As part of a short series that aims to “Understand the Mind of a Lender” we’ve identified 4 key areas a lender will look at to decide if you’re a “good risk” to provide mortgage financing. They are income, credit, downpayment, and property. Here are links to the previous articles in case you missed them:
So let’s talk about downpayment. First of all, if you’re going to borrow money for a mortgage in Canada, lenders are going to want to see that you’ve got some skin in the game. They won’t finance 100% of the property (actually, they can’t), you have to come to the table with something! Bare minimum, you’ll be required to come up with a 5% downpayment, which leaves the lender to finance the remaining 95% of the property.
Obviously, the more money you have available for a downpayment, the more confident the lender will be in your mortgage application. This is because there is less chance you will walk away from a property where you have more money to lose.
Conventional Financing vs a High Ratio Mortgage
A conventional mortgage is when you have a downpayment of at least 20%. A high ratio mortgage is when you are borrowing more than 80% of the property’s value. In Canada, high ratio mortgages must be insured against default at either CMHC, Genworth, or Canada Guaranty. Although the cost of mortgage default insurance is typically added into the mortgage and amortized over the life of the mortgage, a high ratio mortgage is more expensive in the long run compared to a conventional mortgage.
If you have a 20% downpayment, going with conventional financing makes sense to save some fees, however if you only have 5% saved up for a downpayment, high ratio mortgage financing (even with the added insurance premiums) allows you to become a homeowner sooner, and allows you to start building equity sooner, which is a good thing!
It’s good to note that with the most recent mortgage qualification changes made by the government to mortgage default insurance, you can’t just assume that having a larger downpayment will always mean you will get the lowest rate available on the market. Some high ratio mortgage products might even come with a lower interest rate than conventional financing. This just highlights the importance of having an independent mortgage professional on your side. However our discussion here isn’t really about the specifics of mortgage products, it’s about whether or not you will be offered financing at all. So let’s move on!
Sources of Downpayment
Now, we’ve mentioned that in order to secure mortgage financing you’re required to have some skin in the game, but when it comes to downpayments, believe it or not, not all money is created equal. Lenders actually assess the source of your downpayment as well. A downpayment that has been accumulated in your bank account over a long period of time is considered differently than a downpayment that has been borrowed. Let’s have a look at the different types of downpayments.
Accumulated funds. Probably the most straight forward of downpayments, if you have accumulated the funds for your downpayment over a long period of time, and you have the money sitting in the bank, you simply have to prove that it’s yours, and it will be acceptable to the lender. Your own funds, accumulated over time through regular deposits from your employer is the most stable source of downpayment.
RRSP Home Buyers Plan. Now, although an RRSP is a type of accumulated funds it requires special attention as Revenue Canada will allow first time homebuyers to withdraw up to $25k or $50k as a couple tax free towards a downpayment. The money is then repaid to the RRSP over the next 15 years.
Gifted downpayment. Receiving a gift for all or part of the downpayment is acceptable to a lender given the following: the gift is from an immediate family member, it’s actually a true gift with no schedule of repayment, the money is deposited to your bank account directly, and that you complete a gift letter signed by all parties involved.
Borrowed downpayment. It’s possible to borrow your downpayment, assuming you qualify to carry the extra payments created by borrowing this money and you have an excellent credit profile. However both lenders and insurers consider this to be more of a risk and will likely scrutinize your mortgage application a little more as a result. The borrowed money has to be an arm’s length transaction and not tied to the purchase and sale of the property in any way. In order to compensate for the extra risk of a borrowed downpayment, the mortgage default insurance premium is increased.
Regardless of where your downpayment is coming from, accumulated funds, borrowed, RRSPs, or as a gift from a family member, it’s all for nothing if you can’t prove where it’s coming from! Paper trail is everything to a lender. So let’s discuss some of the do’s and don’ts of proving your downpayment.
To prove that you have a downpayment sourced from your own resources, you will be required to provide 90 days of bank statements showing an accumulation of funds. Now, if the money has been sitting in a savings account, that’s great, the money has to be in your possession for 90 days to be considered from your own resources.
If the money has been accumulating in an RRSP, you can use the Home Buyers Plan to access that money. If your money is tied up in the stock market, you will be required to liquidate your stocks or mutual funds, and the lender will want to see that money deposited into your account. It’s good to note that if you’re selling stocks or mutual funds, you’ll still be required to prove 90 days statements on those accounts.
For gifted funds, you will be required to complete a gift letter (standard document that will be provided to you) signed by both you and the family member who is gifting the funds. The gift letter will outline that this is a true gift and that it doesn’t have to be repaid. Proof that the gift has been deposited to your bank account will have to be forwarded to the lender by way of bank statements. Please note that the amount stated on the gift letter should match exactly to the amount deposited in your bank account. No more, no less.
For a borrowed downpayment, the terms of the loan will be disclosed to the lender for review. Proof that the loan has been advanced and is available in your bank account may be required. In some cases; where a line of credit is being used, a statement showing the available credit may be enough proof.
When the lender is looking at your bank statements, any time there is a deposit of $1,000 or more, where the money is being used as part of the downpayment, you will be required to prove the source of those funds. And although this may seem like a random statement, it comes from experience, when providing bank statements to the lender, please don’t black out any information. The lender doesn’t care how much money you spend on shoes or fast food, they are trying to substantiate the legal accumulation of funds, making sure that you aren’t laundering money through the purchase of a property.
To really understand how a lender views your downpayment, you have to understand that they are picking through every document with a fine tooth comb looking to prevent fraud. They have to make sure that you are who you say you are, you work where you say you work, and that the money you are using for a downpayment came from where you say it came from and that you aren’t trying to launder money.
Purchasing property would be an excellent way to launder money if there weren’t so many controls in place! What is money laundering and how does it come into play when buying a house? Well, very simply, if the proper controls weren’t in place to verify funds, profits from illegal activity could be used towards the purchase of a property. When that property is then sold legally, the proceeds of the sale would then provide the criminals with “clean money”, that is, money that was “earned” through the sale of a property, and making it look legitimate.
In order to prevent money laundering, it’s a lender’s responsibility to verify the source of a downpayment, and they take this responsibility very seriously. Sometimes to the point of becoming quite overbearing with the documentation they require.
So if you ever feel like a lender is asking you for too much, it might be a good idea to take a step back and try to understand that they don’t know you, they are assessing whether they should lend you hundreds of thousands of dollars to buy a house, and that they want to make sure that you aren’t simply using this transaction for illegal gain.
So there you have it, the sources and verification of a downpayment are fairly straightforward, the hard part for most people is simply saving the money for the downpayment (especially in the case of first time homebuyers). If you would like to discuss your financial situation please contact me anytime, I’d love to work with you.
Stay tuned for the final part of this series when we discuss how the lender looks at the property as part of the mortgage application.