Wednesday, November 28, 2007

Why Taking a Mortgage Is Leveraging Your Equity: Understanding the Potential Risks and Benefits

Buying a property with a combination of equity and mortgage is actually leveraging your own equity. Leverage is essentially the use of borrowed funds to complete a transaction. Leveraged transactions hold significant potential benefits and, more importantly, significant potential risks. It is important to understand why leverage is the source of these risks and benefits.

In order to simplify matters let’s look at the following example:

1. John has 1,000$ he wants to invest in ABC Inc. (ABC).

2. We’ll assume two scenarios:
a. One where ABC goes up by 10 and John gains 100$.
b. One where ABC goes down by 10% and John loses 100$.

Investing his 1,000$ John has either gained or lost 100$.

Reading a blog post about leveraging John has decided to loan an additional 1,000$ at 5% from GoodWill-NoSoul Bank (GWNS). John now has 2,000$ to invest but he also has a loan to repay with interest. Let’s examine the results of the two possible scenarios:

1. ABC goes up by 10%: John now gains 200$, repays 1,050$ and is left with a net gain of 150$
50% more then he had gained without leveraging

2. ABC goes down by 10%: John has lost 200$, repays 1,050$ and is left with a net loss of 250$
150% more then he had lost without leveraging

This outcome is due to the loan taken which is repaid in all scenarios. This fixed loan payment causes the results of the scenario’s to vary greatly thus increasing the inherent risk in the transaction (measured usually by the statistical variance of possibilities).

It should be clear by now why buying a property with a combination of equity and mortgage is leveraging. In the case of sudden drops in housing prices, much like the current market situation, a borrower might find himself (or herself) in a very difficult spot, having not only lost on his equity but on the debt as well. The mortgage is to be repaid in all scenarios.

This result of leveraging equity with mortgages is also behind the current sub-prime crisis. This crisis is essentially a sharp drop in housing prices which caused sub-prime lenders immense losses on both equity and mortgage and left them with no ability to repay the loan taken.

Image by D'Arcy Norman


Richard said...

Excellent post Dorian.
Recently, mortgage lenders have made adjustments in what they will lend, and to whom. This shrinks the pool of eligible mortgage borrowers. Mortgage lenders use credit scores to predict the likelihood of a homeowner not paying on a home loan. The lower the score, the more likely a homeowner is to default.


SA Property said...

Yeah in South Africa we recently had something called the Credit Act that was put into place.

They did this because of the poor credit ratings people in South Africa had and with credit just being given out left right and center including mortgages, people were falling into massive debt traps.

The new credit act has fixed this and we get rated accoding to something called the delphi score which is your credit score rating.