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Financial Literacy

Financial Literacy

Home Financial Literacy Mortgages The Lex Luthor Called Leverage: Good, Bad, Ugly

The Lex Luthor Called Leverage: Good, Bad, Ugly

Housing stories weren’t always precursors to horror films.

Once upon a time…

It was a simpler, kinder, gentler, lower interest rate time. Ma and Pa Shtetl bought their house in Reseda, CA (near Van Nuys and Chatsworth, the modern day porn capitals of the world). They bought it in 1950 and paid $40,000. It was a nice house at the time – a big stretch for them financially. But they made it work.

That house grew in value at 8% a year – for 50 years. California land became more valuable. There was inflation. And their home was one of the finest in all of the greater Reseda area. (If you don’t know the area, listen to a few Tom Petty songs.)

Along the way, the home consumed a lot of cash – there were taxes; there were repairs; there was insurance; there was weekly maintenance. And interest on the loan.

But mentally you look at those things as just “the cost of living,” so you don’t attach them to the value of the home as an investment.

The key element here is the 8% a year compound rate – and the 50 year duration. You just oughta know The Rule Of 72. No, it’s not the one that says comedy comes in 72’s. If you’re telling a joke with that much setup, most people will have already left the building.

Divide the 8% into 72 and that’s the number of years it takes to double the value of the entity being considered. In this case, the home that cost $40,000 in 1950, 9 years later was worth $80,000. That is, 8 into 72 is 9. We kept the math simple for you; you’re welcome. So the value of the house doubled in 9 years. Awesome. Lovely. It’s 1959 and the home carries a market value of $80,000 and the $35,000 loan has been paid down to $30,000.

So the equity value in the home is now $50,000. Wow. Remember Ma and Pa put just $5,000 into the home when they bought it; 5 grand down, 35 grand mortgage.

They have made 10 times their money on the original 5 grand investment (forgetting closing costs, commissions if they sold the house tomorrow and taxes on the investment gains in their house.)

But wait! There’s more!

Ma and Pa kept living in their Reseda home – they continued living there and after 9 more years, it was 1968 and their home’s value had doubled again – now to $160,000. Awesomeness squared. (Not literally squared, or their home would now be worth $1,6 billion. Keep dreamin’.)

And then another 9 years go by and the home’s value doubles again – that 8% a year thing really adds up. It’s 1977 and their home is worth $320,000. And oh, by the way, their 30 year mortgage is almost entirely paid off so they will soon own their home “free and clear.” No debt! Woot!

Another 9 years pass and it’s 1986 and the home is worth $640,000. Slot another 9 years – yeah, Ma and Pa are starting to get old – but it’s now 1995 and they are real estate millionaires with a home worth $1,280,000. And they are starting to think about selling it. They have grown to love the place, of course, but Ma’s knees are no longer able to handle the stairs like they used to. Also, the $1,280,000 thing is making them drool.

Home prices trek upwards for another 5 years and in 2000 they decide to sell. They list it for $1.6 million; it sells for $1.5 million. It’s an old home with lots of repairs needed – after those costs and the other closing costs and commissions – they net $1.4 million.

They show an investment gain of $1.395 million (remember they put $5,000 down in 1950 – that was their original investment). The laws change regularly around how real estate gains will be taxed – in the worst case scenario, they would pay a long term gain tax of about 23% in California (Federal plus State taxes) and net about $1.1 million; but for many holdings, there is a “tax hiatus” where low or no taxes are charged on gains like this as a one-time thing. As you can see, even the worst case is none too shabby.

So they made almost 300 times their money on the 5 grand they initially put down. Theirs was an American Dream and they rode the greatest real estate bull market in history. Bless ‘em.

It won’t happen to you.

Hey, who said every story had to have a happy ending?

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