Building Equity by Downsizing Debt

A lot of us are learning about the value of having equity in our home loans. Most people buy their houses for emotional reasons. They are in search of that mythical place called “home”.

Not surprising really, as being “home” gives us the feeling that it’s a place where we can exercise choice   away from the pressures of the outside world. Also, we tend to believe our house is a solid investment.  We are all familiar with the adage “as safe as houses,” and in the years before 2008, phenomenal capital gain tended to support this theory.

However, irrespective of whether we call it “home”,  houses, like any other investment commodity, are subject to market forces and any adjustment in the economy can influence the value of  housing as it does any other sort of  investment.

Recently a lot of us have had equity problems.  Equity being the percentage of the home that we actually own against the percentage the bank owns.

Our problems with equity became apparent after the credit crunch and, unfortunately, continue on through the resulting recession.  This is because, during the credit crunch, banks suddenly found the scale of unsecured mortgage debt that they owned was a threat to their survival.  Their response was to make it more difficult to obtain home loans by only processing new loans if the applicant had saved 20% equity and had good earning capacity. This meant that someone contemplating buying a house with a market value of $400k would need a deposit of $80k!

Unfortunately, not only did the new 20% equity ruling make it difficult for people new to the housing market but put enormous pressure on people who had recently purchased houses.  This is because prior to the credit crunch, conventional trading banks were lending up to 95% and new no doc or low doc loan products had also come onto the market. 

To compound the problem, over-valued real estate meant people purchasing in good faith with only minimal equity were exposed to the risk of owing more than their house was currently worth.

On top of these woes many had signed mortgage contracts whose long term nature meant that the build up of equity was so slow it could be twenty years before it was possible to pay sensible amounts off the principal. 

Others found that the percentage of house-hold income diverted into mortgage payments began to put pressure on the amount they had to spend on their life style needs. Many therefore converted their home loans into interest only facilities because at least this enabled them to stay on living in their homes. Sadly, interest only loans are an expensive form of rental to pay to landlord bank. A landlord who, incidentally, does nothing towards upkeep or rates.

In many cases the dream of home owning as a form of respite from the problems of the outside world  has become the principle stressor in people’s lives.

So far, so bad, but having identified the problem let’s look for solutions

On Saturday 20th, The Auckland Herald mentioned the imminent release of an ipad version of the fable of “The Hare and  the Tortoise.” Written by Lucas Remmerswald, supposedly for children, it’s called “Buffet Tortoise and Trader Hare” and, as you can imagine, preaches that slow and steady wins the race.
And although slow and steady might suit a tortoise,  from a fiscal  point of view its an unfamiliar concept after years of having instant gratification by purchasing things on credit  i.e. our house, our car and all the other “things” we care to mention.

Certainly there’s no instant fix for those who have low equity and are contracted into long-term mortgages but, lets look at how slow and steady might help people get sensible traction on their future.

Some things people might wish to consider.

The cardinal rule is to take responsibility for your situation. Don’t blame the government or the bank. What they do is beyond your control.  Instead find out what you can do that will make a difference to your circumstances.  Here are some suggestions that could help you to take back control of your future.

1. You might like to look at treating your domestic economy as a business. This means you take responsibility for monitoring what you earn and what you spend. Treat any savings as profit. In any good business a proportion of profit always goes into development.
    
2. Lets say your development savings are assigned to building equity in your home. To make this work you need to record your income and outgoings over a number of months. There will be fluctuations according to what expenditure you need to make in any given month but you will get an overview of what your domestic economy looks like and what you can see, you can start to manage.  On the basis of this you can start to itemize and predict profit i.e. savings
    
3. You might also like to investigate the possibility of banking through your saving account because, unlike your cheque account, you can earn interest on any money retained in this account.
    
4. If you aren’t too wary of credit cards, you could consider using your credit card for your groceries, petrol etc. The trick is to put a limit on it which relates strictly to your monthly outgoings so you have checks and balances in place and are not running the gauntlet all the time. The benefit is that while the money sits in your account you can earn interest on it. However, the key to making this work is always to keep tabs on the balance between income and expenditure as borrowing more to support the status quo is always a bad idea because credit always costs too much. Just think of the amount of interest you are paying on your house and be wary.
    
5. As your equity increases you might consider looking at a mortgage management system. This sort of system is professionally managed to make sure you never pay unnecessary interest on your home loan. Such systems could save virtually the cost of your house in interest so can be a very significant benefit.  In this respect, it’s a bit like hiring an accountant to minimize the amount of tax you pay. The business analogy again!

 
The other factor in the equation is that, if the debt problem is properly managed by the government and the lenders over the next few years, there could be an ease up on interest rates and borrowing criteria and house values could pick up. However, waiting and hoping for some external solution depends on variables which are outside our control. So, instead let’s take the power back into our own hands and once more think of “home” as a place where we can exercise choice, and take pride in our ability to make intelligently, self interested decisions about how to make our income work to our current and future advantage.