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Building equity is an important method for growing your wealth. Equity is one of the best arguments for why people should own their homes instead of renting. After all, no one likes the feeling of a mortgage hanging over their head.
Your priority as an investor is naturally to increase equity in your property. The more of it you own, the stronger your assets. However, there is a time when you should not focus all of your efforts on equity: when it comes at the expense of your liquidity. Choosing equity over liquidity can lead to financial ruin.
As an investor, you’re likely eager to pay off the investment in your mortgage property. The sooner you pay off your debt, the more you can profit from rental income from tenants. However, paying off your mortgage with all of your cash on hand is not a wise decision. To understand how this can lead to bankruptcy – and how to manage your assets accordingly – you need to understand how equity works and how to determine your liquidity risk.
Equity, liquidity and risk
Equity is the total amount of your property that you own after factoring for debt. You can determine your equity by subtracting your loan balance from the current market value of your property. There are two ways to increase equity in your property: increasing the property value or decreasing the amount you owe.
Increasing your property’s value can be tough. You can either hope that the market leads to increased real estate values, or you can actively invest in improving your home’s value. Renovations like updating the kitchen and making the home energy-efficient can boost the property’s value. Routine upkeep isn’t as flashy, but it’s also part of improving your home’s value. Both of these types of fixes require cash upfront and don’t always have a high return on investment.
Paying down your debt seems fairly straightforward: the more you pay, the more equity you have. Most standard mortgages are structured for long periods, e.g. 30 years. Monthly payments lead to greater equity. Some property owners choose a more aggressive approach and have shorter loan terms, such as a 15-year mortgage allow. Others prefer to make extra payments each month or to send in an extra payment periodically.
Investing in renovations or planning for accelerated debt repayment are common options to increase equity faster but are only smart decisions if you can afford them. Otherwise, you risk losing all of your liquidity.
Before placing their cash into an asset, investors must consider the liquidity risk. There is always some risk that an investment won’t have a buyer when you are ready to sell, leaving you with an asset at a time when you need cash. If you lose your job and need to sell your investment property, you may not be able to find a buyer for the foreseeable future. If all of your money is tied up in the investment property, this could be devastating and ultimately result in bankruptcy.
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When equity can lead to foreclosure
Continuing on that unpleasant example, once you’ve lost your job and are unable to sell your property the financial dominos keep falling. Perhaps your tenants decide not to continue their lease, leaving you with no income to pay the mortgage. The bank wants to recoup its losses quickly, so after two to three months of no payment from you, they will move forward with foreclosure.
If you don’t have a lot of equity in the property, the bank won’t gain much back from selling the home at a discount. If you’ve paid $75,000 on a $300,000 property, they would need to make sure they sell the home for at least $225,000 to recoup their losses from your loan. However, if you’ve been making your payments at an accelerated rate and only owe $25,000, the bank knows they can easily recover the remaining balance. This makes your property a stronger target for foreclosure than someone who owes a lot on their property.
How to minimize risk in your investments
The best way to protect yourself from foreclosure and bankruptcy is liquidity. You can keep foreclosure at bay by continuing to make your minimum monthly payment on time. That’s why it’s important to always have enough cash on hand and/or liquid investments so that you can continue paying your mortgage and other obligations.
Debt is treated as a bad thing, but your total debt is less important than the amount of cash you have on hand once you’ve satisfied your monthly payments. The more money you have leftover once you’ve made your monthly payments, the less likely you are to experience a financial crisis due to a lack of cash.
You can increase the cushion between your take-home pay and your debt obligations by ensuring you make investments that you can afford. Don’t get caught up in get-rich-quick schemes or convince yourself that it’s worth liquidating your accounts to buy an investment property. The best investors understand that their top financial priority isn’t return on investment, but rather liquidity.
Of course, the remaining liquid carries its risks. If you continue to spend your cash elsewhere and don’t pay your mortgage, you aren’t building equity nor boosting your liquidity. Some people struggle to have unrestricted cash on hand and prefer it to be put towards another investment. If you find yourself with extra cash and want to invest, consider making a liquid investment. Liquid investments include money market funds and shares of publicly traded companies.
No one wants to be in debt. Between mortgages, credit cards, student loans, medical bills and more, the average Canadian consumer owes $71,000. As an investor, you’re likely better off than the average Canadian because you can afford to put your money towards additional properties and create passive income. To protect your investment and your finances, you’ll need to find the right balance between and liquidity and debt to successfully grow your wealth.