Leverage

The Concept of Leverage - Maximized

Real estate is many individuals largest single asset.  They own real estate for many reasons, mostly to live, but in addition, its an asset in their retirement portfolio. One that creates wealth. This wealth comes in the form equity from market appreciation and paying down the mortgage, and tax deductibility of mortgage interest and property taxes.  The amount of benefit derived is a function of the individual owners income. Many are conservative and accept the benefit without an analysis of the benefit. 

Owning a home in the California has provided steady market appreciation over the last few decades.  There have been several 3-4 year periods where the market has cooled after periods of sharp appreciation.  But over time the market appreciation has been strong and steady.  Our local market has benefited from the “Go-Go” 90’s Tech boom and sustained low interest rates which lead to an environment of wealth and affordability.  It also had created the housing shortage we face today.  In spite of increasing interest rates demand continues to remain high as the number of listed homes continues to lag buyer demand.

The average homeowner is conservative.  They value the benefit of having the home as a place to live is paramount and investment and tax benefits secondary.  Most have taken advantage of the recent stretch of low interest rates and locked into 30 year fixed mortgages.  In some situations, it is my opinion the 30 year fixed loan, at any interest rate, is the wrong loan product.  The reasons are that most people do not live in their homes for 30 years, full amortization eliminates financial flexibility, and costs some people money, under certain circumstances.

The circumstances described here are specific to the Bay Area region of California.  The information contained here while factually correct may not be suitable where the real estate market is more cyclical and sensitive to swings in labor market and interest rate changes.  Please consult your local real estate professional for additonal information if you do not live in the Bay Area of Northern California.

Lets take 2 examples in retrospect. Lets roll the clock back to 1990 years and assume no knowledge of events to come.  One example will be a young early 30's couple, double income, no kids but planning to have some “when the time is right”.  They purchase a condominium close to 200k, a typical 2 bedroom 2 bath.  The other example will be a middle age couple 40's single income, children in high school.  They owned their home for 5 years, which we will value at $450k.  Interest rates then were higher, so lets say they both have 30 year fixed mortgages at 7.5%.

In the first example it is likely within 5 years the first couple may have life changes, they have a baby, likely have had several increases in pay, and their home equity starts to grow from the wealth created from the economy.  Specifically, stock option money creeping into real estate pushing prices upward.  Then interest rates start falling.  Its most likely the couple in this scenario did move at some point sooner than the 10 year mark but they could have been in their home long enough to refinanced at least once. In the second scenario, this couple would more likely have stayed in their home the full 10 years.  Refinanced several times, probably at least once pulling cash out to do home improvements, pay off high interest debt, or put towards the kids college tuition.

Both couples would have saved money with an adjustable rate loan of any kind by eliminating refinance costs and savings from lower monthly payments, but since their crystal ball was broken, the next illustration will show how they could have saved with any interest only fixed rate loan.

The graph above is a graphical illustration of the amortization table of several loans.  The purchase amount is $500k with 10% down.  These numbers are purely arbitrary and do not consider the impact of closing costs but the chart looks generally the same at any loan amount with 10% down and any interest rate.  The area under the curve will vary with the various interest rates representing interest paid.  Considering our examples above both couples would have paid down little in the 10 years of ownership. Comparing the amount of loan principal paid down to the amount of market appreciation and the original laon balance you can see the amount is very small.

Heres the clincher, this example is based on 5% appreciation.  There has been double digit appreciation in Contra Costa over the last 10 years.  In 2004 we have already 12%, last year three years have averaged 20-30% and according tomls data last years annual appreciation in Central Contra Costa County was 22%.

The tax benefits remain unchanged as the interest is till fully tax deductible and property taxes remain unchanged.

Now, should these buyers have taken out a loan of this type.  The younger couple probably should have provided they were planners and savers, or are upwardly mobile or union and have regular and steady income increases.  The middle age couple is a maybe.  Do these people need to maximize

One more comment about the interest only loan product, there are situations where the interest only loan is not appropriate.  This is for people who are investors or who plan to staying in their current financial or living situations for less than 10 years.   The interest only loan product additionally or consequently permits approved buyers to increase the amount of home purchased for a set loan payment.  In other words, buy a more expensive house.  Today, due to escalating prices, many first time homebuyers have used interest only loans to stretch financially into homes more suitable to their expectations.  The suitability of this decision is only recommended for individuals who anticipate regular and substantial increases of income over the planning period.