Leverage

SUPPOSE YOU BUY a $300,000 home. To avoid taking out private mortgage insurance, you make a 20% down payment, equal to $60,000. You borrow the other $240,000 using a 30-year fixed-rate mortgage with a 5% interest rate. Five years later, your home is worth $360,000, or 20% more than you paid.

Your gain, however, looks considerably larger. Your home equity, which was initially $60,000 thanks to your down payment, has grown to $120,000. That’s the wonder of leverage: A 20% rise in your home’s value translated into a 100% increase in your home equity. In fact, your home equity would be closer to $140,000, because you would have whittled down the $240,000 mortgage balance to almost $220,000 with your first five years of monthly mortgage payments.

But leverage is not always so kind. From the mid-2006 peak to the early 2012 trough, home prices tumbled 27.4%, as measured by the S&P CoreLogic Case-Shiller U.S. National Home Price Index. In the above example, that decline would have left you underwater, wiping out both your $60,000 down payment and the $20,000 you had trimmed from the mortgage balance with your five years of monthly payments.

Moreover, even if your home’s value had climbed by 20% to $360,000, you would have paid a high price for that appreciation. Over those first five years, you would have coughed up almost $58,000 in mortgage interest. There would also have been homeowner’s insurance, property taxes and maintenance expenses. Sound bad? It gets worse: If you tried to cash in your gain and paid a 5% real estate commission to sell your $360,000 home, you would immediately lose $18,000.

Yet none of this should dissuade you from buying a house. We’re still missing the final piece of the puzzle: the so-called imputed rent.

Next: Imputed Rent

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