Cliff D'Arcy looks at how 'gearing' can magnify your gains -- and your losses -- when you invest in property.
This article was originally sent to Fools via email on January 8th
As The Fool's 'Your Finances In 2012' campaign continues, I'm going to look at how the concept of ‘gearing' can magnify your gains - and your losses - when you invest in property.
According to my Foolish chum David Kuo, the average UK property will be worth £185,000 in 2012, compared to £198,000 today.
In other words, David believes that the value of a typical home will fall by £13,000, or 6.6%, over the next four years. He expects a dramatic drop in prices this year -- as much as a fifth (20%) -- before modest growth resumes in 2009 onwards.
Of course, this news may come as a shock to many homeowners, especially given the gargantuan rise in property prices since the turn of the century. However, domestic property has become increasingly unaffordable on many measures, and something's got to give.
Given these price falls, one problem which could rear its ugly head once more is the threat of negative equity. This is where the value of a property falls until it is worth less than the mortgage owed on it. For example, a house worth £180,000 with a £200,000 mortgage has negative equity of £20,000. In other words, to clear the slate, this unfortunate owner would have to sell his home and cough up twenty grand on top. Otherwise, he can expect to be chased by his mortgage lender until the debt is cleared, even if this takes many years.
Then again, there are two simple ways to minimise the risk of negative equity. The first is to put down as big a deposit as you can muster. For instance, if you hand over a quarter of the value of your home as a deposit, then house prices would have to fall by more than 25% for you to encounter negative equity. Also, paying off your home loan as you go with a repayment mortgage is less risky than buying with an interest-only mortgage, where your debt doesn't change.
Furthermore, the threat of falling house prices will expose ‘the double-edged sword' of homebuying: gearing. In many areas of investment, investors use gearing to magnify their gains (or losses) by borrowing money to invest alongside their capital.
For example, to buy a £200,000 house, I might put down a deposit of a tenth (£20,000) and borrow the remaining £180,000 from a bank or building society. (Probably the later, as banks have suffered a steep drop in mortgage lending since the Northern Rock crisis.) Thus, although I now have a £200k stake in the property market, it only cost me a down-payment of £20k.
Now let's look what happens when the value of my property rises by 20% or falls by 20%:
Price rises 20%
• My property is now worth £240,000;
• My mortgage is £180,000; and
• I now have equity of £60,000, so my deposit has tripled. Nice!
Price falls 20%
• My property is now worth £160,000;
• My mortgage is £180,000; and
• I now have equity of -£20,000, so my deposit plus a further £20k have gone up in smoke. Nasty!
So, when property prices are rising strongly, gearing helps homeowners to bank mouth-watering returns. However, when property prices start to fall, as they did for several years in the Nineties, gearing turns around and bites homeowners on the behind.
In summary, when the sun is shining and property prices are rising to ever-greater heights, gearing produces extraordinary returns for all homeowners and buy-to-let investors. However, when sentiment turns and prices go into reverse, gearing destroys wealth like nobody's business. Since property prices are expected to fall over the coming year, now might be a good time to reduce your gearing by paying down your mortgage. Then, even if prices do fall, your property may be worth more than the loan tied to it.
Finally, if you don't think that negative equity could happen to you, then think again. A good friend of mine bought a flat near the top of the housing boom in the late Eighties. When prices tumbled, interest rates leapt and his monthly mortgage repayments soared, he handed his house keys to the building society and walked away. Years down the line, the lender came to him demanding that he make good its losses plus interest -- a sum in the region of £20,000. Thus, more than fifteen years after he walked away from his first home, he's still repaying this debt at around £100 a month. That's gearing and negative equity for you!
> If you're thinking of remortgaging this year, visit The Motley Fool Mortgage Service and we could find the best deal for you.
