Understanding the Risks of Leverage when Getting a Home Loan

Real estate has always
been seen as a low risk investment.  Houses always go up in value,
people say.  Sometimes prices might 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 and wait for the market to recover.

Before the 2008 fall in
real estate prices, many believed that houses could not decline in
value, at least not by much.  Declines of 5-15% had been seen here
and there, but certainly not 30-40% declines.  The thought was that
one should take out a huge loan and 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 that trip
you’ve been wanting to take.

For many the home has
also been the retirement plan.  One would have essentially no
retirement savings, unless the company they worked for provided a
pension.  Because the house was paid off, however, they were able to
sell the big house where they kids were raised and move to a small
condo, using the rest of the money for living expenses.  Somehow
there was this huge, risk free investment that only increased in
value and gave great returns.  It was even tax free unless the home a
was above a certain value.  Unfortunately the latest generation have
been taking out so many loans on their homes, getting a new loan for
a kitchen upgrade or a vacation each time the value increased, that
instead of having home equity to use for retirement they’ll have a
set of mortgage and home equity loan payments to pay well into their

Buying a home has been a
good investment for many that has resulted in a fairly good, if one
forgets about all of the upkeep expenses.  One must remember,
however, that risk and reward are always tied together.  One
investment type cannot generate a greater return unless it involves
more risk.  Note that the converse is not always true – there are
plenty of investments where the return does not justify the risk.

Until recently, many did
not realize the risk inherent in buying a home with a huge mortgage.
The reason that individuals could put a few thousand dollars (or
maybe nothing) into a home and sell it a year or two later and make
tens of thousands of dollars was that they were dealing in huge
amounts of leverage.  Leverage
is when a small amount of money is used to control a large amount of
money.  For example, with stock options one can pay a few hundred
dollars for a set of options that control a hundred thousand dollars
worth of stock.  If the stock goes up a few dollars, one can easily
make a few thousand dollars, resulting in a gain of hundreds of
percent even though the stock’s share price only changed by 10% or

The reason for the
outsized gains from home purchases in the 2000’s was that people 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 instead, 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 employed 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 than the
price for which you could sell the house.  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 the person was planning to stay in the home, but throw in a job
loss and you see someone trapped by leverage in a place with no jobs.
To make matters even worse, many of the loans were adjustable rate,
meaning that the initial low teaser rates were replaced with higher
rates, resulting in an increase in the monthly payment.  Because many
of the people who took out these loans could only afford the low
teaser rate, they were unable to keep paying the mortgage payments
after the rates reset even if they kept their jobs.

This resulted in a
foreclosure or a short sale, which drove prices down further,
uncovering other home purchasers, and the cycle continued.  In some
cases individuals decided it was unfair that they should have to
continue to pay for their mortgage if the house was not worth the
current loan value, so they simply stopped paying the mortgage,
driving prices down further.  Hence the current financial meltdown.

The point is not that
people shouldn’t 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.  Buying real estate as an investment is also a
good way to smooth out ones portfolio since real estate often moves
in a manner uncorrelated with the stock market.  When stocks go down,
house prices may go up or at least remain about the same, and rents
will usually continue to come in.

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.
In buying one’s own home, 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 term
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.  This will
save tens of thousands of dollars in the actual amount paid for the
home.  The interest rate will also be lower.

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 starting out
with a smaller home and 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.  With an adjustable rate mortgage, the interest rate will
always reset at the worst possible moment.  And with rates currently
at all time lows, in which direction would you expect them to reset

Comments appreciated! What are your thoughts? Questions?

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