The article “Are Millennials Better Off Renting? Why Young Canadians May Want to Put Off Home Ownership.” was originally published on The Financial Post on August 7, 2015.
The U.S. Federal Reserve recently suggested that young Americans may be wise to delay the purchase of a home. Given Canada’s surging home prices, young Canadians should be even more inclined to consider the advice to put off home ownership.
In a report from the St. Louis Fed, titled “The Demographics of Wealth,” the authors raise concerns that buying a home too early is putting young families on a trajectory to be poorer than all previous generations. It was released earlier this year and is based on data collected from 40,000 households between 1989 and 2013.
Delaying home ownership is a solution that they put forth, suggesting that millennials “delay purchase of a home with its attendant debt burden until it (is) possible to buy a house that (does) not make the family’s balance sheet dangerously undiversified and highly leveraged.”
The U.S. real estate bubble burst in 2007, after a run-up that began in the early 1990s, around the same time as Canadian real estate started its current ascent. Many Americans who bought their first home 25 years ago are still feeling the pain today. On an inflation-adjusted basis, the net worth of U.S. families headed by someone aged 41-60 has fallen by about 1/3 if you compare 1989 families to those in 2013, meaning this generation of middle-aged Americans is less wealthy than the previous generation.
Given that homes cost more in Canada (averaging $453,560 nationally vs. approximately $311,619 in the U.S.) and household debt is higher here as well (Canada’s debt-to-income ratio is 1.63 versus 0.96 in the U.S.), Canadian millennials should pay close attention to the advice being doled out by the U.S. central bank.
In particular, the researchers are worried about young people putting what little savings they have into a home and having a mortgage so large they are unable to save in the future. This will be a big concern when interest rates rise in Canada and mortgage payments take a bigger chunk out of budgets, further limiting the ability to save.
Furthermore, an inability to accumulate non-real-estate assets means the net worth of young people is becoming increasingly undiversified. Being all-in on real estate leaves little opportunity to consider other asset classes, including stocks.
Historically, stocks have been a great way to grow wealth. Over the last 60 years, the Toronto Stock Exchange has grown 9.5 per cent, while inflation has averaged 3.7 per cent, yielding a 5.8 per cent real return in excess of inflation for Canadian stocks.
The Canadian Real Estate Association began publishing consistent average home price data 35 years ago, in 1980. Since then, average home prices have risen 5.4 per cent, while inflation has averaged 3.1 per cent. The real rate of return on real estate, after inflation, has therefore been about 2.3 per cent.
If stocks generally perform better than real estate in the long run and millennials put everything they have into real estate, they might be making a costly mistake. Since this seems to apply in an average real estate market, Canada’s current housing market would likely magnify the difference.
That’s because, in a hot real estate market, young people need to be cautious about putting their modest savings into a downpayment on a home that may end up being their only asset. If they overpay and then run into financial difficulty or the real estate market takes a downturn, it could take years for them to recover their losses.
Consider that a 5 per cent home downpayment — the minimum currently required in Canada — amounts to 1,900 per cent leverage (that is, the mortgage is worth 19 times the downpayment). Prior to the 25-year bull market in Canadian real estate, buyers needed a much more conservative 25 per cent downpayment.
Personally. I still think that buying a home is a good forced savings plan, and from a non-financial perspective, there’s an invaluable pride of ownership and a benefit to not being under a landlord’s thumb. But the financial risks of putting everything you have into real estate are clear.
So how long should a millennial wait before taking the plunge and buying a home? Sadly, there’s no perfect rule of thumb to apply to the purchase of a home as far as when to buy and how much to spend. Building a financial plan that projects your financial future will help to provide some personalization to your financial decision-making.
Generally, I’d say to aim for an amortization that would have your mortgage paid off at least five years before you would otherwise like to retire. That minimum five-year cushion should help protect you from an inevitable increase in interest rates, as well as the potential set-backs that most anyone experiences during their working lives.
In the long run, if a mortgage prevents young people from diversifying their assets into stocks, taking advantage of the tax benefits of RRSPs, saving for children’s education and so on, they might be better off renting for a few more years.
Jason Heath is a fee-only Certified Financial Planner (CFP) and income tax professional for Objective Financial Partners Inc. in Toronto, Ontario.