By Dian Hymer
In times of steadily rising home prices, it's possible to use the equity accrued in an existing home for a down payment on a larger, more expensive home.
Let's say you bought a home for $200,000 with a 20 percent cash down payment of $40,000. Ten years later, the home is worth $275,000. Your family has grown in size and you're ready to move up to a larger $400,000 home.
After 10 years of making mortgage payments, you've paid your $160,000 mortgage down to about $140,000. Your selling costs, in addition to paying back the balance of the mortgage, will be about 7 percent of the sale price, or $19,000.
This leaves you $116,000 for a down payment on a new home.
Trading up is relatively easy when you can count on home price appreciation to provide the cash for the down payment. Today's trade-up buyers, however, can't always count on equity build-up. Depending on location, if you bought when the market peaked at the end of the 1980's, your home might not be worth much more now than it was then.
Even where home prices have appreciated substantially, some homeowners are mired in housing debt. One Oakland couple recently sold a home they'd owned for over 10 years. They paid $190,000 for the property and sold it for $350,000. They had remodeled the home extensively, refinancing with a $275,000 mortgage to pay for the upgrades. Their net from the sale was barely enough for a 10 percent cash down payment on their new trade-up home.
First Time Tip: There's no guarantee that a home will appreciate enough during your period of ownership to generate the cash required for a down payment on your next home. For that reason, you shouldn't buy a home purely as an investment. Home prices go up and down like stock prices.
The Oakland couple in the above example more than doubled their income during the years they owned their first home. This allowed them to qualify for a larger mortgage. So even though they didn't have a large cash down payment, they were able to move up to a $500,000 home.
They financed their purchase by using 90 percent financing consisting of a first mortgage for 80 percent of the purchase price and a second mortgage for 10 percent of the purchase price. The beauty of using a combination of first and second mortgages for 90 percent financing is that you avoid having to pay for Mortgage Insurance.
Putting less down on your trade-up home is one way to finance a move to a larger home if you have little or no equity. Another way is to liquidate other assets. Some home buyers are liquidating stock in order to come up with their down payment money. Others are borrowing against retirement plans.
Buyers tend to be leveraging their home purchases more today than they did in the past. This means that they are making lower down payments in relationship to the purchase price. Some buyers are leveraging out of necessity, others out of choice to conserve cash for other investments.
The Closing: Not everyone feels comfortable with high leverage. One way to build equity and reduce your leverage ratio is with a mortgage that's amortized over 15 years. The monthly payment is higher on a 15-year mortgage than it is on a 30-year loan. And you'll need a larger income to qualify. But, you start paying back principal (the amount borrowed) much more quickly and the long-term cost of the loan is dramatically less.
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