In most cases, the interest paid on mortgage loans is deductible from your federal income taxes. You may therefore want to make financing decisions on an after-tax basis, particularly when you are comparing a tax deductible mortgage loan to a consumer loan. To do so, you need to know your marginal tax rate. This is the amount of each additional dollar of income that is taxed away. It is also the amount of each dollar of tax-deductible expenses that reduces your taxes. So, if you know your marginal tax rate, you can easily determine how much tax you will save.

We can illustrate the use of the marginal tax rate with an example. Suppose a single taxpayer currently rents and is considering buying a home. Her adjusted gross income is $30,000, and she has no itemized deductions. If she buys the home, tax-deductible interest and property taxes would amount to $6,750 the first year. By itemizing, she gives up her standard deduction of $4,400 (based on 2001 tax law), so the amount of additional tax deductions would be $2,350. Her marginal tax rate is 15%. Buying the home would save her $352 (.15 times $2,350) in taxes the first year.

To see that this is correct, we can calculate her taxes with and without the additional deductions. As a renter, her taxable income would be $22,700. This is her adjusted gross income of $30,000 less a $2,750 personal exemption and $4,400 standard deduction; taxes would be $3,405. With the additional deductions, her taxable income is $20,350 and taxes are $3,503. The difference is $352.

In 2002, there are currently six marginal federal tax rates: 10%, 15%, 27%, 30%, 35%, and 38.6%. You can find the rate for any income range by referring to the Tax Rate Schedules included in the Form 1040 book mailed to most taxpayers in January

Once you have settled on a lender and the type of loan you want, it is time to make a formal application. The time between application and approval of the loan may be two to eight weeks. This is a time of anxiety for many borrowers, especially if there is some question as to whether they can qualify for the loan. Even for those who easily qualify, the delay can be frustrating.

It may help to understand what the lender is doing during this time. The lender’s most important task is to assess the risk involved in granting the loan. The lender must also prepare the necessary documentation on the loan to satisfy government regulators and investors who may purchase the loan.
The lender will order a credit report, which shows your history of meeting financial obligations. Problems may occur if you have defaulted on loans and credit agreements in the past, or if you have yet to establish a credit record. The lender will also verify information you have provided on income, employment, and bank accounts. This information is needed to see if you qualify for the loan (see Key 8).

The lender also orders an appraisal of the property. This is used to verify that the property is worth at least as much as you agreed to pay for it. The loan-to-value ratio is applied to the lesser of the contract price or market value. If you are buying a house, the loan will be a percentage of its appraised value or its cost, whichever is less.

In addition to the lender’s work, it must be approved if the loan is for more than 80% of value by FHA, VA,or a private insurer. This may add some time to the approval process.

When all intonation is in, the application is presented to the loan approval committee. This committee meets periodically to endorse or reject the recommenda­tions of the loan officer. If your application is approved, you can proceed with the closing. If not, you must start over with another lender.
Recently, some lenders have been trying to gain a competitive edge by offering quick loan approval through less documentation than has been required in the past. Traditional requirements and newly devised ones are compared below. Some lenders will use the method more suitable for you.

Traditional - New Alternatives

Verify employment * Two years’ W-2 statements, and current paycheck stub with year-to-date earnings Three months’ savings and checking account deposits Credit report reference for last six months, or six months’ mortgage payment history, or canceled checks for last year.

Technology continues to transform the ways in which loan applications are submitted and evaluated. Today, you can start the loan application process over the Internet or in a real estate broker’s office. Many lenders use automated systems to analyze the risk of making the loan. The major loan purchasing firms, Fannie Mae and Freddie Mac, operate computerized loan underwriting systems with their criteria built in. If the loan passes the test, there is no need for a loan approval committee. As a result of these advances, the time required to approve a loan is shrinking. This is good news for homebuyers waiting for the go-ahead to complete a purchase. Ultimately, this trend will bring down the costs of secur­ing a loan as well.

Many people do not think about mortgage financing until they enter into a contract to buy a home. In fact, most mortgage lenders will require you to have a signed purchase contract before you can apply for a loan. However, that does not preclude a bit of pre-arrangement on your part at the start of the home shopping process. In fact, it can save valuable time and may give you some negotiating advantage.

This financial pre-planning can take several forms, from basic research to actually starting the loan application process. The most casual effort would be to check current interest rates available from lenders in your area. This task is often simplified by the local newspapers, which commonly compile tables of current mortgage terms and report them weekly in the business, real estate, or “homes” section of the paper. Also, most real estate agents will have a list of current loan terms prepared for your perusal. If you want more information, you can call the lenders on the list. They should be willing to quote interest rates, origination fees and points, application fees, and what types of loans they offer over the phone.
The next level of preparation is to get “pre-qualified.” Pre-qualification is an informal and highly simplified version of the qualification process you go through after you apply for a loan. Basically, the loan officer will apply the standard qualifying ratios to your income and debt level and determine how much loan you would qualify for if you were applying for a loan. Pre-qualification assumes that all the other things that go into the loan approval decision are acceptable. It does not indicate that you have any leg up in the loan application process. In fact, your real estate agent can probably pre­qualify you. If you follow the process outlined in Key 8 and know how to calculate mortgage payments, you can pre-qualify yourself!

The purpose of pre-qualification is to get an idea of how much house you can afford. If you know how big a loan you could qualify for and how much cash you can invest, you can add the two totals to determine the most expensive house you can consider This information can be valuable as you search the market (unless you are looking for a dream home that will likely remain a dream).
Pre-approval is more serious. With pre-approval, the lender goes through the entire loan approval process as if you were applying for the largest loan you can get. The purpose is to set a limit on your house search (as in pre-qualification) and show you are creditworthy at that level. The process must be performed by a lender (or someone authorized by the lender to process loan appli­cations) and will probably require some type of fee (to compensate for the cost of a credit report and processing time). More importantly, you will need to decide on the lender and type of loan you plan to use to finance your eventual purchase. This is because pre-approval applies only to a specific loan offered by a specific lender. If you choose another lender or loan later on, your pre-approval will not apply.

While pre-approval shortens the loan processing time once the loan application is submitted, the real value is in the negotiating power it can provide in competitive markets. A home seller might favor a buyer with a definite chance of getting funding, this can translate into a better price or other concessions. It could prove decisive if you are a first-time buyer or if you need to make a minimal down payment.

If you have any question on how far your income will go in the current housing market, you should get Pre-qualified. There is no need to waste time on homes you cannot afford. If you have any doubts about your ability to get a loan (perhaps you have had some credit problems in your past), you might find it worthwhile to get pre-approved. Or, you may want to defer that decision until you test out the market and can better judge whether pre-approval will be useful.

The lender’s qualifying criteria determine how big a loan you can get. The lender will need to know if you can afford to make loan payments regularly based on your income and other financial obligations. There are several standard ratios used in loan qualifying depending on what type of loan you are seeking. These ratios compare required housing costs and other long-term obligations to your income in an effort to determine affordability.

The best way to describe loan qualifying is with an example: Suppose the Browns apply for a mortgage loan of $150,000. The lenders then ask them to state their income. Mr. Brown makes $45,000 a year, and Mrs. Brown makes $30,000, bringing their total monthly income to $6,250. The loan is for 90% of value with a fixed rate of 8% (30 years). Monthly payments are $1,101 for principal and interest, plus $300 for escrow.

The lender divides the PITT by monthly income:

$1,401÷ $6,250 = 22.4%

This ratio is within the 28%* needed to qualify, so the loan looks affordable. Next the lender considers payments on other debts. The Browns pay auto loans of $600 per month, and a $250 monthly student loan. Adding these to the mortgage payment makes their total debt payments $2,251 per month:

$2,251 ÷ $6,250 = 36%

Because the debt ratio is right at the 36%* needed to qualify, they should qualify for the loan. This assumes that the Browns’ credit rating or score is sufficient to entitle them to the best credit terms. A low rating might have disqualified them even though they passed the ratios. On the other hand, an excellent rating may encourage the lender to bend the ratios if necessary. Also be aware that some first-time homebuyer programs offer more liberal ratios. if the Browns are applying for an adjustable rate loan, the lender may base the loan payment on a rate higher than that charged initially. This practice accounts for the likely increase in the rate after the first year of the loan.

If they were applying for an FHA loan, the criteria would change (even though $150,000 is more than the PHA can insure, we will use the same example). Since the FHA ratio of PITT to income should reach no more than 29%, and total debt payments no more than 41%, no problem arises here. In fact, they pass with more of a margin than in the conventional case.

The FHA uses a new way of calculating the maxi­mum loan it will insure. A maximum percentage that varies by the price of the home and whether it is located in an area with traditionally high or low closing costs is applied to the value (the lesser of the price or appraised amount) of the home. These percentages range from a low of 97.15% up to 98.75%. The up-front mortgage insurance premium (MIP) and closing costs can be financed into the loan, but the borrower is required to make a cash investment equal to at least 3% of total purchase costs.

The purpose of these qualifying ratios is to prevent making loans to people who will find it difficult to meet the payment obligation each month. You may consider the maximum payment allowed more burdensome than you would like, and there is no reason you must get a loan that large. You may want to look for a home that is more modest. However, you may feel comfortable taking on a payment burden even more onerous than the maximum allowed. In that case, if you can present an argument for the increase by pointing out any “compensating factors” that might indicate your ability to handle the extra debt, you might secure a larger loan. For example, if the home is newly constructed or is especially energy efficient, the lender might employ a higher ratio reflecting the likely lower maintenance cost. If you make a larger than normal down payment, you might get a larger loan relative to your income. If your record shows you paid a comparable amount of rent in a timely manner, the lender might allow a higher payment-to-income ratio.

Loans specially tailored for first-time homebuyers often allow higher ratios for both mortgage payment and total debt than other conventional loans. For some pro-grams, the 28/36 percent ratios are extended to 33/3 8 percent. That means if you think you can qualify for one of these types of loans, you may expand your home search to a slightly more expensive range. On the other hand, if you are planning to use an Adjustable Rate Mortgage with less than a 10% down payment, the ratios probably will be lower (25/3 3 percent). That would narrow your range of houses a bit.

*These ratios apply to “conforming” loans. A conforming loan is one that is eligible for purchase by Fannie Mae or Freddie Mac. These agencies establish specific criteria for loans they purchase. More importantly, the government restricts the loan amount these agencies can purchase. The amount, which now stands at around $250,000, is raised each year. Loans over the limit are called “jumbo mortgages” and they carry higher interest rates and less attractive terms.

When you buy that first home, the financial hurdles can be formidable. You need enough income to qualify for a loan sufficient to buy the home. This means you need a steady income and established credit. You need cash for a down payment as well as for the expenses normally incurred at closing. The down payment, prepaid expenses, and closing costs generally represent at least 5—6 percent of the cost of the home.

It is no wonder that first-time homebuyers are at a financial disadvantage. Fortunately, the government and large financial institutions recognize how important it is to maintain a steady stream of new homebuyers in the market and they have devised a number of loan products specially tailored for first-time buyers.

Traditionally, first-time buyers turned to the FHA for help in getting a loan. Loan insurance from PHA, the 203(b) program allows borrowers to buy with a down payment of as little as 3 percent of the cost of the home. The program is not restricted to first-time homebuyers, but several features of the program make it especially applicable to them. First, the amount of the loan is limited to encourage and allow the purchase of modestly priced starter homes. Second, the insurance premium paid at closing is priced to favor first-time buyers. If you have not owned a home in the past three years, you receive a quarter-percentage-point discount on the pre­mium. If you attend special pre-purchase counseling sessions, you can get another quarter-point discount. Thus, first-timers can pay only 1 .75 percent in upfront insurance premiums compared to the standard 2.25 percent premium.

The big secondary purchasers of mortgage loans (that is, buyers of existing first mortgages), Fannie Mae and Freddie Mac, each offer programs intended to help first-time buyers. Like FHA, they are not restricted to first-time buyers but they contain features that are especially helpful to first-timers. The loans have names like “Affordable Gold” or “Fannie 97.” The essential features of these loans include:

A low down payment with provisions for help from relatives or government and nonprofit agencies.
Required pre-purchase educational session.
Relaxed qualifying guidelines that recognize non-traditional sources of income and wealth and use a history of rent-paying to establish credit rating.

Those who originate mortgages will provide homeowners with loans that conform to the guidelines of secondary purchasers.

The regional Federal Home Loan Banks are mandated to devote a certain portion of their funds to affordable housing programs. To do this, the banks award grants to local lenders who devise special lending programs tailored to the needs in their market area. These programs may offer special low interest rates, low down payment requirements or cash assistance, or relaxed qualifying guidelines. In most cases, eligibility is re­stricted to first-time buyers with incomes below a specified amount.

Local and state governments offer special mortgage loan programs for first-time homebuyers. These loans carry below-market interest rates. Borrowers must not have owned a home in the last three years nor have an income above a specified amount (which varies according to the local median income). The government funds these loans by issuing municipal bonds that sell at low yields because interest is exempt from federal income tax.

All of these loans are originated by regular mortgage lenders: banks, thrifts, mortgage bankers, and brokers. The agency or company sponsoring the loan either provides insurance or buys the loan once it is originated. Therefore, you can obtain information about what is available in your area by asking local lenders. Alternatively, you may want to contact the housing department of your city or county to find out what help they can offer. In addition, you may be able to get a list of approved lenders from the FHA, Fannie Mae, Freddie Mac, or your local housing office.

If you plan to buy a house sometime in the future, but not within the next five years, a good way to save up a down payment is to put money in a Roth Individual Retirement Account (Roth IRA). You can invest up to $3,000* per year in the account. Although you must pay tax on the money invested, all earnings and appreciation are tax-free. So when you take fit money out, you will pay no taxes on it. Ordinarily, you cannot touch the money until you are 59 1/2 years old, but with a Roth, you can withdraw the money to make a down payment on a first home purchase without penalty as long as the account is at least five years old. Check with your tax advisor for more details.

A first lien loan is the mortgage placed on the home before any other loans are taken out. It is usually the loan you use to buy the home and may be the largest loan on the home. The lender of a first lien loan has first claim on the home in the case of default.

There are several types of lenders who specialize in making loans on homes.

S&Ls and MSBs. These are savings and loan associations and mutual savings banks—depository institutions that offer checking and savings accounts and use the money to make loans. Most of these institutions also operate mortgage banking operations, which makes available to them a wider variety of loans they can keep or sell. Because of certain regulations, most of the loans they make are home mortgages. The institution you deal with will probably be a local association or branch, but in some cases out-of-town lenders will be actively making loans in your area.

Mortgage Bankers. These companies make loans and sell them to investors. Incidentally, it makes little difference who owns your loan. It does make a difference who services your loan, that is, who collects the payments and handles the escrow account. In many cases, the lender who originated the loan will service it. However, it is becoming more common for the servicing to be transferred, even for loans made by local institutions. Servicing entails collecting your payments and making sure that sufficient insurance is maintained and property taxes paid.

Mortgage Brokers. These firms operate much like mortgage bankers. However, they do not use their own money to originate loans. Instead, they find the type of loan you want and originate the loan for the lender chosen. A broker may represent a number of lenders. They can help you choose from among an array of loan types. Often, they can find loans that cater to special problems, such as a borrower without an established credit record. Brokers operate on fees that lenders pay for submitted loan applications.

Within limits, real estate brokers can act as mortgage brokers. Some are hooked up to special networks of mortgage lenders. Through the use of specialized computer software, the broker can access information on loans currently offered by lenders in the network arid help the homebuyers select a loan and prepare a loan application, all within the real estate broker’s office. If you like the convenience of such one-stop shopping, ask about the availability of “Computerized Loan Origination” when meeting with your real estate sales agent.

Other types of lenders may make home mortgage loans as well:

Commercial Banks. Although banks specialize in short-term and business loans, they are becoming more active in home mortgages, particularly adjustable-rate loans. Physically, banks and savings and loans are similar. Banks generally have the word “bank” in their title, while S&Ls often use the word “savings?’ If either uses the word national or federal in its title, it is chartered by the Federal Reserve System (for banks) or the Federal Home Loan Bank Board (for savings and loans or mutual banks). Others are chartered by a state authority. The difference may affect the types of loans they are allowed to offer.

Credit Unions. If you are a member of a credit union, you may be able to get a mortgage loan from this source. Credit unions specialize in smaller, shortterm loans but may offer some types of home loans.

Stockbrokers. If you have an account with a stock brokerage firm, you may be able to secure a mortgage there. Most stockbrokers, even discount brokers, offer mortgage loans. If your portfolio is substantial, you may receive favorable terms on the loan. Many brokerage houses offer a “pledged asset” mortgage that obviates the need for a big cash down payment. If you pledge the portfolio as collateral on the loan, you may borrow up to 100 percent of the value of the home. Of course, you cannot liquidate the portfolio while it is pledged and you may have to add securities or money if the stocks fall in value.

Sellers. When buying a home, it is also possible to obtain financing from the seller, especially one who is anxious to move. The mortgage rate buyer and seller agree upon may represent a happy compromise between what the seller could earn on money in the bank and what the buyer would have to pay for borrowed funds.

Refinancing Options. If you are refinancing a first mortgage, you may want to check with the original lender first. It may be possible to avoid some of the closing costs, especially if the loan was made within the past few years. You have established a payment record with the lender, so a new credit report shouldn’t be needed. Also, it may be possible to use the original survey. If your lender refuses to waive these costs, you may want to consider other lenders.

When you shop for a loan, you should look at more than the interest rate alone. Mortgage loans usually require the payment of discount points in addition to the various fees associated with originating the loan. These points are additional interest paid at the time the loan is closed and can add substantially to the cost of the loan. When the lender quotes an interest rate, it is usually expressed as “eight percent plus two points.”

Each point is a charge of 1 % of the amount of the loan. For example, if you are seeking a loan of $98,000, one point would cost you $980. At the closing, the lender will advance only $97,020 ($98,000 less $980), and you must make up the difference. Alternatively, you can write a check to the lender for $980 and the lender will advance the full amount. There is no real difference, except for tax purposes. If you write a check for the points, you should be entitled to an immediate tax deduction for the points, provided you are getting the mortgage to buy a principal residence (refinancing will not qualify) and that the points are a customary charge in your local area.

In either case your loan payments are based on the full $98,000, and that is how much principal you will eventually pay back to the lender. This means you must come up with additional cash to buy the home or to refinance an existing loan. In some cases of refinanced loans, the lender will allow you to borrow the points and pay them back as part of the monthly payments. You should take this expense into account when deciding whether or not to refinance.

Within the loan market, there probably will be a vanity of combinations of interest rates and points. The same lender may offer different combinations. If you are short of cash, you should look for loans with no or few discount points. However, these loans will probably carry higher interest rates. If you are having trouble qualifying for the loan, you may wish to pay more points for a lower interest rate. Many lenders allow you to pay additional points to reduce the interest rate further. These types of loans are called buy-downs. You may even try to negotiate with the seller of the home to pay some or all of the points.

If you are indifferent as to whether you pay the cost of the loan in the form of points or a higher interest rate, you will want to compare loan offerings on the basis of actual cost. When the points are factored into the cost of the loan, the rate is called the effective interest rate. The lender’s disclosure of the true cost of the loan should indicate the annual percentage rate (APR). This is the effective inter­est rate assuming you keep the loan until it is paid off. As a rule of thumb, each discount point adds approximately one-eighth of one percentage point to the interest rate. This can be seen by referring to the chart below.

As the chart indicates, a loan at 10% interest and four points has the same effective interest rate as one at 10.5% interest and no points. These comparisons are for loans held for the entire 30 years to maturity. If the loan is held for a shorter time, the effective rate will be higher, depending on how long the loan is outstanding. Differences are not too great for loans that go beyond ten years, but they are for loans paid much earlier.

For example, a 10% loan with two points that is pre­paid in one year has an effective rate of 12% because the two points are all returned in just one year; so the two points can be added to the 10% annual interest rate. If that loan is outstanding for two years, the two points are spread over two years; so the annual interest rate is about 11% (10% interest plus one point each year). As you can see, the idea is to spread the points over the life of the loan. However, points are not spread evenly owing to a complicated computation of the effective interest rate.

If you’ve been waiting to see when interest rates will bottom out before buying, you know how difficult that can be. When rates are falling, there’s a temptation to wait for a further decline before buying. But then rates can turn up sharply, and the opportunity may slip away. On the other hand, if you buy and afterward interest rates drop even further you may have an opportunity to refinance. Refinancing is replacing your old mortgage with a new one.

Whether it is the original mortgage or a refinancing, shop carefully for the best mortgage you can. A real estate broker can be helpful, but plan to spend several hours on the phone asking for rates. Some newspapers print mortgage rates offered by local lenders once a week.
That, too, is useful information, but be sure to call and verify. Take out the Yellow Pages and call every lender. Ask for rates, points, and all other costs for the type of loan (e.g., FHA, fixed-rate, ARM) and repayment schedule that you want.

Make a chart on which you enter each lender’s name, phone number, loan officer, rate, points, fees, lock-in period, and application fees. Often, local newspapers compile a similar table and print it weekly in their business or real estate section. These tables may have week-old information, so they should be used as a guide and not as a complete substitute for the one you compile yourself The mortgage business today is as much national as local, so you may want to include some large loan companies in your matrix. Finding information about loan terms is relatively easy over the Internet. A search of Web addresses under the topic of “mortgage loans” will give you a large cross-section of lenders from which to choose. You may even want to e­mail some of them for more detailed information.

You might also ask friends about their experiences with their lenders. Many times it is better to deal with a lending institution that has an outstanding reputation than to attempt to get the best terms. If you are working with a real estate agent, do not hesitate to ask for a referral. Agents work closely with lenders and they know which ones are the best for completing a sale. Recognize that federal law discourages an agent from referring you to a lender because that lender offers to pay the agent a fee. However, agents may refer you to a lender with ties to the brokerage firm, or the agent may have access to a computerized network that can process loans. There are disclosures required to alert you to these arrangements, so you probably do not have to worry about being taken advantage of in such cases. On the other hand, you should have a general idea of what kind of terms are available in the market before you select a loan through these types of referrals.

Rates have a way of changing quickly; so ask about the length of the lock-in (the period for which their rate quote will be valid) and the amount of the application fee. Some lenders will offer a 60-day lock-in but may want a 1% nonrefundable fee. Others will refuse to lock in, especially when rates are volatile, giving you the prevailing rate at closing. Beware of the lender with the lowest quote and a long lock-in.

Types of Lending Institutions. Most mortgage lenders, such as banks, sell off their loans to investors after the closing; often, even the right to service the loan (collect payments for a fee) is sold. Consequently, the identity of the original lender often doesn’t matter to the borrower, who may begin dealing with someone else even before making the first payment. (Keys 7 and 9 offer descriptions of mortgage lenders.)

Guidelines of income required for various types of loans are described in Key 18. Some lenders will pre-qualify you, that is, tell you how large an amount you can borrow. This can give you confidence, when shopping for a house, that you will be able to close, and will also expedite the closing time. However, most lenders won’t take you seriously until you show them a signed contract to buy a house.

When you approach a lender, have all of your financial papers in order. Make a list of your accounts: checking, savings, and debts. Include account numbers and balances. Bring copies of car titles. Bring a list of securities you own and their value. Bring copies of 1099 tax forms to show dividend, interest, and royalty income. If you own rental property, bring something to prove you get rental income. If either spouse is divorced, show proof of alimony and/or child support, whether paying or receiv­ing. List your jobs for the past ten years, with addresses, phone numbers, income, and supervisors. Bring W-2 forms for the past two years and your Form 1040.

Your lender will want a copy of the sales contract (not necessary for a refinancing) plus details of all the other items noted above. Help the lender to verify as this will expedite the loan process. The lender will want money for a property appraisal (about $400) and credit check ($50). Ask your lender how long the process normally takes. Call back regularly to be certain there are no unusual snags. Your seller and broker will also appreci­ate being kept informed of your loan approval status.

Anytime you use borrowed money to make an investment, you are using leverage. In the case of buying a home, you probably have little choice other than to get a mortgage loan. Very few can afford to buy a home with all cash. However, even if you did have that much cash, you might still want to borrow money to cover part of the purchase.

For one thing, you might not want to tie up a large part of your cash in property. By borrowing, you can keep those funds available for emergencies or to take advantage of good investments as they appear. You are better able to spread your funds among many investments, so that you are not so dependent on the success of each one.

Finally, using leverage can improve the performance of your investment. You may not think of buying a home as an investment, but it is. First, you are investing in housing for the future. Instead of renting a home, you are renting the money to buy that home. It is true that you could lose that home if you don’t keep up the “rent” payments on the loan, but you don’t have to wony about losing your lease because the owner of the property changes plans.
Furthermore, your home can return a profit if it increases in value while you own it. Leverage will increase the rate of return you may realize on appreciation. For example, if you buy a home for $100,000 cash and sell it the next year for $110,000, your rate of return would be 10% on your investment. However, if you borrowed $80,000 to buy the home, the rate of return on your $20,000 down payment would be 50%.

Refinancing to take out equity keeps the maximum leverage working for you. In the example above, say you sold the home at the end of the second year for $120,000. With the original $80,000 loan, the return on your equity in the second year would be 33%. If you refinanced the loan after the first year for $90,000 (taking out $10,000 in cash), your return on equity in year two would be 50%.

The other side of leverage is that it increases your risk of loss. The more you borrow, the more pressure there is on your income to cover the payments on the loan. If you run into problems, you may have trouble making your payments. Also, if the property declines in value and you must sell, leverage acts to increase your loss. For example, if the $100,000 home is sold after a year for $90,000, you would suffer a loss of 10% of your investment. If you had used a loan of $80,000, however, you would have lost half of your equity.

In any financing or refinancing decision, you should keep in mind the effect the arrangement will have on your exposure to financial trouble.