Step 2: A Fistful of Dollars — The Money

Thus far we have been talking about the type of documents you need in order to go through the process of buying a house. Now let’s talk about the money.

Down Payment

This is where rule number three of Money Fundamentals begins to pay off with dramatic results! You know that 10% of your income, that you have been saving every month? Voila – down payment. If you have been religiously saving 10% of your income, you will eventually have enough for a down payment on a house. You will get all the way there just by saving 10% of your income. No kidding.

You should always strive to save and contribute a 20% down payment of the purchase price on a real estate purchase so that your monthly payments are not too high. Some banks allow less than a 20% downpayment, and some banks require a 20% down payment on the purchase price.  

Private Mortgage Insurance is Related to Equity

If you only put down 10% of the purchase price, the bank will require you to pay private mortgage insurance (PMI) every month as part of your loan. PMI protects the bank in case you default on the loan. The bank reasons that if you cannot contribute 20% to the purchase of the house, then your money habits are not that good yet. The bank wants to have extra protection so that they can get their money back in case you default on the loan. The good news is that once you have paid the loan down enough to where there is more than 20% equity in the house, you can ask the bank to remove the PMI charge on your account.  

What is Equity and Why Can It Make You So Wealthy?  

Equity is the value of the house, based on what other houses in the area are selling for, in relation to the loan on the house. In our example, you want to buy a house for $300,000.00. Other houses in the same geographical area are also selling for roughly $300,000.00. You put 20% down, which is $60,000.00. So the bank will give you a loan of $240,000.00. You automatically have 20% equity in your home through your down payment. That is one way to have equity in your house – through the down payment.

Another way to have equity in your house is by consistently paying the loan down through monthly payments. Say you live in the house for five years and commit to reducing the mortgage principal by $10,000.00 per year. This means after five years, you would have reduced your mortgage principal by $50,000.00.

So back to our example, our loan was $240,000.00; if you reduce the mortgage principal by $50,000.00, you would owe $190,000.00 left on the loan. You would then have $110,000.00 equity in your home – from the down payment of $60,000.00 and the mortgage reduction of $50,000.00 on a house you bought for $300,000.00.

But wait! One of the most wonderful things about owning real estate is that it can increase dramatically in value, simply with the passage of time. It is not uncommon, especially in highly populated areas of the country, for the value of a house to double in ten years. For example, you could buy a house in Los Angeles, California for $300,000.00 and properties in the same area would be selling for $600,000.00 ten years later. That would mean that you would have a property worth twice what you bought it for simply because ten years had passed.

So, let’s continue, in our example, to assume that you bought a house for $300,000.00 with a 20% downpayment ($60,000.00). And let’s assume you have been faithfully making the payments and have managed to reduce the mortgage principal by $10,000.00 every year. So, you still have a loan now for $190,000.00 and $110,000.00 equity in your house.

But! now, five more years have passed, and you have owned the house for ten years.  And because, now you have excellent money habits because you kept reading this blog, you kept on reducing the mortgage principle by $10,000.00 per year. So now you have reduced the mortgage by $100,000.00. ($10,000.00 per year for ten years.) Now you have paid $160,000.00 off on the original loan of $240,000.00 and owe only $80,000.00 left on the house. 

But now here is why you can become so wealthy in owing real estate – the house is no longer worth $300,000.00. Ten years have passed and the properties in the same area as your house are now selling for $600,000.00. How much is your equity in the house?  Roughly 700%. Your house is now worth 7.5 times the balance of your loan. If you sold the house for $600,000, you would realize a profit of $520,000.00, after you pay off the remaining $80,000.00 to the bank. That means that you have turned $160,000.00 investment into $520,000.00, simply by the passage of time. That is why you can become so wealthy in real estate. 

Now you may say, “Hey wait, it’s been ten years and the property did not double in value!” Well guess what — you don’t have to sell it. You can buy and hold. You can rent the property and get a very healthy income stream from the rental. And you would still have the equity in the property, as described above. You can buy and hold until it does double in value. 

And even better, real estate is a tax preferred investment. The entire interest portion of the mortgage payment is deductible off of your taxes. For example, if you make $100,000.00 per year, but are paying mortgage interest of $15,000.00 per year, the government takes the $15,000.00 off of your income and only taxes you on $85,000.00. Plus, any money you put into keeping the place maintained, is deducted from your rental income, right off the top. Real estate is a tax-preferred investment.

But getting the right kind of loan is an extremely important issue — read on to find out the right type of loan to get!