The dangers of leverage? Could someone explain?

Question

I don't completely understand this and need someone to explain it to me.

2 people have 50k equity in their 100k home. 1 decides to refinance and cash out 25k and bring the house back to 75% LTV. The other is cautious and leaves things as they are.

A recession hits. Rents fall and vacancies rise. How is the guy with extra equity more protected? Perhaps even the guy/girl who did the cash out is more protected as he can dip into the cash out funds to pay for losses. And if the economic situation is so bad that you're going to be running cash flow negative long term, it doesn't matter if you have 25% or 50% equity in your home. You're in big trouble.

I can see the dangers of leverage when there's no money down. But can someone explain this to me?

Bill Gulley · Answer

Several aspects may apply and the difference on reality at either of these equity levels is probably minimal. First issue is not really what the principal amount owing is the more significant factor but the terms the financing. Your 50K obligation could have a higher payment than your 75K obligation! You could have a balloon requirement on that 50K, the 75K may be fully amortized. Your assumption seems to be all things being equal, which they never are, in how equity effects leverage. At this level and in reality there isn't much difference. Having less equity lowers your net worth unless you keep the cash or reinvest it. It may limit your ability to borrow have less equity and more debt. Obviously your return on equity is decreased, it may be offset by reinvesting the cash. It's more to asset and debt management than an amount of equity. Equity earns the rate of appreciation as money in the walls of the property. You can borrow against it but doing so will cost more than it is earning in the walls. Only two ways to get that equity out and use it, borrow or sell the property. What you do with those equity dollars is what counts, is the cash obtained reinvested at a higher after tax rate than what it was earning before? If so, the investment can subsidize lower rents and perhaps better so than having the equity tied up in the walls. I have refinanced many properties taking the cash out to be used and so long as your new investment is available to pay the additional debt it's pretty much a wash. The use of cash is then critical, if you buy a non-earning asset, like a car, it's costing you. Either way, your equity position doesn't change, you're moving the value of one asset to another asset class, property equity is moved to cash on hand, the 25K stops earning the rate of appreciation, if any at all, and moves to another investment, if it's at a higher rate you're making money. Does your investment earn more than the return on equity from rents, part of the rent is assigned to that equity as well as the cash used to acquire the asset. Income from rents does not increase based on your equity amount, nor do rents decrease due to your equity position. You're mixing the relationships of assets and income, they are two different matters and rather independent from each other, your balance sheet measures your financial position at a point in time with respect to assets, liabilities and net worth, your income statement measures the performance of the use of assets and management over a period of time. This doesn't touch on the economic aspects, opportunity costs or alternative investments. Did that help or did it just make it more foggy? Your assumption is that we have a complete financial disaster with rents dropping. An empty house that is owned free of debt can still be an economic or financial liability. There is also an assumption that the property must be sold, that may not be the case. I didn't sell anything I "held" over the balloon popping, held it through the paper losses and all is fine. :)

James Wise · Answer

If they were both keeping the properties and trying to rent it out but rents lowered and vacancy rose the Guy who didn't pull money out has lower monthly payments. If they were selling the properties Guy who did pull money out has a higher chance of being underwater if prices dropped dramatically.

Chris Masons · Answer

I Was lookingf forward to explaining the issues and dangers that leverage can cause but it was perfectly done by John, J, and James. Only thing I would add is that usually you don't see things coming IE. quick and urgent need to sell house and or come up with funds in a hurry. As John stated people were leveraging the crap out of their properties, buying vacation homes, taking HELOC and going shopping, ETC thinking prices would just keep going up and up and banks were happily lending to anyone who could half heartedly show some income and own a property. And then look what happened BOOM Reality hit and the market went bust... That is an extreme example but can happen on a much smaller scale and still have a huge impact. Leverage is great if used correctly and responsibily. Have a plan and an exit plan. regards, Chris

Jon Holdman · Answer

Which is EXACTLY what happened to many people during the boom. Jobs dried up and people were out of work. Property values plummeted. Much more than 30% in many cases. So owners were stuck. No jobs where they were, no ability to sell.

J Scott · Answer

In addition to what James says above, if market values drop 30% and both owners find themselves in a situation where they need to sell for some reason, the one with (previously) 50% equity can sell without having to come up with any money and the one with (previously) 25% equity is now underwater and has to come up with funds to sell -- if he can't come up with the funds, he's got a big problem.

Cal C. · Answer

Leverage is like a power saw when used correctly it is great tool, but when not used correctly... To add to @Chris Masons point, it is very important what you do with the money you pull out of a cash refi. If you go blow it on a shopping spree you are asking for trouble. If you find a relatively safe (what was in 2008-9?) investment for the money and have access to it then it makes sense. If you use it to buy more properties it can work, but only with a carefully thought out plan, always keeping in mind what happens if rents drop, vacancies soar, and house prices crater, like what happened in Atlanta. Also don't forget a lot of people had their lines of credits reduced drastically or cancelled altogether. You have to have contingency plans in place. @Alex Silang This is not an easy concept to understand as evidenced by the large amount people who simply ignored overleveraging prior to 2007 to their great regret.