Payment Engineering

When buying a home one should keep focused on the actual price as opposed to the payments. This is especially true today with all the ways the they can be made to appear lower in advertisements. Consider this builder ad I found in the "Homes" section of the Edmonton Journal.



$611 bi-weekly? In the example below I will start with a fairly normal mortgage and work towards this engineered payments of $611. This will highlight how much impact different choices can have on the appearance of financing costs.

The listed price is $383,800. With a 10% down payment, 2% of that would go to CMHC fees and the total mortgage amount would be $353,096. Assume a 25 year amortization, 10% down and a 5 year fixed rate of 4.5% the mortgage payments would be $1,954.30/month

This does not include property taxes typically rolled into the mortgage payment. I would not expect a builder to include this but it is useful to note among other things when comparing to rent. These payments are for the first 5 years only, the remaining 20 will be paid back at a different rate. For example if interest rates are 7% during the last 20 years of the mortgage the monthly payments for that time period would be $2,384.91.

How do we get to $611?

1. Bi-weekly payments

Bi-weekly is a clever way of showing payments because initially people think of it as pretty much two payments a month. However on average throughout the year it is actually 2.17 payments per month. $1954.30/month works out to $977.15 semi-monthly and $901.99 bi-weekly.

2. 35-year amortization

Bi-weekly payments are reduced from $901.99 to $767.06 when the amortization is increased by 10 years. No free lunch here as in the end the longer amortization costs a lot more in total interest.

3. Downpayment

This example started with a 10% down payment but this ad used a 20% down, or $76,760. A buyer enticed by low bi-weekly payments over 35-years probably would not be putting down that much which is why I picked 10% for this example. Using a 20% downpayment reduced the payment to $667.01.

4. Interest rate

There was no mention of the interest rate but clearly they are using less than 4.5%. With a 3.84% rate instead I arrive at payments of $611. This rate is now only available with a shorter term, probably 3 years, which neglects the remaining 32 years of financing at unknown (higher) rates.

All the above serve to reduce the payment shown but each carries some risk or cost. No matter how the debt repayment is structured buyers are on the hook for the purchase price.

Update: This ad has been updated with payments of $599. They must have lowered the interest rate used in their calculations.

Marketing Synergy

The city of Edmonton teaming up with Rohit, Landmark and the Edmonton Journal to build and market townhouses for stretched wage earners in a program called First Place Edmonton. The prices aren't terribly cheap at $266,710 for a two bedroom townhouse in Millwoods. The land is valued by the city at $30,000-35,000 so Rohit could end up with $235,000 to build the structure of a two bedroom 906sqft townhouse with no garage and an unfenced yard. In the same area of Millwoods some townhouse prices appears to be competitive to these values. For Example:

This townhouse is fairly close to the development in Greenview. It is built in 1989 but unlike the City of Edmonton/Rohit townhouse it has an attached garage and a third bathroom. It has quite a bit more space (1345 vs 906 sqft) for a similar asking price of $274,900. The appliances, finishing and exterior appear to be fairly good from the photos.


This 1995 duplex with attached garage is close to the Canyon Ridge development at $279,000 is a few thousand more than the townhouse but has a back yard and more space.



The Edmonton Journal appears to be helping advertise these units for Rohit and Landmark developers in the article titled "First-time buyers catch a break in housing deal"

Under the new program announced Tuesday, 85 townhouses in the Greenview and Canon Ridge communities will be sold at a cut rate to qualified first-time home buyers.

The lottery is a nice touch as it is a well known marketing strategy used by developers.

In order to buy one of the 85 townhouses, applicants must enter a city-run lottery. There are strict guidelines on who can enter the lottery. Potential buyers must have a combined family income of $69,000 to $88,000 per year.

The qualifying metrics are outdated as they use the now defunct 40-year mortgage. From the First Place Edmonton site:

* Must be first-time home buyers in Canada
* Must be Canadian citizens or have permanent resident status
* Must be able to obtain qualify and have pre-approved financing (based on 5 % down payment, 40 year mortgage amortization, 32% gross debt service ratio and 42% total debt service ratio)
* Must be employed and have a combined income between $69,000 and $88,000, see your financial lending institution for more details.
* Must have a net personal worth less than $15,000, excluding a primary vehicle, locked-in or group RRSP and the 5% down payment required for the condominium unit.
* Applicants must agree to be full time occupants and residents of the condominium unit for the first five years.

Since this program was initiated 40 year mortgages have been discontinued by the Government of Canada because they pose too great of a risk to the financial system. It is interesting to note that the City of Edmonton suggested these mortgages to help Rohit and Landmark developers sell houses.

I just don't see how these deals are remarkable. Other examples of townhomes can be found throughout Edmonton. A 2004 townhouse in less central but more "faux-posh" Summerside is listed for $288,000. This listing has more space, a double garage and has been on the market for some time so the market price may differ from list.


Just north of Ellerslie Road there are a glut of townhouses in this price range and lower lingering on the market. This is very apparent when using the REALTOR.ca website with map search!

What the ads don't say

Here is a builder ad for new condos in Edmonton I got in the mail:


Wow! $824/month
The fine print:
4.15% with a $9875 down payment & combined income of $51,364.

On the back:
*Based on a variable rate of 4.15%, OAC, clients to qualify at a 3 yr posted rate with 5% ($9,875) down. Own with a combined income of $51,364. Rates subject to change without notice. E&O apply.

So I assume the payment is based on the lowest priced unit at$197,500 at a low variable interest rate that is subject to change.

What's not on the ad:

1. 40-year amortization. The only way to get this type of payment is to use an extended amortization. Not surprisingly, this is pretty much standard for first time buyers now.

2. CMHC fees. When putting down less than 20% CMHC fees apply. This is a percentage of the loan balance based on size of down payment and amortization used.

Here is a table of premiums from the CMHC site.

Financing Required	Premium % of Loan Amount
Up to and including 65%	0.50
Up to and including 75%	0.65
Up to and including 80%	1.00
Up to and including 85%	1.75
Up to and including 90%	2.00
Up to and including 95% Traditional Down Payment Flex Down	2.75 2.90
Up to and including 97% Traditional Down Payment Non-Traditional Down Payment	2.90 3.00
Up to and including 100%	3.10
Secured Line of Credit Surcharge Non-amortized repayment option: 5 years 10 years	0.25 0.50
Extended Amortization Surcharges Greater than 25 years, up to and including 30 years Greater than 30 years, up to and including 35 years Greater than 35 years, up to and including 40 years	0.20 0.40 0.60
*Premiums in Ontario and Quebec are subject to provincial sales tax — the sales tax cannot be added to the loan amount.

So with 5% down and 40 year amortization the expect CMHC premium is 2.75+0.6= 3.35%. This gets rolled into the loan balance calculated as follows

$197,500 (purchase price)
-
$9,875 (down paymnet)
=
$187,625 (mortgage balance before CMHC premium)
+
$6285 (CMHC premium)
=
$193,910 (mortgage balance)

Using the above loan amount 40-year amortization and an interest rate of 4.15% returns a monthly payment of $828 using this mortgage calculator. Basically the same as the number used in the ad.

3. Floor plan details

So I am making the assumption that this price refers to the smallest 1 bedroom floorplan on the main floor of the complex. This floorplan is 610 sqft and shown below.

I thought I would be creative and add a 6ft tall person laying on the floor of the master bedroom. (estimated from dimensions on drawing)

It is also interesting to add up the square footage of the rooms above:

living: 11`x 9`2 = 100.83 sqft
dining: 11`x 5`4= 58.67 sqft
kitchen: 7`9 x 8`3 = 63.94 sqft
bedroom: 10’-1 x 11’4 = 114.28 sqft
bath: 5’-1 x 8’2 = 41.51 sqft
total of these 5 rooms:
379.23 sqft

Note that I did not include some of the other areas such as the laundry/"storage"or the "walk-in" closet or hallways/balcony so i do not dispute that it is possible to arrive at the 610sqft using an alternate method. Even still there is more fine print on the floorplan:

The developer reserves the right to make modifications and changes to building design, specifications, features, and floor plans. Suite sizes are approximate, and are based on building area not the legal measurements as shown on condo plan.


4. Condo fees - the quoted price does not include condo fees.

5. Property tax - the quoted price does not include property tax. You know the tax that pays for stuff like this.

These ads are very common in the industry. Take a look at a different one shown below, I wonder what type of financial engineering is used to arrive at the payment shown.


I strongly recommend watching this CBC Marketplace video on buying a new condo.

Yours for just 300 easy payments

Consider this promotion offering a Toyota Camry with a new home.

No, the developer isn't just being nice giving you a free Toyota Camry. You'll just end up taking out a bigger mortgage and paying off your car for 25 years (or more).

Here is what the Toyota looks like in the first year of amortization.
And this is what it will look like once it's paid off.
Reclaimed by nature.

**Correction: The offer is for a 3-year lease. The same concept applies - the cost is added to the mortgage and you end up paying for 25+ years to lease a car for 3.

Builder Incentives and Arbitrary Pricing

A home builder is offering the following incentives in an advertisement found in the Edmonton Journal:

• 3.95% 3-year fixed mortgage
• No payments until May 2008

They value these incentives at $37,317 Based on the following:

• sales price of $519900
• 10% down, 40 year amortization
• compared to a rate of 6.05%.

With a $52,000 down payment and ignoring the months effected by the incentives, the monthly payment would be $2,566*. For 40 years!

What happens if we lower the price and reduce the amortization to 30 years?

• sales price of $482,583 (original price - incentive value)
  
• same $52,00 down payment
  
• 30 year amortization
• Rate of 6.05%.

The monthly payment would be $2,575. Virtually the same as above. Bottom line is a lower price is much more useful to the consumer than incentives. In this example a person could use the estimated cash value of the incentive to pay off the mortgage 10 years sooner.

Why use incentives then? With prices being arbitrarily high the psychological effect of incentives valued at $37,317 is greater than a price decrease. On paper the difference between $519,900 and $482,583 does not get as much attention. Also the incentive may cost the builder less than the estimated value in the ad.


*using TD's mortgage calculator.