So You’re Conservative- Go 100%

Clients tell us all the time, “I’m too conservative to finance my home 100%.” This line of thinking is understandable it’s what we have been told our whole life and with all the media telling us how bad it is to finance 100%.

Let’s start this section with explaining something we talk about in most of our teachings. Equity in your home earns a 0% rate of return. Once again this is counter-intuitive, but if you will hang in there with us we will explain why we believe this.

Let’s assume two families want to live across the street from each other, they are buying similar $300,000 houses, and they both have $300,000 available for the purchase. Family A is old school in their thinking so they will put the whole amount down so they don’t have a mortgage. Family B believes in the New Rules of Money so they will finance $300,000 and keep the $300,000 for other investments. Let’s assume appreciation in the area was 5%, so both homes are now worth $315,000.

Family A put $300,000 down, had no mortgage and their house value went up $15,000. Family B put no money down, had a $300,000 mortgage and their house went up $15,000. The fact that Family A had more equity had no bearing on the value of the home, the home is going to go up or down in value no matter how much or how little equity someone has. Therefore equity in your home has NO Rate of Return.

In fact if you want to look at Return on Investment from our initial down payment Family A earned a 5% return on their $300,000 down payment and Family B earned an infinite return on their $0 down payment. If Family A had put 20% down $60,000 they would have earned a 25% return on their investment.

Ok, Ok, if Family B borrowed $300,000 they had some carrying costs in their mortgage. Let’s say the rate on their $300,000 mortgage was 7.00% (APR) and lets say that Family B was in the 31% tax bracket (25% federal 6% state) their net cost to borrow would be 4.83%. If they are paying 7% (APR) more than likely they could earn say 6.5% in a tax-free environment. (We are not qualified to recommend particular investments, we are just using estimates, check with a qualified financial advisor to verify the returns in our example.)

Here’s what that would look like. $300,000 earning 6.5% $19,500 in year one, their net cost on the $300,000 at 4.83% is $14,490 so they are ahead by $5,010 at the end of year one. Remember that amount would compound so in year two they would be earning 6.5% on $319,500. In five years Family B would have a house worth $385,000 (at 5% appreciation) and $414,845.20 in their side account.

Just to be fair, Family A could take that same net payment of $1,207.50 ($300,000 at 4.83% divided by 12 months) and invest it in the same 6.5% investment, they would have a house worth the same $385,000 and in their side account they would have $85,338.82.

Family B has $85,000 in equity gain and $114,845.20 in investment gains for a total of $199,845.20 growth in net worth. Family A has the same $85,000 equity gain and another $85,338.82 in that investment account for a total of $170,338.82 or $29,506.38 less than Family B. Remember that in the first couple of years Family B also had more than $300,000 in a conservative liquid side fund to handle life’s curve balls and Family A had very little in that account.

Which way is more conservative? A true conservative person would recognize that with 100% financing, the party with the most risk is the bank. The homebuyer has very little at stake. What if the property depreciates? Family A loses the amount the house depreciates while Family B hasn’t lost anything because their equity is separated into a conservative side fund that is still earning interest. Plus, in a depreciating market lenders are more inclined to do what is called a “short sale” where they actually take a loss and accept less than the person borrowed. Let’s say the $300,000 house is now worth $285,000 and you have say $17,000 in selling costs, the lender agrees to accept $268,000 ($285,000-$17,000) for full payment on the $300,000 loan. A good agent would also negotiate with the lender to not hold a deficiency judgment against the client. (There is no guarantee that a bank would do this, but they have in some areas of the country that have experienced real estate value declines.)

When you have your home financed to 100% you will have more options than someone that put more money down. Which way is more conservative? Which way is safer for you? Well if you can shift some of or most of the risk to the bank and away from you that would be the “conservative” approach, wouldn’t it? Of course we don’t recommend to do 100% loans and consume that down payment we suggest that you work with a qualified financial professional to put it into a conservative, safer, liquid side fund that earns at or above your net cost to borrow. That is the most conservative approach available.

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