Thursday, November 24, 2016

The Real Reason Why a Big Mortgage is a Bad Idea

We can try to justify taking on a huge mortgage by doing detailed projections of house price increases and accounting for various housing costs, but this isn’t the path to a useful answer. It’s unexpected factors that drive this decision.

One factor that many don’t properly take into account is repair costs. We all know the furnace, roof, and other expensive items will need replacing, but we usually can’t predict when. This makes it easy to ignore such infrequent large costs in a budget. Some inexperienced homeowners may even forget about predictable costs like property taxes, house insurance, and condo fees.

Another category of unexpected factors is reduced income. If you buy a house with a spouse right up to your joint affordability limit, any reduction in income can be devastating. We’ve all been told that we could lose our jobs, but in my experience, most people don’t think this will happen to them, even though it’s common. You may believe you could lose your job, but that you’d find another one easily enough. It’s very common for people losing their jobs to end up with a lower-paying job. Getting forced into permanently lower pay can happen to anyone, but is common for those over 50.

Health problems are another common reason your family income can drop. You may not be able to work at all or have to get a lower-paying job. Health issues are a common reason why some people are forced to retire before they want to.

Another factor younger people tend not to think about is that you may want to do something new later in life. If we could stop people on their commute to work and get them to answer honestly how they feel about their jobs, an alarming number of them would say they dread going to work and feel desperate and hopeless. They are trapped in their jobs by debt. They yearn to do something else, but that something else likely pays less money, at least for the first few years.

We can push all these worries aside by just leaving a healthy gap between the size of mortgage you take on and the size of mortgage a lender will let you have. Don’t give up future flexibility for an expensive house.


  1. Your words of wisdom are spot on Michael. It seems too many people are over leveraging themselves now. This seems particularly true in some of the larger markets, with a belief real estate will always go up.
    The greatest mortgage leverage I ever had was 1.2X earnings with my first home as a single person with 25% down. (I also bought a rental property at about the same time) I could have afforded a much more expensive home but my need and debt tolerance won out.
    I also agree real estate (personal home) is not necessarily a good choice from a pure "investment" decision- at least in the area I live, although I have never considered a personal residence an investment. Without getting into details on the 4 homes I have owned over the past 31 yrs of and considering an approximate value of what we have now: I have made a few percent overall (tiny gain), without considering inflation, or what that capital could have generated invested and renting instead. Completely different from those whose net worth rose largely due to real estate. In some of these markets today and with my dislike of debt I wouldn't remotely consider buying with such inflated prices and the certainty rates are rising.

    1. @RBull: I have sympathy for today's young people because of the high real estate prices they face. I was able to buy at a much lower price. But as you say, it's still dangerous to over-leverage.

      While I have no opinion about the direction of interest rates, I always proceed as though a sharp rise in rates is one of a range of possibilities.

  2. The following exchange is reproduced to remove broken links.

    ----- BHCh November 25, 2016 at 12:19 PM

    It is a risk. Sometimes it works out and you win, sometimes not and you lose. Yes, there needs to be a contingency to leave you some margin to address risks if they materialize.

    Still, mortgages serve a useful purpose by both letting young families to borrow from future selfs so they can have a decent house when they need it.

    And on average house prices go up. As long as you own the house(s) long term leveraging through mortgages will make you money. Add to it the financial discipline which it introduces by forcing you to save and pay off the principle, and it becomes apparent that most of the time it is a wise decision.

    ----- Michael James November 25, 2016 at 12:27 PM

    @BHCh: Actually, historical average real estate returns have not been great if you go back to before interest rates started their multi-decade decline. Stocks have a better record. But as I argued, these aren't the important considerations. There is a big difference between a "wise decision" and something that happened to work out well. Millennials will have a very different experience from their parents and lenders are willing to lend ever-larger multiples of people's incomes. This is a deadly combination. I'm not against home ownership. But people need to set a sensible limit on their size of mortgage. I think 2.5 times income is enough.

    ----- BHCh November 25, 2016 at 5:40 PM

    Agree that 2.5 times is enough.

    While stocks have a better long-term record, they are more volatile and you can't leverage to the same extent. And you can't live in them.

    ----- Michael James November 25, 2016 at 6:20 PM

    @BHCh: True. However, as I've argued, I don't think it's a good idea to take on too much leverage for a house. The cost savings that come from living in your "investment" are largely offset by property taxes, repair costs, house insurance, condo fees, and the costs of buying and selling a house. In most real estate markets in Canada, renting and investing the difference will make more money in the long run. That said, I choose to own because I'm willing to give up some money to live the way I want. Also, my wife doesn't want to rent.

    ----- BHCh November 25, 2016 at 7:09 PM

    Well, that's ironic because we have just sold the house (having owned our houses since 1995) and are going to rent for the next little while.

    ----- Michael James November 25, 2016 at 7:10 PM

    @BHCh: That's probably a good move financially, but there are no guarantees.

    ----- BHCh November 25, 2016 at 7:18 PM

    Worth noting that had we got out of stocks, we would have had to pay huge capital gains. Selling your house nets pure untaxed profit.

    ----- Michael James November 25, 2016 at 7:51 PM

    @BHCh: It's good to have a rich person's problem. Few people are able to max out RRSP and TFSA.

    ----- BHCh November 26, 2016 at 7:57 AM

    ...most people who purchased a house in GTA or Vancouver a couple of years ago are "rich" by this definition. Which brings us back to you being a tad categorical when you say that a big mortgage is always a bad idea. Like everything, it's a game of probabilities. People who win big tend to be the ones who take the biggest risks. They can also be the biggest losers.

    ----- Michael James November 26, 2016 at 9:22 AM

    @BHCh: Buying a house and taking on a mortgage isn't either universally good or bad financially -- it depends on the numbers. People who bought homes long enough ago were generally not making a poor financial choice because prices weren't unreasonably high. Buying now too often requires taking on a ridiculous mortgage. If you think I am arguing that that boomers shouldn't have bought their homes, then we don't understand each other's positions yet.

  3. The following exchange is reproduced to remove broken links.

    ----- Alan November 25, 2016 at 2:21 PM

    The 2.5 times amount seems reasonable to me as well, and I believe that was what the bank let me do for both of our houses (maybe they offered more, but not much more). Things happen in life, and if you are only 3 months away form trouble, you are living to close to the edge.

    ----- Michael James November 25, 2016 at 2:24 PM

    @Alan: Agreed. Staying away from the edge should be a goal.