Your Mortgage : ‘Leverage’ Is Out--but ‘Equity’ Is in Fashion

QUESTION: I have followed your arguments about accelerating the payoff of your mortgage interest and have come to the conclusion that you’re all wet. Haven’t you ever heard of “leverage” and the wisdom of using the other fellow’s money to make money for yourself? Your emphasis on speeding up the payoff of a mortgage flies right in the face of this conventional wisdom.

ANSWER: On the face of it, nothing has quite the appeal in theory--except for finding the Fountain of Youth--that leverage has. For example: You buy a $100,000 house with a 5% down payment.

Two years later you sell the house for $150,000 (we’re ignoring selling expenses and whatnot for simplicity’s sake). How much of a gain do you have? Fifty percent, right? No, not really. After paying off the mortgage, you have a gain of $50,000, but since you only put up $5,000 in the first place you’ve got a solid gain of $45,000--nine times your actual investment.

Now, what’s wrong with that? Not a cockeyed thing, of course. The only problem is that it requires a neatly meshing set of circumstances that has become rare to the point of non-existence. What if the house, instead of appreciating 50% percent, declines in value 25%? So you sell it and where are you? Again ignoring selling expenses you’re going to come out of with $75,000, but unfortunately you still owe the lender $95,000 over and above the original $5,000 down payment which is already down the old rat hole. So you take a walk.

Why do we have record foreclosures today? In large measure for this very reason--reliance on leverage, which blew up in the face of thousands of home buyers. And this is also the reason why lenders have tightened up and the old 5% down payment and a casual attitude about the buyer’s debt load are out the window.

I don’t like to belabor a point, but I think that something very fundamental has changed since leverage hit the peak of its popularity: Leverage, as personified by debt, is very much out of fashion and equity is very much “in.”