How Mortgages Create and Decimate Wealth

Yes, I used it…the dreaded “M” word.

To be honest, I am sick and tired of everyone and their dog running around spouting off about the housing market and sub-prime mortgages etc. Aren’t you?

The fact of the matter is that for the average person, the only mortgage that actually matters is their own!

A mortgage is a tool used for financial leverage. In fact, it is one of the best wealth creation tools available to the general public. It’s true…if you don’t believe me just try to go to your bank and borrow $100K to invest in the stock market.

Furthermore, the majority of the general public could not afford to “buy” a home without the assistance of a mortgage. A mortgage is a contract between you and your financial institution that says you promise to make the payments in certain intervals for a certain period of time and that you are using the real property as security for that contract.

It is really pretty simple when you break it down.

The key component of the mortgage lies in the fact that it is a financial tool of leverage. You are leveraging the power of your own funds (down payment) and the bank’s funds to purchase real property.

Leverage Can Be Good Or Bad

The leverage that a mortgage provides can be good for you when home prices are rising because if you sell your home for more than you purchased it for, the bank just wants the original mortgage paid off. In this instance you are left with a tidy profit (one that also has tax advantages…but we’ll leave that for another day).

Let’s say we purchase a home for $200,000 and decide on a 5% down payment. Our investment in the home is now $10,000 (plus some incidental closing costs etc.). If home prices were to rise by 10% and we decide to sell our home for $220,000 ($200,000 + 10%) we are left with a profit on the sale of $20,000. A 10% return isn’t that bad! But wait…we actually only put in $10,000 of our money to start with, so we actually doubled our money! This illustrates the positive power of financial leverage.
(please note that this is a very basic example)

Let’s take a look at the negative effects of leverage.

Supposed now that we purchased the same home for $200,000 and decided again on a 5% down payment of $10,000. In this instance home prices drop by 10% and we are forced to sell the home for $180,000. In this instance, not only have we lost the $10,000 down payment, but we still owe the bank $10,000! ($200,000 purchase price – $10,000 down = $190,000 mortgage)

As you can see, the mortgage is a VERY powerful financial tool and has the ability to create exponential wealth if used correctly. It also has the power to decimate wealth as well.

Margin Vs. Mortgage

Leverage can be utilized when purchasing stocks as well; this is called “margin”. Margin has the same basic effect as a mortgage, but is not nearly as much of a concern to the general public. Margin, as a tool of financial leverage is granted to those investors who have proven themselves to be worthy of such credit.

What makes mortgages so dangerous is that they are granted to most anyone in the general public regardless of any evidence of knowledge of the effects of financial leverage. Sure there is a credit check and the bank assesses your capacity to make the payments, but when banks start offering interest-only ARMs and other product to try to make homes affordable, there is bound to be trouble.

Know The Score

In fact, a lot of your ability to qualify for a mortgage and the interest rate you will pay is based on your credit score. The banks have access to your credit score and place a lot of faith on that number when making decisions. Qualifying for a mortgage and getting a great rate can be easy when you have a good credit score.  However, the average person doesn’t even know what their credit score is – let alone how to improve it.

Do you know what your credit score is? If you don’t, you can access it here for no cost through Experian. I highly suggest that everyone identifies what their credit score is and learns how to maintain and/or improve it.

On The Other Hand

It is unlikely that large stock brokerages will offer enormous margin accounts to “Joe Common” because he decides it’s “time I started investing in stocks”. Why then should mortgage lenders offer up hundreds of thousands of dollars in “leverage” simply because Joe decides it’s time to buy a house. Or, to make this worse Joe decides…”Buying a house is a great investment”!

I’m not going to tackle the subject of whether or not one’s home should be viewed as an investment; that is best left for another day.

However, if you’re itching for some good discussion, you can read a great debate on this subject at Ramit’s I Will Teach You To Be Rich and a breakdown of the financial decision to Buy vs. Rent from Jim at Blueprint for Financial Prosperity. Trent over at the Simple Dollar also unleashed a similar discussion while reviewing Rich Dad Poor Dad.

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