By Dian Hymer
One benefit of buying real estate is that you can use someone else's money to finance the purchase. This way, you tie up a small amount of your own cash relative to the purchase price. If the price of the property goes up, you earn appreciation on the entire asset, not just on the amount you invested. This is called leverage.
Let's say you buy a property for $300,000. You make a cash down payment of 20 percent of the purchase price, or $60,000. Ten years later the property is worth $400,000 and you sell it. You will have earned $100,000 in appreciation. Your $60,000 investment will have earned a return of 167 percent.
Now suppose that you bought the same $300,000 property, but put only 10 percent down, or $30,000. In ten years, if you sell, you will have earned the same $100,000 in appreciation. But, your $30,000 will have returned over 300 percent of your original investment.
The higher the leverage, the greater the opportunity for a higher return. But, along with higher leverage comes a higher risk factor. Here's why. Real estate prices are in a continual state of flux. They move up and down, although historically the trend has been upward. If you buy a property with 10 percent cash down and prices drop 10 percent, you'll lose your cash investment unless you can wait for prices to rise again before you sell.
For many homeowners, having a large mortgage is well worth the risk when tax relief is taken into account. With some restrictions, the federal government permits homeowners to write off interest paid on their home mortgages. The larger the mortgage, the bigger the write-off. However, keep in mind that the tax break comes at a price. If you're in the 28 percent tax bracket, you can write off 28 cents for each one dollar of interest paid. So you pay one dollar for a 28 cent tax break.
Buyers typically put in the range 5 to 25 percent cash down. The larger the cash down payment, the easier it is to qualify. Your lender will determine how much you can borrow based on your credit, cash assets and income. Lenders usually want the monthly housing expense (principal, interest, property taxes and homeowner's insurance) to be no more than 28 percent of the borrower's gross monthly income, but some lenders are more flexible.
First Time Tip: With interest rates as low as they are today, you may find that you qualify for higher mortgage payments than you feel comfortable paying. Although lenders review your entire financial statement before granting a loan, they base loan qualification on guidelines that don't factor in the financial goals of individual borrowers. Determining what size mortgage is right for you is a personal decision that you should make based your current and anticipated income, your overall investment strategy and the property in question.
For example, suppose you're buying a home that needs a lot of renovation. You could finance the improvements by taking out a construction or equity loan after closing. However, the interest rate charged on these loans will usually be higher than it would be on most home mortgages. Also, the loan term will usually be shorter. So you might be better off financing the initial home purchase with a larger mortgage. The cash you conserve by making a smaller down payment can be used to pay for renovations.
The Closing: Regardless of the mortgage amount, be sure that you have enough cash reserves to cover unexpected expenses like home maintenance.
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