House Rich, Cash Poor: Beware of Strangling Your Kids with Debt

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It’s a question clients ask us a lot: can we, or should we, gift our kids cash for a down payment on their first home?

It’s a thorny issue that puts parents in a tricky spot. Most parents’ gut instinct, of course, is to do everything they can to help their children. But in this case, doing so could do more harm than good. We’ll give you three reasons why in a moment.

It’s easy to see why more parents are giving their kids an assist in cracking the housing market, especially in big cities like Toronto, where the average residence sold for about $800,000 in April, with detached homes going for an average of $1.35 million, according to the Toronto Real Estate Board (TREB).

Numbers like that strike terror in the hearts of millennials who fear they’ll be forever shut out of the market as prices race away.

The reality is, it can make more sense for younger people to continue to rent and use their long investment horizon to accumulate savings until they are on more solid financial footing.

Here are three reasons why helping your kids with their down payment could hurt — rather than help — their financial futures:

1. You Could Shackle Them to Years of Suffocating Payments

When it comes to housing, the 28/36 rules of thumb are standard — total housing expenses should be no more than 28% of gross household income, with all debt payments eating up no more than 36%.

So let’s say your child and their partner, both of whom are first-time homebuyers, are eyeing a smaller detached home or higher-end townhouse in Toronto valued at about $1 million. You decide to give them 20%, just enough to avoid buying the otherwise mandatory mortgage-loan insurance from the Canada Mortgage and Housing Corporation. So we’re looking at a $200,000 gift here, for one child, leaving them an $800,000 mortgage.

There’s more, though. They’ll also be on the hook for closing costs, such as the land-transfer tax (LTT) — about $25,000 on our $1 million Toronto purchase (even after assuming our young couple qualifies for the LTT’s first-time homebuyer’s rebate), lawyer’s fees and title insurance.

But for now, let’s rather generously ignore all that and just say your child is left owing $800,000. Interest rates on a mortgage with a 25-year amortization and a five-year fixed term currently hover around 3.50%, setting up a monthly payment of approximately $4,000, or $48,000 a year.

Your child and their spouse would have to earn — from the get-go — over $170,000, year in and year out, through all of life’s twists and turns — job loss, illness, unexpected major expenses, not to mention the cost of raising children — just to squeeze the mortgage into that 28% envelope we mentioned earlier.

That’s a tall order for any couple starting out, and it would still come up short of the 28% target when factoring-in other home-ownership costs beyond the mortgage, such as property taxes, utilities, insurance and maintenance.

Finally, keep in mind that the 28%/36% rule of thumb is just a guideline. Many financial experts think spending 36% of your gross income on debt service may be aggressive, depending on one’s effective tax rate and level of after-tax income.

2. Their Costs Will Likely Ratchet Higher

You may also have to increase your gift to make sure your child passes the new “stress test” introduced January 1, under which all borrowers must prove they can handle mortgage rates at either the Bank of Canada’s current five-year benchmark (5.34%) or two percentage points above the mortgage’s “contractual” rate (3.50% in this case), whichever is higher.

So even though they’d still pay the $4,000 a month, they’d have to show they can keep up with payments at a 5.5% rate, or $4,900 a month — $900 higher: a payment requiring $210,000 gross household annual income.

Truth be told, a jump like that is entirely possible at renewal time if your son or daughter opts for a five-year fixed-rate mortgage. That’s because fixed-rate mortgages are tied to bond yields, and the yield on the 10-year government bond is headed upward: it’s now around 2.50%, up from 2.00% at the start of 2018.

The key is that, as a parent, you need to be mindful of saddling your child with too much debt that they may not be able to afford in the future, particularly if they experience a setback. The flipside to this argument is that if you are going to go down this path you should be prepared to help your son or daughter along the way with additional payments beyond your initial gift, if required.

3. A Correction Could Wipe Out Your Gift

Finally, rising house prices are far from guaranteed. Just look at TREB’s latest numbers, which show that the average Toronto home price was actually down 12.4% from a year earlier in April in the wake of the new mortgage rules and an uptick in interest rates.

Going back to our example, such a drop would slash $124,000 from the value of our house, erasing 62% of your $200,000 gift! A 20% decline would eliminate the entire down payment — and could make it tough to renew the mortgage in five years, or at least at a favourable rate.

The bottom line? Gifting down-payment cash to your kids isn’t necessarily a bad idea, but as parents, we need to look beyond our natural urge to help them and be sure we’re taking in the whole picture.