Free money at last!

Once my honeymooner guests agreed that purchasing a home would be a good investing goal, the question became how much equity to maintain?

I explained that if you have an empty glass, worth $100 (let’s say it’s a collectors’ item) representing your house then it makes no difference how much fine wine (also a collector’s item at $100 a glass) you have poured into it as to the future value of the glass …

… the glass can be full or empty, but if collectors’ glasses double in value every decade, it will still be worth $200 in 10 year’s time.

Of course, after consuming a few glasses of that fine wine, another question arises:

What happens if I put less money into the house (or other real-estate)?

Simple, you have to borrow the rest: less deposit, more borrowings/mortgage … more deposit, less borrowings/mortgage.

Then, in deciding exactly how much wine to pour into your glass, you think of the next logical question:

What’s the ideal amount (or %) to borrow against the property i.e. how much deposit should I put in?

Given the current ‘crisis’ in domestic RE values, it’s popular to imagine a high number: 20%? 50%? 100%?

But, it’s not so long ago (and, I wager it won’t be more than a decade before it comes around again) that it was popular to imagine a low number: 10%? 0%? Even negative 10% (as people borrowed 100% of the property PLUS closing costs)?

But, what’s the right number?!

Surprisingly, at least to me, there’s no magic ‘right’ number …

… once you realize that it matters not what equity you have in the house as to how your future wealth increases – based on the appreciation of such fine real-estate.

So, another question forms instead:

What does it cost/save me if I put in more/less money into the RE purchase?

Well, we know it does not cost you future capital appreciation, but it does cost/save you exactly what the bank would charge in you in mortgage interest and ancillary charges … circa 4% – 5% these days.

So, let me ask you two closing questions:

1. Do you think that you can do better than getting ‘free money’ by owning real-estate that appreciates, perhaps even doubling every 7 to 18 years (depending upon whom you believe), leaving you with virtually ALL the excess over the original purchase price?

2. Do you think that you can invest money that would otherwise cost/earn you only 4% – 5% for more than that [Hint: how about some more of that yummy real-estate? Failing that: stocks; business; P2P lending; etc; etc; etc? But, we covered this question last week ]?

… at least those are the questions that I put to our house guests 🙂

What do you think?

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7 thoughts on “Free money at last!

  1. I think you need to add another element in the logic here about risk management.

    I was just talking to friends this weekend and they have a rental property that has been sitting vacant for 12 mos. First they had to fix up the place after the last tenant trashed it, and now they have had trouble renting it out as local rents softened substantially (price war for lowest rents) and they have been slow to follow the market. They are annoyed by the negative cash flow from the place, but it isn’t killing them. However they have more than 50% equity and could sell the property quickly – even in today’s market – if they had to.

    My point here is: if you are low on cash and in a bad position to absorb negative cash flow situations on rental properties, you should have enough equity (i.e. down payment) to be able to sell the property quickly even if the market fluctuates 10-20% up or DOWN.

  2. @Jake,
    I agree that knowing (and following) your personal ability to handle risk is vital, espcially with rental property. I think Adrian is assuming you don’t go over his home property limits (20% of income was it?)

    And although my wife agrees that we shouldn’t pay extra on our mortgage (since our rate is only 4.5%), she still talks about paying it off early so she doesn’t feel indebted to anyone.

    So far I’ve managed to convince that as long as we *can* pay it off, we don’t have to pay it off, and our extra money is better put to use somewhere else.

    Heck I even set up an automatic transfer to move out the money we are saving thanks to the timely refi.

  3. @ Jake – We’re talking two scenarios here:

    a) Your own home – it matters not how the equity fluctuates as you move it from house to house over your entire life. Of course, rental is not the issue.

    And, Neil is right: once you are in your first home, the 20% and 25% rules ‘kick in’, partly to stop you from overinvesting in your home.

    b) Investment properties – the 20% and 25% rules do NOT apply here; but, it is sensible to maintain a buffer against future problems (such as vacancies) … I recommend witholding 25% of your rental income for this purpose.

  4. Pingback: Is your first home a good investment?- 7million7years

  5. Adrian, I have to think about this one, I’m in the camp that you don’t leave too much equity tied up in the walls of a house. That being said there is a risk factor or a comfort zone that every investor has to know. The bottom line is you don’t want to get over leverage and get caught on the short end of a declining market.

  6. @ Whittier – I have NOTHING to say about how much equity – as a % of your house value – and, EVERYTHING to say about how much equity – as a % of your Net Worth – you should have tied up in your own home 🙂

  7. Pingback: How much home should I buy?- 7million7years

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