How pre-construction homebuyers can navigate higher mortgage rates on closing

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A series of aggressive interest rate hikes from the Bank of Canada (BoC) in the past year aimed at taming inflation have put pre-construction homebuyers on the back foot.

Financial advisors say they still have some options to manage higher expected monthly mortgage payments but can be limited if they’re struggling to qualify for the stress test.

When homebuyers purchase a pre-construction property, they’re “essentially buying a promise,” according to a RE/MAX Canada blog post. Rather than putting down a whole down payment at one time, buyers put down a smaller amount upfront and then make scheduled deposits until they close on the property. While homebuyers can continue saving ahead of their closing date, it also means an ultimately larger down payment than buying on the resale market. RE/MAX estimates pre-construction buyers end up paying up to 20 per cent upfront, as opposed to the minimum 5 per cent down payment resale buyers can make.

Buying well ahead of the home’s completion date also makes buyers vulnerable to rising interest rates, as their closing date will likely occur months or years after their locked-in rate expires. Realtors are reported to be hearing from more pre-construction condo buyers worried they may no longer be able to close the deal.

The BoC’s policy interest rate is currently sitting at 4.5 per cent, following an additional 25 basis point hike on Jan. 25. To pass the stress test, homebuyers may now qualify at 5.25 per cent or the mortgage contract rate plus two percentage points, whichever is higher.

Jason Heath, a fee-only certified financial planner and managing director at Objective Financial Partners Inc. in Markham, Ont., says interest rate hikes have changed some young clients’ budgets for buying a new home, while some clients who were purchasing pre-construction investment properties are now reconsidering the math of the rental income they can get relative to the mortgage they would pay.

Maili Wong, senior wealth advisor and senior portfolio manager with The Wong Group at Wellington-Altus Private Wealth Inc. in Vancouver, also says pre-construction buyer jitters are showing up in her practice, mostly in the form of clients concerned for their adult children.

“We’re seeing some stress with first-time homebuyers in their 20s and 30s who want to get into the housing market and are now worried about closing on their homes,” she says.

Ms. Wong generally does an “informal stress test” for clients preparing to buy a house or pre-construction property by giving them projections of how buying at different interest rate levels would affect their overall financial plan and ability to sustain their lifestyle and other savings priorities. That can give clients a reality check on what they can afford, or act as reassurance when rates have risen.

Mr. Heath acknowledges there will be some pre-construction buyers who are no longer in the position of being able to meet the stress test.

“The magnitude of the increase in interest rates combined with the magnitude of the drop in real estate and stock prices, among other things, has probably put a lot of people in positions in which a little tweak here and there might not solve the problem,” he says.

Selling before closing

For those buyers, he advises an assignment sale on the contract ahead of closing, but this option comes with tax implications. If the buyer is able to sell for a profit, it will likely be considered business income as they never occupied the home rather than as a capital gain – meaning the transaction is fully taxable.

“There are also people, no doubt, who would be selling at a loss, but I think that for anybody who is nervous about closing on a new property, they should at least be considering the potential of selling before it before they close,” he says.

Mr. Heath says someone purchasing a pre-construction property to use as a rental and selling at a loss might be able to make the case from a tax perspective that they were buying the property as a speculative investment and could possibly claim the hit as a business loss.

“But if they were buying it [with the] intention to move in on their own … they’re less likely to be able to do that,” he says.

Considering tapping into RRSPs and TFSAs

Depending on how soon they’ll be closing after their purchase, Aravind Sithamparapillai, associate at Ironwood Wealth Management Group in Fonthill, Ont., says these buyers may be able to use their registered retirement savings plan (RRSP) for the Home Buyers’ Plan (HBP). The plan requires applicants to move in no later than one year after buying or building the home.

In very specific cases, he says, pre-construction buyers who both qualify to use the HBP and are parents could focus on contributing to their RRSPs ahead of closing on their home. Doing so would lower their overall taxable income and thereby increase their Canada child benefit payment – which they could put toward their deposits or higher mortgage payments – and give them more money to pull out of their RRSP through the HBP.

But Mr. Sithamparapillai acknowledged that this approach “will only be useful in a small set of circumstances and also, given the magnitude of the issue for many people, may not have large enough of an impact.”

Buyers can also look to any other sources of money they didn’t initially plan to tap such as their tax-free savings account (TFSA), Mr. Heath says.

Ms. Wong says she advises making tradeoffs such as cutting back more on discretionary parts of their budget like travel savings or new-home furnishings. She also notes clients may want to consider looking for a higher-paid job or taking on a side gig, asking parents for financial help and reviewing their investments to see where they might be able to earn higher rates of return.

“If they have an RRSP or TFSA, or cash in a savings account, they can get a higher rate of return than last year because interest rates are higher and equity valuations have come down, so prices on high-quality bond and stock investments are very attractive,” she adds.

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