were trying to make is this:

For all the good investment advice in the world, the one thing in life you can't buy is time.

Therefore, for that reason alone, I think it's good to see a planner sooner rather than later. Even if you feel like you don't have a lot of money right now, that's all the more reason to start addressing that issue to plan for your future. Make them earn your business and trust while you build your nest egg and plan for your goals.

Another consideration: If you are married, you have a whole host of options available to you regarding income distribution for taxation and retirement saving which can save you a lot of money especially if one spouse is making more than another and is in a different tax bracket.

There is also a crucial point which is highlighted: the need to revisit financial plans. Your outlook as a young person buying a house will change in the next two years. Envision when you have a house (and a mortgage) and how that changes your cash flow. How will this affect how you save and plan for the future? What we're really saying here is that you have TWO obvious time horizons - 1. Saving for your deposit in two years time 2. Saving for your retirement (please never lose sight of this goal). Don't forget to make sure you also have enough cash on hand to enjoy life now.

Steve, I hope this answers your question, but I would love to follow up or address anything else I may have missed.


Steve said...

Wow Josh, thanks for the thorough reply! Here's some more detail on my situation. Again I would appreciate your advice.

I've been "timing" my RRSP contributions to have as close to $20,000 as possible at the point in time when I purchase a house (which is a moving target). At one point I was deducting 13% of my pay and it was adding up quickly in my RRSPs. I then panicked a bit with the fear that if the time comes to purchase a house and I have $30,000 in RRSP's, I've "wasted" 10k which is locked in and I can't access.

Now you're going to say that that 10k isn't wasted because it is contributing to retirement. However, that's 10k less on a downpayment. So now I have 10k locked away that I can't touch, and I'm paying a bank intererst to borrow 10k plus the remaining amount of the loan.

You might bring up the issue of tax sheltering at this point which is a little more complicated that I can handle.

Essentailly what I'm wondering is, will I regret contributing an excess of $20,000 into RRSPs when it comes time to buy a house?

Thanks again,

Joshua Wong said...

Good news and bad news:

Some good news: Apparently, the their most recent budget, in an effort to boost the housing market, the Federal Government has upped the limit from $20k to $25k. I'm not sure exactly when this will be in place, but it should be soon (if not already).

Also, don't feel too bad about "wasting" the remaining $5k. First of all, it is pre-tax income, so even if you are in the lowest tax bracket, you've "saved" (or rather, have not been taxed on) at least about 21% of that right off the bat (or if you're in the highest tax bracket, about 40%). That's a lot of money - $1050 @ 21% or $2000 @ 40%. Plus, even in a conservative RRSP, it should experience growth (over time). Although the growth is probably not as "fast" as the interest you'll pay on the loan, all things considered, you're not really that much worse off.

I don't think you should regret contributing the marginal excess. Another reason why you might still consider contributing to your RRSP even after you buy a house is that although you can carry unused portion of your RRSP contribution tax benefit forward there is a limit.

It seems like the ideal situation for you (now that you've hit your $20k - $25k goal and then some) might be to throttle back your contributions to both get the tax benefit, but also keep money in your pocket to pay the loan and stay liquid. This is a more long term view. A shorter term view would be to abandon the RRSP contributions altogether to have great cash flow and pay down the mortgage fast, but I think your retirement savings will suffer in the long run because of the lost tax benefits. You'll have to do the math yourself to be sure.

Also, when you get a mortgage, you'll need to check your repayment terms (some banks will penalize you for paying too fast as they want to make a profit from you one way or another).

Another goal for you to keep in mind is that most banks have a lower rate for people who have a 25% or more on hand for their house deposit (as it is considered a less risky loan). So this goes back to Step 1 in terms of understanding the size of your house, deposit and your repayment schedule.

Tax considerations can get complicated, and the bad news is they get more complicated as life gets more complicated. That would be a good reason to get some help and support in this area sooner rather than later.