Real estate has always been seen as a low risk investment. Houses always go up in value, people say. Sometimes prices stall for a while or don’t grow that fast, but they will always pick up again. You may need to just sit pat for a while.
Before the recent fall in real estate values, many believe that houses could not decline in value, at least not by much. The thought was that one should buy all of the home one could. As it went up in value, you would gain on the equity. You could even take the equity out and pay for college, a new car, or just that trip you’ve been wanting to take. Somehow there was this huge, risk free investment that only increased in value and gave great returns.
Until recently, many did not realize that they were dealing in huge amounts of leverage. This is why they could make $20,000-$50,000 per year or more from their house appreciating, despite never having anything like that kind of money to invest. The reason for the outsized gains was that they were putting small amounts of money down, sometimes less than 5% of the home’s value, and using leverage to control the rest. For a down payment of $5,000, or no down payment at all, one could buy a $500,000 house — you were multiplying the purchasing power of that $5,000 one hundred to one! If the housing market went up just 5% that year, you could make $25,000, or a 500% gain. If you had bought the house for cash, you would have only seen a 5% gain, and most of that would have been due to inflation. It is the large amount of leverage that causes the outsized gains.
But as anyone who has even dealt with leverage will tell you, it cuts both ways. If that same house went down just 5%, you would now owe $20,000 more that you could sell the house for. The person who had trouble scraping together the $5,000 down payment and was barely able to make the monthly payment now would need to come up with $20,000 from somewhere if he wanted to sell the house. This was not a big deal if he was planning to stay put, but throw in a job loss and you see someone trapped by leverage in a place with no jobs. This resulted in a foreclosure or a short sale, which drove prices down further, uncovering other home purchasers, and the cycle continued. Hence the current financial meltdown.
The point is not that people should not buy houses – it is definitely good to get to the point where you own your house outright and don’t need to worry about a rent payment. The point is to understand the leverage involved in real estate loans and to minimize the amount of leverage used to lower risk and avoid being trapped. Here’s how:
1) Make as big a down payment as possible. 100% down is not a bad plan. If you can’t manage that, at least give yourself enough of a cushion so as to not be trapped in the house if prices decline.
2) Take out as short a loan as you can. You should have the house paid off before the kids are ready for college. Think 15 year loans or less.
3) Home mortgage payments should not exceed 25% of your take home pay. This is a manageable amount. A bigger loan increases risk of default should something happen to your income stream. Even if you have the disposable income to make the payments, a large mortgage will reduce your ability to save for retirement and obtain other goals.
4) Consider trading up. Remember that your parents didn’t start their first job and buy a 4000 square foot McMansion. They probably started small and worked their way up. If you can start in a small house early when you don’t need much space (and could use the extra time working rather than cleaning house or doing yard work), work hard to pay it off, and then trade up in house with a big down payment from the sale of the smaller house, you can reduce your risk substantially.
5) Always use a fixed rate loan. The interest rate will always reset at the worst possible moment. And with rates at all time lows, which direction would you expect them to reset in?
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Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.