Rent vs. buy? It comes down to debt management

There's good debt and bad. For first-time homebuyers, knowing the difference between the two and how to manage debt wisely is a critical step towards owning a home.

Repeated warnings from the Bank of Canada and elsewhere that Canadians are overextended on debt might be keeping some potential buyers at bay. But Rob Macdonald, a mortgage broker with Invis in Vancouver, says the key to understanding whether or not it's time to buy comes down to planning and how you manage your debt.

Home ownership: Not just about mortgage rates

"One of the biggest mistakes first-time homebuyers make is they get absolutely fixated on what interest rates are. The interest rate in a mortgage is just a piece of the puzzle," he explains. "Managing the debt through the length of the term is one of the more important features. Managing your mortgage to avoid payment shock can save you thousands of dollars versus the best rate you would've got originally."

An average mortgage in Macdonald's market (the Fraser Valley neighbourhood in Vancouver) presently falls between $300,000 to $400,000. Interest rates are terrific today he acknowledges -- a five-year mortgage is at 3.3 per cent currently versus 5.5 per cent just a few years ago.

"If you get a low rate today at 3.3 per cent you're enjoying a mortgage payment of around $2,000 a month," he explains. "Five years from now it goes to 5.5 per cent and your payment jumps by $350 to $400 a month."

Chris Kiskunas, regional mortgage sales manager, Royal Bank of Canada (RBC) in Toronto, says to be wary of the proliferation of personal debt.

"Sometimes a few hundred dollars on a credit card doesn't seem like a lot (of debt). But when you also have the same or a little more on other cards and you total it all up, it can actually prohibit your ability to qualify for as much as you might on a home," she says. "For someone preparing for first-time home ownership, evaluate your financial situation and determine what you owe, to whom, and what are the interest rates? Position yourself to qualify for the most home you can buy."

Kiskunas recommends potential buyers take in the big picture when thinking of home ownership, which will help first-time buyers to get a sense of how much it costs to actually own and maintain a home.

"Any financial institution or lender that is going to consider approving you for a mortgage is going to look at the mortgage principle and interest payments, the taxes on the property and the estimated cost of heating the property," she explains. "The industry rule of thumb is all of those costs should not exceed 32 per cent of your gross combined income."

Any other debt (credit cards, line of credit, car loans, etc.) should not exceed 40 per cent of your total gross income.

"The mistake that people make is they don't calculate the cost of carrying that home. Beyond taxes and heat there's gas, hydro, TV and Internet, insurance, and then any other payments you're responsible for," she adds. "When you want to determine the affordability factor on a home you want to know you have money at the end of the month to be able to eat."

What to do when rates rise?

With current interest rates being as attractive as they are, is it worthwhile to strike while the iron is hot and buy now? Or is it wiser to remain a renter for the time being? It depends on personal circumstances, Macdonald says, but if interest rates are going to climb you'll likely face the same hike in the rental market. In short, it's a catch-22.

"If you don't buy today for example and interest rates start to go up, what happens is it's less likely more people will be buying in the coming years. That'll put pressure on the rental market," he says. "That means less vacancy and then landlords have the ability to raise rates. And if mortgages get more costly for landlords, landlords will typically download that expense on the tenant."

Never too early to starting your research

Perhaps sorting that out comes down to having a discussion with a mortgage broker. But should you wait until you believe you have everything lined up? Or is it recommended to embark upon the effort much sooner? RBC's Kiskunas believes the latter is best.

"Studies have shown that regardless of the fact that people might feel better educated (about mortgages and real estate) they still want to talk somebody," she says. "It's never too early to get educated about what you're planning to do. You can get really good advice from a mortgage specialist whether or not you choose to buy within the next six months or the next two years. The relationship should start now."

As for the all-important down payment, Macdonald says it too is based on individual circumstances. If you're buying within your means and it's an affordable monthly payment not too far removed from the amount of rent you're paying, most are comfortable with five per cent down.

"As long as you follow a plan and have someone assisting you with managing your mortgage that's taking advantage of opportunities along the way -- if you were to lock-in for a longer term or an early renewal for instance -- I don't think five per cent down is a bad thing," he says.

However, it's been reported Ottawa is considering raising the minimum down payment for homebuyers from five to seven per cent in order to stop some consumers from taking on too much debt.

"It'd certainly be more challenging for many homebuyers to get into the market (should a hike come to fruition) in some of the bigger cities," Macdonald adds. "At the end of the day, I don't think it'd be a tremendously bad thing for Canada. It just means we're a little more cautious as to what our risk might be in the market."

If the thought of a higher minimum downpayment is causing anxiety, than it may be best for first-time buyers to reconsider their purchase plan, Kiskunas says. "If (Ottawa) shortens the amortization or imposes a higher qualifying rate from an interest rate perspective, if it's that close to the wire for that individual buyer, then I'd suggest that maybe this isn't the right time to buy.

"You need to leave yourself some financial wiggle room to help insulate yourself against any changes that might be brought in like that."

In any event, there are online tools that are worthwhile to use in order to gauge the difference between paying a mortgage and paying rent. CanadaMortgage.com provides an online calculator that draws these comparisons. So too does the online calculator offered by Industry Canada. Also useful is the Canada Mortgage and Housing Corp.'s guides to renting a home and buying a home. RBC, too, provides a free, online tool for helping calculate whether you should rent or buy.