Are you as leveraged as Goldman Sachs?

By Mike

IMG_3620For decades, many of us have been putting more and more of our money into real estate. Strange enough, it is an asset class that many owners do not even consider when they answer questions about their stock portfolio or investments even though it is by far the most significant in many cases.

Are you among those who complained about the major banks’ excessive leverage?

Chances are that you or your neighbour is leveraged at least as much if not more. Think about it”¦ If you own a house that is worth 400,000$ and you have a 360,000$ mortgage, you are leveraged 10 to 1! Many banks used that kind of leverage.

But for some reason, that has been ok and has become so accepted that it is almost surprising when someone buys a house with 30-35% cash down. Of course, that happened mainly because we have expected prices to rise continually. The worst that can happen is for my home’s value to stay the same for a few years right? So why not leverage myself, enjoy the good life and then sell my house 10-20% higher in 3-4 years? That is exactly what happened in the past couple of decades as owners’ bought more expensive houses and often even chose to own several houses simultaneously. Of course, when prices in many regions such as Florida, California and Las Vegas dropped by 30-40%, it created a very tough situation for many homeowners.

Imagine you have a 500K mortgage on a home that you paid 600K”¦ and a few years later, your home lost 30% of its value”¦ and so you now own a 400K house with a 500K mortgage, which is described as “negative equity”. Add a lost job and you have major trouble. The bank can take possession of the home at any point in time in such a situation and selling your house becomes a major insult as you “realize” your loss.

It’s always interesting to meet people who look at me as if I was from another planet when I suggest using leverage when investing in the stock market while hearing that they put little to no cash down when buying their half million dollar home. Sounds a bit ironic in my opinion. While you don’t see the definition of leveraging to buy a house in any investment guide, the point is that you are still borrowing a lot of money and taking a substantial risk in buying your principal residence.

Of course, most would say that they have no choice and that buying their home in cash is simply impossible. And in most cases, I agree. I don’t think there is anything wrong with that and as long as real estate prices do not experience a crash you are fine. Yet I still consider it very important to at least acknowledge that you are using a leverage strategy and that there is risk involved. If you are leveraged 10 to 1, there is risk. I’m not against leverage, far from it. But we should all be aware of how much we use leverage in our personal finance.

4 Responses (including trackbacks) to “Are you as leveraged as Goldman Sachs?”

  1. ABCs of Investing Says:

    This is very good – I love your point about how some people will put you down for leveraged investing (with a sneer) yet they don’t seem to think that they are doing the same thing with their house.

  2. Financial Samurai Says:

    Leverage cuts both ways indeed.

    It’s good to be leveraged in a bull market. Mike, don’t you feel the economy is healthy and recovering?

  3. Mike Says:

    I actually think we are in a Bull Market. But depending on your situation (financial situation and investment knowledge), leveraging may or may not be an option ;-)