Credit leverage: how much house can i afford to buy?

The sun shines. In your hands you hold a cool beer. On the grill sizzle sausages and steaks. You invited everyone – and everyone came. You celebrate the completion of your dream home.

You can hardly believe your luck. You have a lively chat with your guests. On this summer day your life is simply perfect.

Over the next 10 years, you will regularly remember this day – the day when the repayment of your real estate loan began ..

Credit leverage: house and equity balance each other out

You made a mistake.

Lured by the low construction financing interest rates you have taken out a large loan. What no one foresaw at the time:

Interest rates have been rising slowly but steadily. At the same time, real estate prices have fallen.

The consequence:

After the end of the 10-year fixed-interest period, the monthly installment increases so much that you can no longer service it.

You also have no possibility to get a follow-up financing at a new bank and that although you have always served your installments. The banks you asked have kindly presented you with a calculation – and it goes like this (you can do the math here):

Dear Mr. Mustermann,

You took out a loan 10 years ago for 500.000 euros taken up. With their own funds over 50.000 euros you paid for the ancillary purchase costs.

Your initial repayment rate was 2 percent. The interest rate was also set at 2 percent. This has resulted in a monthly installment of 1667.67 euros. These you also paid each month.

Now – 10 years later – there is a remaining debt of 389.400 euros.

Unfortunately, real estate prices have fallen by 30 percent in the last 10 years. Your property is currently valued at 350.000 euros valued. This means that it is no longer sufficient as loan collateral.

Please provide additional collateral of at least 40.000 euros at my disposal. Otherwise a follow-up financing is not possible with us.

With kind regards

Only gradually do you realize what all this means for you. Additional collateral? You do not have. This means that follow-up financing with a new bank is not possible and you are dependent on the conditions of your current bank. Since they charge interest of 6 percent, you cannot afford the new installment of just under 2600 euros.

Standing in your front yard again like 10 years ago. The sun shines. But this time there is no party. This time you lock your front door – and for the last time. The house is no longer yours..

Pay attention to credit leverage so your property doesn’t become a fiasco

When you buy a property on credit, you leverage your investment. The leverage effect changes the risk structure decisively.

You buy for 100.000 Euro a house. 10.000 Euro you pay out of your own pocket. The bank adds the rest on top.

If your property loses 10 percent in value, you make 10.000 Euro loss. That is 100 percent of your equity.

Conversely, this means:

If your property gains 10 percent in value, you make 10.000 Euro profit. That is 100 percent profit, measured against the equity.

The more equity you contribute, the lower the risk becomes.

When does the risk become relevant?

The equity ratio or debt leverage has an impact if you

  1. You need follow-up financing
  • Falling home prices and rising interest rates may mean that follow-on financing is not an option
  1. Want to sell
  • If you want to (or have to) sell, falling real estate prices can lead to losses that exceed your equity

How likely are falling real estate prices?

Nobody can look into the future. Sure is probably:

In the long run, real estate prices cannot decouple from real incomes. Otherwise, no one could afford a home anymore. The increase potential is therefore limited.

Moreover, one may ask the question:

Who can afford the current prices in the future, should interest rates rise??

Falling real estate prices are therefore possible. The question is from my point of view:

Would I like to put my financial fate in the hands of chance?

If your answer is "no," you should place great importance on a solid equity base for your financing.

Conclusion

The equity brought in can decide if you "only" made a bad deal or if you get into serious financial trouble when real estate prices fall.

If you have little equity capital available at the beginning, you can reduce your debt and thus your risk quickly by making high repayments and additional unscheduled repayments, whereby you are more flexible with unscheduled repayments.

A long fixed interest rate creates additional security.

Note

Calculate the muscle mortgage carefully. If you can’t manage the personal contributions planned in advance, a follow-up financing may become necessary – often at worse conditions than the main financing.

Do you have previous experience with real estate financing?

Your financial chef
Christoph Geiler

Image source: © pogonici – fotolia

Portrait of the author of this article

As a financial advisor, I specialize in financial planning, investing, and retirement planning. As a financial chef, I conceptualize and create content. In my free time I swing the wooden spoon, do sports and play with my son.

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