Borrowing as Much as You Can Creates Leverage

By Dian Hymer

Many financial advisors, even conservative ones, recommend borrowing as much as you can at today's low interest rates. Today, lenders make it easier than ever to do just that.

Not long ago, lenders limited the amount borrowers could pay for their monthly housing expense (principal, interest, taxes and insurance) to 28 percent to 32 percent of their monthly income. Now, many lenders permit high income-earners to apply as much as 50 percent of their income to their housing expense. This makes it easier for borrowers to qualify for larger mortgages and to buy more expensive houses.

Lenders have also eased up on the amount of cash they require a borrower to contribute to a home purchase. First-time buyers in high-priced markets like San Francisco, Boston and New York City, are often making cash down payments equal to 5 percent of the purchase price, or less. A couple of decades ago, the norm was 20 percent.

House Hunting Tip: An advantage of borrowing as much as you can is that you can take advantage of leverage. Leverage is using someone else's money to buy an investment. The less of your own money you use to buy an investment, the more highly leveraged you are. For example, if you put 5 percent cash down and borrow 95 percent of the purchase price, you'll be more highly leveraged than you would be if you borrowed 80 percent and put 20 percent down.

One reason to consider a highly leveraged purchase is that the profit potential is greater than it would be with a less leveraged purchase. Suppose you buy a home for $350,000 and put 20 percent, or $70,000, down. If the property appreciates 10 percent, it will be worth $385,000. You will have earned $35,000, a 50 percent return on your investment of $70,000. With a 10 percent down payment of $35,000, you earn 100 percent on your investment. The lower down payment yields a higher return. But, if you were to pay all cash, you would earn only 10 percent on your investment.

Keep in mind that where there's a high profit potential, there's also high risk. Leverage works wonders as long as property values are going up. But, when values reverse direction and decline, a highly leveraged investor can end up owing more than the property is worth.

During the early 1990's -- another time when lenders made it easy for home buyers to qualify for mortgages -- many first time buyers got themselves in to trouble with highly leveraged financing. One young couple, with two small children, bought their first home with 10 percent down. The real estate market softened soon after they purchased. About a year later, they were transferred. They kept the property because they thought they'd be returning to the area, and they didn't want to sell in a bad market.

After a few years, they realized they wouldn't be transferred back and decided to sell. Property values had dropped about 20 percent. So, when they sold, their mortgage amount far exceeded the sale price. They had to use savings in order to make up the difference to complete the sale.

When home prices are rising steadily, as they have been for several years in this country, buyers usually feel compelled to buy before prices rise further. As prices rise, buyers often find themselves taking out larger mortgages to make their home purchases possible. As buyers with limited cash resources, chase the market higher, they inevitably find themselves in a more highly leveraged purchase.

The Closing: You can reduce the risk factor by buying for the long-term so that you're not caught having to sell in a down market.

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