Last week CityNews reached out to me for comment on RBC’s Housing Trends and Affordability report. I had not read the report so I asked for a little bit of a backgrounder. The reporter explained that according to the report, people in Toronto were spending 72% of their income on housing. He wanted to get my thoughts on that number and was looking for my comments on how people would be affected if interest rates would go up.
So what was my reaction? I was in shock! I knew that people in Toronto spent a lot on housing, but 72% is an insane amount. Understandably, during the interview, we didn’t have time to dive deep into why spending that much on your home could destroy you. As you’ll see below, I shared just a few quick points. But in this post, I wanted to look at some real-life numbers to explain why we need to take our budgets seriously.
72% of your income spent on housing is this much
The RBC Housing Affordability Measures percentage refers to the cost of owning a home and includes the cost of mortgage payments, property taxes, and utilities. With that in mind, we need to factor in all other costs. The report doesn’t mention if the 72% is before or after tax dollars. For the purpose of this post, I’m using after-tax dollars since that’s actual money we can spend.
Now let’s get to the numbers. Let’s say your household income is $90,000 in Toronto (the average income is actually $70,000). That means you would net $5,908 every month. Note that this number only factors in personal tax, CPP, and EI. 72% of your take home pay would be $4,254 leaving you with just $1,654 for all other expenses. What other expenses are we talking about? The below are the most common expenses with some estimates of costs.
- Home insurance – $75
- Maintenance fees (if you own a condo) – $400
- Groceries – $400
- Cell phones / internet (for two people) – $250
- Transportation (car, gas, insurance, transit pass) – $100 – $500
- Entertainment – $200
- Personal items (clothes, toiletries) – $200
All these additional expenses add up to $1625 – $2025 per month. If you went with my minimum numbers, you would be left with $19 dollars every month. If you went over budget just a little bit, you would instantly be in the red. Of course, you could probably spend less than what I estimated to give you more flexibility. But, even then, you’d have to be pretty tight with your budgets.
However, have you noticed that I left a few things off my list of common expenses? I listed just the main things that affect us day-to-day, but how about long term expenses? You know, things like the following:
- Home maintenance and repairs
- Car repairs
- General savings (emergency fund, short-term)
- Vacation fund
- Retirement fund
- The cost of raising kids
By spending 72% of our income on housing, we’re putting our futures at risk. Taking a vacation or owning a car may be out of the question. Having kids and providing for their future may also be difficult. I’m not saying it can’t be done, but money will be tight.
Toronto doesn’t even rank as the most expensive city. In Vancouver, residents spend 79.7% of their income on home ownership (WHAT!)/ Clearly, Toronto and Vancouver skew prices since the national average is 45.9%.
So how much should we spend on housing?
In my interview I say 40% is a good number to work with, but did you know that banks used to recommend even less than that? When lenders calculate how much they’ll extend to you, they use a gross debt service ratio (GDS) or 32%.
Your GDS is calculated by adding up your estimated mortgage payments, property taxes, utilities, and 50% of condo fees; then dividing that number by your annual income.
What’s interesting is that number has become a bit loose over the years. These days, those numbers are calculated with your gross income (before tax). I also believe in the past, lenders calculated your GDS with 100% of your condo fees. It also seems weird that lenders calculate these numbers with before-tax dollars, but we can only spend our after-tax dollars. These small changes have allowed people to qualify for larger mortgages.
There’s also the Total Debt Service Ratio (TDS) which takes your GDS and adds any outstanding payments you may have (credit cards, car, loans). Generally speaking, lenders want this total number to be less than 40% (again, of your gross income).
The recommended GDS and TDS ratios are just guidelines. There’s nothing preventing lenders from offering people with good credit more money. This shouldn’t be a real surprise considering how much banks will lend people. Heck, when I was buying a home with my wife, we were offered a million dollars. We politely declined that amount.
What happens if there’s an interest rate hike?
The timing of the RBC report couldn’t have been better (or worse). A few days earlier, Stephen Poloz, the Governor of the Bank of Canada implied that a rise in interest rates could be on the horizons. Now, we’ve been hearing this for a while now, but the current economic conditions favour an interest rate hike.
But how high will interest rates go? It wouldn’t be a stretch to see rates increase by 1% over the next few years. If this happens, it won’t happen all at once. We’ll likely see small increases of .25% until the Bank of Canada is happy where rates are at.
An increase in interest rates helps the Canadian economy as a whole, but that would also increase mortgage rates. Remember, people in Toronto are already spending 72% of their income on housing. So let’s take a look at how at a rate increase would affect people.
We’ll assume a 25 year amortized mortgage with a current rate of 2.6%. I’ll also calculate your payments if rates were at 3.1% and 3.6% (so a .5% and 1% increase). For simplicity purposes, I’ll use the monthly rate and I won’t include any CMHC premiums.
Keep in mind that if you’re on a fixed rate mortgage, nothing changes until the end of your term. However, people with variable rate mortgages would be affected by the changes. The numbers below are for illustration purposes only to show you how an increase in rates affects payments.
If your outstanding mortgage is $300,000, the following is what you’ll pay:
- $1,358.88 – 2.6%
- $1,435.17 – 3.1%
- $1,513.69 – 3.6%
In this scenario, a 1% increase in interest rates would mean the homeowner would pay an additional $154.81 every month. It would also increase your total home ownership costs by 2.6% based on the $90,000 income as stated above.
If your outstanding mortgage is $400,000, the following is what you’ll pay:
- $1,811.85 – 2.6%
- $1,913.57 – 3.1%
- $2,018.25 – 3.6%
In this scenario, a 1% increase in interest rates would mean the homeowner would pay an additional $206.40 every month. It would also increase your total home ownership costs by 3.5% based on the $90,000 income as stated above.
If your outstanding mortgage is $500,000, the following is what you’ll pay:
- $2,264.81 – 2.6%
- $2,391.96 – 3.1%
- $2,522.81 – 3.6%
In this scenario, a 1% increase in interest rates would mean the homeowner would pay an additional $258 every month. It would also increase your total home ownership costs by 4.4% based on the $90,000 income as stated above.
Even though the monthly increase may seem reasonable, when you add it to your overall expenses, you may be stretched thin. Sure, it’s possible you’ll be making more money by the time rates creep up, but your other expenses may have gone up too.
I’m not disputing that living in Toronto and Vancouver is expensive. Heck, renting may not be much cheaper. The point is, you need to try and keep your debt levels (and home ownership costs) within reason. I realize this is easier said than done, but no one is forcing you to buy a home.