How Much Equity Is Enough?

The less actual cash invested in a house, the higher the return on “real” equity.

By Janet Arrowood

No matter how many times your clients have bought and sold homes, the dilemma of how much money to put down as a deposit, how quickly to pay off the loan and how much to use in line-of-credit and mortgage financing remains. Let’s look at some down payment and rate-of-return issues your clients typically have to address.

Many real estate analysts are predicting housing values will start to fall, and even plummet, in many parts of the country. The headlines of late seem to be variations of “Housing Bubble at the Bursting Point,” with dire predictions of 10, 20 or even larger percentage drops in home resale prices. Some parts of the country are already seeing stagnant or only marginally increasing house prices. Woe to the client who is the not-so-proud holder of a 125 percent mortgage/home equity line combination.

Some people hate or dread the thought of a house payment and want to wait until they have saved enough money to pay cash. But let’s hope they are never faced with a falling resale market.

Return on investment
Money in a home—the so-called equity—is only there on paper until the house is sold, closed and the funds are in the seller’s bank account. Until then, anything can (and too often does) happen. Prices skyrocket, plummet or stagnate. Clients over-mortgage their property and find it costs more to sell their home than they have in the house as “equity.”

Consider the total rate of return on the money invested in the house compared with the equity in the house. When analyzing a client’s assets, it is important to make sure the client understands there are three primary rates of return when he is looking at the investment value of a home:

• Return on the actual dollars invested (the down payment and improvements)
• Return on the “real” equity in the house (the amount of money your client gets when all debts and obligations associated with the sale of the house are factored in)
• Return on the paper value of the house—its year-by-year appreciation in value, based on sales of comparable homes

While your goal is to maximize your client’s return on invested dollars, the individual client’s goal may be quite different. You need to understand the different types of return on house investments and be in a position to explain these to your clients so they can make informed decisions.

Return on actual dollars
If your client buys a $200,000 house, there are many ways to finance the purchase. Each affects the total rate of return on the house’s equity. Generally, if the total down payment (actual cash plus the value of any piggy-backed second mortgage) totals less than 20 percent of the house’s appraised value at the time of purchase, there is going to be an added expense: private mortgage insurance (PMI). Many clients have great credit and large incomes, but not enough resources to put 20 percent or more down on a house. Or they want to keep as much of their assets in other investments as possible.

If your client puts 5 percent down on this house, and the paper value of the house grows by 5 percent a year, the rate of return is 100 percent—of the invested dollars. If the down payment is 10 percent, this rate of return drops to 50 percent, and at 20 percent down, the rate of return is 25 percent. This is not bad, but let’s consider the impact of PMI.

A 5 percent growth in the value of a $200,000 house is $10,000 per year (simple interest). If the cost of PMI is $100 per month, that reduces the paper rate of return to 8.8 percent ($10,000 - $1,200 = $8,800).

This sounds like a no-brainer—put as little money down on a house to maximize the paper rate of return. Of course, many clients are simply too risk-averse to consider having so little money in their house. What if prices fall, or even remain stagnant, effectively wiping out (and then some) the equity in the house?

Return on “real” equity
Until the house is actually sold, it is hard to accurately calculate the “real” equity in the house, but a look at the recent selling prices of comparable houses gives a good idea of a house’s value. There are fees and charges to consider—generally about 6 percent for the real estate commission and 1 to 2 percent more for other costs (taxes, fees, filings, etc.). Then any mortgages (first and second) and home equity line-of-credit balances and fees have to be deducted. Only then can the year-by-year real return on equity be calculated. Again, the less actual cash invested in the house, the higher the return on “real” equity.

Return on paper value
Clients have a tendency to over-value their houses. It is hard to separate their emotions from the reality of selling their home. In addition, clients are rarely familiar with what is going on in the market or what the costs of selling a house are. The result is they expect their house to be a far better investment than it is.

The down payment
The role of a financial advisor is crucial here. Clients need to put enough money down to ensure they break even if they have to sell in a bad market or on short notice. At the same time, having too much money in a house leads to illiquidity and poor total rates of return. Risk tolerance, goals and cash-flow needs are factors you can help your clients determine and evaluate. Some people need to have a large cash stake in their house; some want to tie up as little money as possible. The key is to strike a happy balance.

Janet Arrowood is the managing director of The Write Source Inc. She can be reached at info@TheWriteSource.org.