REAL ESTATE'S PUNCH

The Miracle - and Curse - of Leverage

Most home purchases are closed with the help of a mortgage. The buyer makes a down payment, often in the range of 20% of the house price, and a lender provides the remaining funds to be repaid over an extended period of time, up to 30 years. In January 2021, the median home sale price was $303,600, according to the National Association of Realtors. In January 2022, that number had risen to $350,300. For the median purchaser who closed in January 2021 with a 20% down payment, that's a 77% one-year return on home equity: ($303,600*.2)/($350,300-$303,600).

Forbes Advisor tells us: "Whenever you borrow money to acquire an asset or potentially grow your money, you're using leverage ... When you purchase a house with a mortgage, you are using leverage to buy property. Over time, you build equity-or ownership-in your home as you pay off more and more of the mortgage." In the past year, home purchasers with 30-year loans built up a small amount of equity through monthly payments, but experienced a much greater equity growth through market appreciation. Their house-related net worth rose from $60,720 to $112,420: $60,720 down payment + $46,700 + $5,000 principal repayment. Some people would call that a miracle.

The impact of rising rates on monthly payments for a $280,240 (20% down) mortgage used for a median $350,300 home purchase shows the curse of leverage. From April 2020 to December 2021, the 30-year mortgage rate fluctuated around 3%. Since January 2022, 30-year mortgage interest rates have risen from 3.11% to 5.11%. Its impact on a median home buyer is shown in this table:

The "Power of Debt" has given purchasers energy to chase after scarce listings, but it is losing some of its muscle. In just four months, the same size mortgage costs $325/month more, and takes 25% of an annual $72,000 income instead of 20%. Starting the time analysis with a 20% share of income to Principal and Interest allows room to include taxes and insurance in the total payment analyzed by the lender. Although higher interest rates are causing payments to rise now, expect an additional bump as local property tax assessors absorb the 15% value gains into the asset tax base.

It's not all bad news. Even at higher levels, mortgage rates stay below current inflation. Although the equity returns no longer look miraculous, inflation-related appreciation covers most, if not all, of the interest cost -- and the owner keeps all the gains.

Thanks to all my sources: Photo is from Forbes Advisor; data from the National Association of Realtors provides median sale prices; mortgage interest rates are from FRED/Federal Reserve Bank of St. Louis