UPDATE - I feel compelled to add a new comment to the blog subject below.  Just yesterday, I met with some prospects.  As it turns out, their situation almost mirrors precisely the situation below, all the way down to having paid extra to principal reduction when they were able.  Their story ended in both foreclosure and bankruptsy.  Sometimes, we might write things that sound great, but confronting a real truth behind such topics is both sobering and moving.  I am commited to providing value to my new prospects and understand that their way up from the present situation is about 18 months away.

Please take a couple of minutes to read my blog, hopefully from the perspective that it could happen to you, a client, or someone you hold dear.

Thank you, Greg Polashock 

When considering an investment, three factors should be considered - safety, liquidity, and rate of return.

Consider the following questions regarding home financing.  Which is better, a large down payment, or a small one?  When possible, should additional monies be applied to principal reduction?  Is a fixed-rate better than a variable or adjustable rate?  One last question - would you say that you have a higher or lower tolerance for risk when it comes to money?

I espouse no particular strategy when it comes to financing real estate.  Individual circumstances are too, well, individual for blanket recommendations to be appropriate.

Consider this statement - A thirty-year fixed rate mortgage is one of the riskiest mortgage products available.  (In reality, that is neither a true nor false statement.)

Let's look at a sample scenario.  John and Susie Public are in the market for a $300,000 home with $150,000 in total savings available to place as a down-payment.  They could put that $150,000 into the home and carry a $150,000 mortgage using a thirty year fixed product.  Let's say the home appreciates at 3% annually.

They decide to put down $150,000 and carry a smaller mortgage.  One year later, John, the primary wage-earner, loses his job and is out of work for a year.  Finances become tight and housing payments start falling behind.  Being out of work, they cannot refinance to take equity out of the home.  John and Susie have lots of equity in their home but are forced to sell in order to avoid foreclosure.  Because John has been out of work for awhile, they cannot buy another home until John has two years of stable employment history.  Not a pretty picture.

Let's turn the tables.  John and Susie buy the home using 5% cash down - $15,000.  The other $135,000 is put into tax-exempt investments earning 5%.  Yes, they will have a higher debt, and higher monthly payments, but the Publics are also diversified and have the ability to liquidate the investments, if needed.

In a previous column, I mentioned that home equity has no rate of return.  However, John and Susie's money, which is set aside in investments, does.  And not only does it yield a return, it also compounds.  That is, $135,000 generates $6,750 in the first year.  In the second year however, the return grows to $7087.50 because the basis has increased. 

Conversely, this principle does not apply with principal reductions on a loan balance.  If the principal reduction on a loan is $200 in a given month, the bank does not compound that over time for their benefit. 

Taking this a step further, suppose John and Mary did not make any monthly principal reductions on their loan, but instead took that $200 and added it to their investment each month.  That would generate an even greater return for their investment portfolio.

So, in the event that John does lose his wage-earning capability, he and Susie have a tidy reserve fund and get to keep their house.  For sure, there will be some depletion of their investment funds.  However, this may be offset by future increases in the value of the home they now get to retain.  If John is without work for one year, using prevailing market rates, he may deplete his investment fund by a bit over $21,000, but if the home is appreciating at 3%, he sees an increase in home value of $9,000 plus the continued increase in his investments of approximately $6,000.  The approximate decrease in Net Worth for keeping the house during this period of time is approximately $6,000.  This is a far better alternative than having to sell the home investment under pressure, pay closing costs and related fees, and walk away with no asset and suffer an approximate $25,000 hit to the original $150,000 down payment.

Not only is portfolio diversification of investments advisable, developing a sound exit strategy when entering into the investment is quite prudent for ensuring financial security.

Greg Polashock is a Real Estate Home Mortgage Loan Consultant and Certified Mortgage Planning Specialist with Cherry Creek Mortgage and resides in Castle Rock, Colorado.  He can be reached via email at Greg@GregIsFinancingSolutions.com, by phone at 303-887-0672 or on the web at http://www.gregisfinancingsolutions.com/.