We are continuing our series on big ticket purchases and focusing our discussion on personal use real estate, specifically your home. This is often the first thing on many dentists’ list of goals and it’s easy to see why. The benefits of home ownership are:
- Not paying rent which many view as “waste”
- Historically, real estate appreciates in value
- Security since there is no risk of a landlord evicting you and your family
- Tax-free gains if it’s your principal residence
- Forced savings/building equity
Buying a home seems to be a no-lose situation, but the following traps should be taken into consideration.
Most people only take into account the actual dollar cost, not the hidden costs. Get your fishing rod (i.e. practice) then, you can go and catch fish (i.e. home). This means investing in yourself/your business first. Buying a home can save you a couple thousand dollars in rent each month although initially most of one’s mortgage payments usually is comprised of mostly interest (similar to rent) and little principal. Buying a dental practice can bring in hundreds of thousands of dollars a year. Buying a home before you buy a practice means:
- Potential geographical restrictions on where you practice dentistry. Many dentists want to have a short commute to work, buying a home now means you likely won’t look at practices that are too far away. There may only be a handful of practices in any given town, but there are likely hundreds of homes within a 10km radius of any given practice.
- Financial restrictions on the practice you can buy. Everyone has a limit on what they can borrow. Buying a house means getting a mortgage. So, if you have outstanding student loans and a large home mortgage, your ability to obtain financing to buy a practice could be significantly reduced.
Focusing on buying a home first means you may be limiting your opportunity to own a practice somewhere else.
While homes, in general, appreciate in value, that doesn’t mean you can’t suffer losses. Friends and family may boast about the tax-free gains they made when they sold their house, but they often omit many real costs. These include: land transfer tax, renovations and repairs, commissions, property taxes and mortgage interest. A million dollar home with a $750,000 mortgage at 3% interest over 25 years would be over $300,000 in interest, $100,000 of which would be incurred in the first 5 years. If one were to sell the million dollar home for $1.1 million after 5 years, they likely would have lost money once the real costs were taken into account. Also, keep in mind when you sell your house in a hot market, you also need to buy a house in a hot market. We recommend comparing the true cost of buying versus renting in a similar neighborhood to see if you are truly flushing money down the toilet by renting, especially in the short term.
Many dentists are high earners, but not all are big savers. When buying a home, they are often approved for very high mortgages. The trap many dentists fall for is that they often purchase homes based on their mortgage preapprovals. Having a multi-million dollar mortgage approval doesn’t mean you should use it all. Keep the following factors in mind when deciding how much you are prepared to pay for a home:
- Mortgage payments are paid from after-tax personal income. A $1 million dollar mortgage over 25 years including interest at 3% would cost more than $1.4 million dollars. To repay $1.4 million dollars as a high-income earner means you need to earn at least 3 million dollars ($1.4 million/(1-.5353)) in personal income over the next 25 years to repay the mortgage. Annually, you need $120,000 ($3 million/25 years) of personal income to pay for the monthly mortgage without taking into account property taxes, utilities, child care, maintenance, vacations, food and auto expenses.
- Home prices and interest rates usually fluctuate in opposite directions. Interest rates have been at a historical low for many years which is a big reason why home prices have increased. Buyers are able to borrow more when interest rates are low and therefore, offer higher prices for homes. This also presents a huge risk if you recently bought a house. You may be able to lock in rates for a few years, but if interest rates do increase, home prices will generally fall. If you are already over-stretched at current rates, you may not be able to sustain even a 1-2% rate increase. Selling your house also becomes more difficult because the rate increase means other buyers are not able to offer a high price.
- 25 years is a long time. Focusing on the monthly payment and stretching it over 25 years makes a large mortgage seem affordable. Many dentists start practicing dentistry closer to 30 years of age and they do so with hundreds of thousands in student debt. Many foreign-trained dentists practice dentistry in Canada even later, sometimes at the age of 50 or later. Don’t fall into the trap of working for your home and debts. Aim to repay your mortgage off within 15 years, not 25. If you can’t afford to pay it off in 15 years, then reconsider buying that particular home.
Another area where dentists get carried away is with real estate renovations. Unlike what television shows may portray, many renovations don’t pay for themselves. Worst yet are renovations that may reduce the value of your house such as swimming pools. We recommend doing renovations that you either need (i.e. new roof, furnace etc.) or that you have budgeted and saved for. Trying to justify a renovation because it adds value is a slippery slope that will result in overspending.
Home ownership provides many benefits and it’s something dentists should have as a goal. Understand all the costs and risks involved and then, make informed decisions on what’s right for you and your family. Your home should be your castle, not a disaster waiting to happen.
This article was prepared by David Chong Yen*, CPA, CA, CFP, Louise Wong*, CPA, CA, TEP and Eugene Chu, CPA, CA of DCY Professional Corporation Chartered Professional Accountants who are tax specialists* and have been advising dentists for decades. Additional information can be obtained by phone (416) 510-8888, fax (416) 510-2699, or e-mail firstname.lastname@example.org / email@example.com / firstname.lastname@example.org . Visit our website at www.dcy.ca. This article is intended to present tax saving and planning ideas, and is not intended to replace professional advice.