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Last Updated: Nov 2nd, 2009 - 17:32:57 |
Popular wisdom aside, low equity best course for home purchase
Do you think it is good or bad to have a large equity in your home?
Equity is the difference between your home's market value and the total owed on its mortgages.
Most homeowners think it is a good idea to have a substantial equity in their residences. In fact, many homeowners have paid off their mortgages and own their homes free and clear with 100 percent equity.
But Uncle Sam now rewards those homeowners who leverage their homes with big mortgages and small equities. In the 1997 Tax Act, adopted in late 1997, the tax deduction rules for home mortgage interest were radically changed to encourage small down payments.
The new rule, effective for 1998 federal tax returns, allows homeowners to deduct mortgage interest for debt used to acquire or substantially improve principal residences. In addition, homeowners may deduct interest on home-equity loans up to $ 100,000 no matter how the proceeds are used. Existing home loans recorded as of Oct. 17, 1997, are "grandfathered" and are considered acquisition financing.
The definition of leverage is using borrowed OPM (other people's money) to control property and enjoy its benefits. The most extreme example of 100 percent leverage with no cash down payment is a VA home loan. The opposite zero leverage situation is a homeowner who has no mortgage and owns the home free and clear.
Suppose you buy a $100,000 home with a $100,000 VA mortgage. Of course you will be able to deduct all your interest payments on your federal tax returns, thus substantially reducing your after-tax net interest cost. In addition, you will be maximizing your leverage profits. If the home appreciates 10 percent in market value to $110,000 during the next year, what percent is that $10,000 profit? The correct answer is infinite since you made a zero down payment.
Now imagine instead that you buy the same $100,000 home for $10,000 cash down payment and obtain a $90,000 mortgage. Again the house appreciates 10 percent to a $110,000 value in a year. Now your $10,000 profit is a mere 100 percent return on your $10,000 down payment investment.
Finally, let's pretend you bought this $ 100,000 house for $ 100,000 cash and own it free and clear with no mortgage. If it again goes up in value to $110,000 in a year, your $10,000 profit is a mere 10 percent return on your $100,000 investment. I think you get the point that the lower your cash down payment, the higher your profit per dollar invested.
Most people think that high leverage, meaning a low down payment, is risky. However, just the opposite is true. Ask the nice folks in Texas, Oklahoma and Louisiana who lost much or all of their equity due to the recent decline in home values there because of the collapse of the oil industry.
When home values decline, those who suffer the most in lost equity dollars are those owners with big equities. To illustrate, suppose our three $100,000 example homes above decline in value to $75,000. The owner who bought with a $100,000 VA home loan lost nothing. The buyer who made a $10,000 down payment lost his $10,000 equity. But the free and clear owner who paid $100,000 for the house lost $25,000.
The morals to be gained from these examples are: The more equity you have in your home, the more you have to lose in a declining market.
The lower your equity, the bigger your profit percentage in a rising market.
Another way of stating these leverage principles is that, if you think property values will go up, high leverage with small equity will be profitable. But if you expect property values to decline, don't buy.
USA Real Estate Listings:
http://search.ezilon.com/united_states/business/real_estate/index.shtml
Europe Real Estate Listings:
http://www.ezilon.com/cgi-bin/estate/realestate.cgi
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