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decoding the mortgage market

Canadian Mortgage Trends editor Robert McLister's second column for The Globe's month-long Home Buying site looks at the perils of a 5 per cent down payment. Read his first column here.

There are thousands of 20- and 30-somethings out there who are tired of renting. They're itching to buy a house but they have one big problem: they don't have enough of a down payment.

Undeterred, some may fish a few toonies from between the couch cushions and scrape together the 5 per cent minimum down payment required by law.

Many of these folks will then lock in a bargain-basement 10-year mortgage at 3.89 per cent, find a hip property for about $300,000 and move in. For these new happy home owners, life couldn't be better.

But what if, seemingly overnight, the unexpected happened and home prices dove 15 per cent?

The mortgage balance of these young buyers would suddenly be more than their house is worth. If forced to sell now, they wouldn't be able to break their mortgage unless they made up this shortfall from their own pocket.

Their only choice is to ride out the real estate cycle - and hope it's not a long ride.

If the above scenario sounds like a long shot, think again. Home prices are a two-way street. We've almost forgotten what selloffs look like but, believe you me, they happen.

When prices finish dropping, they sometimes rebound - or they can stay flat…for years.

If the latter happens and you've saddled yourself with a big fat mortgage, you could wind up a prisoner in the home you used to love, a home which is now too far from your new job, too small for your growing family or too expensive with your spouse out of work.

This is the very real risk facing people who leap into a red-hot housing market with a dream, a 5 per cent down payment and very little savings.

While not a prediction, a 15 per cent-plus correction in markets like Toronto and Vancouver is a definite possibility. And that means fringe buyers who put down the minimum - and stretch their amortization to the maximum - are taking a Vegas-style gamble.

This hypothetical chart below shows what might happen if you bought a $300,000 house with 5 per cent down and a 30-year amortization. (The average purchase price for a first-time buyer is about $295,000, according to national figures from mortgage insurer Genworth Financial Canada.)

This chart assumes a 15 per cent drop in home value over three years and flat prices for another six or more years. (It also assumes you make no mortgage prepayments, pay a 2.95 per cent default insurance premium - as required by law, and incur roughly 6.5 per cent in liquidation costs, which include realtor fees, legal fees and disbursements, mortgage discharge fees and penalties, repairs and staging, etc.)

In this hypothetical scenario, if you wanted to sell your house after five years you'd owe at least $16,500 more on your mortgage than you could get from the sale.

So here's the simple point: If you have to stretch yourself financially to buy a new home, you're probably not ready to trade in your landlord for a lender.

If you do press forward with just 5 per cent down, be prepared to stay in your home a while - potentially a long while.

Here's what some people with experience say about 5 per cent down mortgages:

• "5 per cent-down mortgages are geared to someone that's more than a few years into their career, with path for advancement and income increases; someone who has a savings plan; and someone who's demonstrated that they're handling credit responsibility and are well below normal debt ratio limits. If a borrower's house was worth less than their mortgage debt, things like job loss, pay cuts and overspending would only exacerbate the risks and further limit their options." — Mortgage specialist Marc Ffrench, Royal Bank of Canada

• "The clients putting five per cent down on a $600,000 house with a high debt ratio are the ones you especially worry about. These are properties where you need two parties with six-figure incomes." — Mortgage planner Geoff Willis, Dominion Lending Centres Origin

• "A five per cent mortgage really isn't suited to a lot of people. If you absolutely have to put down 5 per cent, aim to make additional payments every year to amortize the mortgage faster." — Financial adviser Adrian Mastracci, KCM Wealth Management

• "You should also have some kind of emergency fund - at least three months of living expenses. Put it at an institution that has not lent you any money because they can sometimes use money in savings to offset (delinquent debts)." — Mr. Mastracci

And by all means, if you can't make a healthy down payment, be sure you're financially stable and love your house. There's a chance you could be in it a lot longer than you think.

Robert McLister is the editor of and a mortgage planner at Mortgage Architects. You can also follow him on twitter at @CdnMortgageNews.

For tips, stories, videos and live chats about what's going on in the real estate market, check out the Globe's Home Buying section for daily updates.