The dream of home ownership could turn nightmarish
May 4, 2017
The sad reality of this crazy booming real estate market we have seen in Oakville recently, could end up hurting people.
That financial pain could be felt for decades.
One of the characteristics of owning a house is that mortgages are often much larger than the down payment.
Financial leverage is a wonderful thing when markets are rising, but it can suddenly turn negative if the value of your house declines.
Let’s consider two examples.
The first shows the financial benefit of leverage during a rising market.
In our example, we will assume a couple purchased a $1 million home.
Some homes in Oakville sell for less, some for more.
Assume the couple had a down payment of $250,000 and was able to arrange a mortgage of $750,000.
If the value of real estate rises by 25 per cent the value of their house would be worth $1.25 million.
Because they only invested $250,000 of their own money, that increase resulted in them doubling their equity.
This couple has just made a huge financial gain with an asset that is tax-free because it is their principal residence.
For them, that’s probably the best investment they have made.
All is well in that household. Start with $250,000 and suddenly the equity in the house is $500,000.
The second example is different. After $250,000 is invested in a house worth $1 million the real estate market declines in value.
If the decline in house value was 25 per cent, now their house would be worth $750,000. They still owe a mortgage, so all of their home equity has now been lost.
The example I’ve used here is not extreme. Investments can easily rise or fall by 25 per cent. That is normal.
From an investment perspective, there is nothing unique about the value of your house. It is an asset and assets can, and do, change in value.
Sometimes up and sometimes down. That’s just the way things work.
What makes these two examples so extreme is the use of leverage.
Financial leverage magnifies the end result.
Leverage is the best thing possible when values are rising. But it can be devastating if values decline.
This column is by no means forecasting the future value of house prices in Oakville. My intent is to convey the significance of financial leverage.
If house values are maintained, or if they increase, then all is well.
If the value of houses decline in Oakville, it could be financially disastrous for those who have purchased a house with a large mortgage.