Leveraging Real Estate To Build Wealth: Investors are constantly bombarded with conflicting information on debt, in small soundbites without much additional context. If you scour the internet for influencers’ takes on debt, you’ll see two major schools of thought:
1. Debt is evil. You must do everything you can to eliminate debt and get out from under creditors.
2. Debt is the only way to generate wealth. Get as much money as you can from many lending sources to build your fortune.
There are issues with both viewpoints. Like most things in life, debt is not binary. Some kinds of debt certainly can promote wealth creation, while some can lead to destruction of wealth. These things are dependent on some key factors. This article focuses on debt directly related to housing.
Mortgage interest rates increased across the board over the past year. After years of basically free money and consistently rising home values, people suddenly cannot afford the monthly payment on mortgages they previously could have afforded. The last 10 years, the S&P/Case Schiller U.S. National Home Price Index has enjoyed historically outstanding returns, with home prices increasing an average of 7.7% per year, causing many to want to rush to get into the housing market.
Here is the double-edged sword of housing debt: Borrowing allows people to gain leverage. If you put a $200,000 down payment on a $1,000,000 home and that home value goes up 20% to $1,200,000, you have a $200,000 gain, or a 100% return on your investment (if you sold that day, not considering the interest on the loan you’ve paid or broker commissions).
Leveraging: The Good and the Bad
However, leverage works both ways. In 2008, many people had underwater mortgages, meaning they owed more than the equity they had. Let’s use the same example of $200,000 down on a $1,000,000 home. This time, the home decreased in value by 25% to $750,000. Your equity in the home would then be -$50,000. If you sold your home, you would not only be out $200,000, but you would still owe the bank $50,000. Give careful consideration to purchases using leverage, especially if you may not be able to stick out housing swings or may want to move within five years.
I know many people who have enjoyed the growth of real estate recently and have low-interest mortgages. Sometimes, investors in these cases are in a rush to pay off their mortgages. If you have sufficient equity in your home (say 40%), there is a good argument to be made for keeping that debt on your balance sheet. Individuals get tax benefits, and they could invest excess funds they may have used to pay off their mortgage balance in full to get additional returns above and beyond the interest they are paying. For example, the S&P 500 has averaged more than 10% in returns per year since 1926 . The stock market can be volatile year to year, so I would recommend a long-term vision and high risk tolerance for a strategy like this. Even certificates of deposit rates may yield higher returns than the existing low interest mortgages from more than a year ago.
Home Equity Lines Of Credit
Other real estate investors talk about purchasing a home and taking out the equity in the form of a Home Equity Line of Credit. If an investor has a surplus of home equity, this can be an effective strategy for gaining liquidity, bearing in mind that the person must have sufficient cash flow to pay off this new debt. Some people advise taking out a HELOC for 100% of the equity gained from housing appreciation to put a down payment for your next mortgage to keep gaining more properties. I urge caution in this strategy. Contrary to what some influencers may indicate, there is no guarantee of property values increasing. Over-leveraging oneself is a far greater risk than the diversification benefits one would gain from this strategy.
Again, debt is not binary. It can be a useful tool for wealth creation but each time you take on debt, think about the impact it will have on you and your financial future.
By Cicely Jones, Contributor