The benefits of home ownership
There is no better feeling in the world, as a homeowner to see the value of your property going up in value each year. Seeing neighbours sell their property at ever increasing prices creates a sense of empowerment. A desire to spend and spend big as the value of your house goes up. This is known as the wealth effect and while it is great for the health of the economy it has the potential to be catastrophic for an individual or family that isn’t careful.
The pitfalls of a home ownership
The big problem arises when individuals equate asset value growth with an increase in earnings. They often think it is the same but there is a critical difference. A raise or promotion puts more cash in your pocket and so you have a choice to spend that extra cash, save it for a rainy day or invest it for a more secure future. An increase in the value of your house however does not put extra cash in your pocket unless you sell the property. This is sadly when many get into trouble as the they think the higher value of their property gives them the right to spend more and in far too many cases borrow more. Lenders are smart because they can sense the pent up desire to borrow and spend more and so they encourage it. As a result we are constantly bombarded with ads urging us to take on a second mortgage or far more damaging, to spend more on that credit card or most tragically of all, take on additional credit cards.
Home owners need strong financial skills to avoid common home ownership pitfalls.
Home ownership creates a false sense of wealth
In a rising market increasing asset values are not directly proportional to how much you can spend because it is not equivalent. The problem is that your property is not earning interest, borrowing does. For each dollar that you borrow you have to pay interest, lower if it is secured against your house and much higher if it is unsecured such as a credit card. So for example you see your neighbour’s house go up in value $20,000 from the year before so you could rightly argue that yours has gone by the same amount. But if you borrow that $20,000 the amount you pay to service that debt varies.
For example:
A mortgage at 3% will cost you $600 per year.
On your credit card at 20% it will cost you $4000/yr.
So at the end of the year you have attained a net gain of $19,600 with the mortgage and only $16,000 if borrowed with unsecured debt.
What happens when the market turns
Severe problems really arise though when your house stops going up or in the worse case it starts dropping in value. Property prices do not go up forever, it is cyclical. A plan must be put in place for falling home prices. A family with small debts can lament on what might have been as they sit through the cycle and the oscillation of their house value but they will emerge from the downside in decent shape. The family who thought they were smart by borrowing in the good times can get themselves in a dangerous situation when prices start falling. Continuing, with same scenario, if the $20,000 disappears from the value of your home and you have borrowed that you have put yourself in a very large hole. It is further compounded by the fact that there is a strong correlation between house prices and the economy. When house prices falls so does spending. When spending falls people lose their jobs and so it becomes a vicious cycle. Then try selling that house in a falling market.
How to protect yourself
Educated consumers armed with financial literacy skills understand that the equity is no more than an opportunity for wealth but only upon selling the home. It has never been more important than now – in an era of lower interest rates – to be fiscally responsible. Consumers need to learn budgeting skills that ensure they are always living within their financial means not over spending and then using their equity like a bank to bail out bad financial habits.
More importantly, the federal government and the banks have been bracing for an economic downturn by restricting mortgages, financial products, and 2nd mortgages with tougher requirements.
They know that eventually the market will turn leaving thousands of consumers vulnerable to financial failure such as bankruptcy or consumer proposals. Don’t be one of the thousands that need debt restructuring and if you have problems budgeting get help now!
About the Author:
Laurence Herzenberg
4 Pillars Newmarket Information
Tel: 289-803-6314
