Financing-Did You Know Return on Equity is Effectively Zero!
I was asked recently, “I just sold my home and received a lot of cash at closing. Should I pay cash for my new home?”
Nearly every transaction I’ve participated in over the years has involved some form of financing. Financing (or leverage) allows one to purchase more real estate with less cash. It’s been the primary catalyst that’s driven the housing market in this country for the past 80 years. But what if one has the cash resources? Why bother with financing?
I recommended they not pay cash in this low interest rate market. Here’s why: Say you purchase a $500,000 home with cash. Your equity is $500,000. Say homes in this area are appreciating at 5% per year. With a 5% return on appreciation, in a year your home is worth $525,000: $25,000 profit. If you purchased this home with 100% financing, at the end of the year it would still be worth $525,000. The point here is that appreciation is independent of financing/equity. Often people confuse or comingle return on equity with return on property appreciation. RETURN ON EQUITY IS EFFECTIVELY ZERO.
Here’s how it might work if you put that equity to work elsewhere. In this example if you purchased with 20% down ($100,000) and financed the balance at 3%, you would have $400,000 cash remaining to invest elsewhere with let’s say a 10% return. At the end of the year your home will have appreciated by $25,000 and your investment grow by $40,000. The cost of the mortgage interest would be about $12,000. Your net gain for the year based upon appreciation and return on the $400,000 minus mortgage cost would total $53,000. That’s more than double the annual return from just appreciation.
The point is that it may be an advantage for you to put your equity to work elsewhere if you can expect to earn more than the cost of the mortgage.
For most people, buying and selling their homes are the largest transactions they are involved in. Beware: Real estate markets change. Financing markets change. Investment markets change. Tax laws change. One should always consult with a professional real estate broker, a loan officer, and an investment advisor.