Let's say you bought your home 10 years ago for $200,000 and it's now worth $600,000. Let's also say your original mortgage was for $150,000 but you've reduced it to a mere $40,000. The equity in your home has increased from 25 percent to 93 percent. Even better, your income has risen to $150,000 annually. You've worked hard to pay down your mortgage.
Perhaps you think things couldn't be better, but they could.
Using smart debt to increase your net worth is a fundamental aspect of wealth management. Assuming a gross debt-service ratio of 25 percent, a person with $150,000 in yearly income can put aside $37,500 towards housing expenses, including mortgage costs. Given current expenses, you can expect to have $30,000 left over annually to put toward housing beyond your current requirements. In simple terms, you could leverage your current mortgage for another $330,000 using your existing cash flow. This doesn't even take into consideration the cash flow of the investment property you ultimately purchase.
Based on this example, how much property could you purchase by leveraging your current mortgage? The quick answer is $1.2 million, assuming a 25 percent conventional down payment. However, banks often only count 50 percent of the gross income when approving a mortgage. The annual income from an appropriately priced property would be $144,000. The bank would use $77,000 as the income number on the mortgage application. This could cut the mortgage amount available to $450,000 and a maximum purchase price of $600,000. Nonetheless, you now own two properties worth $600,000 each instead of just one, using the same existing cash flow.
Investing in rental properties can be an excellent method for increasing your wealth, and positive cash flow is critical to your success. If you lose your job or tenants leave and you can't replace them immediately, these factors will seriously impact your investment. If you keep an emergency fund available to cover unexpected reductions in cash flow, you'll be able to keep your properties for an extended period of time and take advantage of historical rates of appreciation.
In addition to the leveraging possibilities, there are deductions available to help reduce your taxable income to something lower than your existing amount. That's always an attractive proposition.