FOOL SCHOOL
Homeowning: The Effects Of Gearing

April 22, 2002

In this article we're going to look the effect of gearing in relation to house prices, and how it can work to your advantage. Don't panic, this isn't as complicated as it sounds -- it simply works like this.

If you buy a house for £100,000 with a £90,000 mortgage, then you have invested £10,000 yourself. This £10,000 is known as your equity. It's the part of the value of the house that belongs to you.

If the house then increases in value by 10 per cent to £110,000, the value of the £10,000 that you put in has doubled. It's increased by 100 per cent to £20,000 because you still only owe £90,000 on the mortgage. The flip side to this is that, if the value of the house falls by 10 per cent to £90,000, then the value of the £10,000 that you put in has fallen by 100 per cent, to zero.

If the price of your house were to fall even further, so that your mortgage was greater than the value of your house, then you would be in what is known as negative equity. This makes it difficult for you to move house and you'll need to find additional money to pay off your mortgage, or hope that you catch you mortgage lender in a good mood!

So gearing means that your short-term risk is dramatically increased. But, since the value of our homes is expected to increase over the long term, our long-term returns should also be increased. This gearing effect is, for many, one of the attractive aspects of property as an investment.

More: The Homeowning Centre