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Money, banking and financial markets Suppose Joe and Mile purchase identical house for...

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ranger1980 | Student, Undergraduate | Valedictorian

Posted February 24, 2012 at 12:01 PM via web

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Money, banking and financial markets

Suppose Joe and Mile purchase identical house for 200,000. Joe makes a down payment of 40,000, while Mike only puts down 10,000. Assuming everything else is equal, who is more highly leveraged? If house in the neighborhood immediately fall by 10 percent (before any mortgage payments are made ), what would happen to Joe’s and Mike net worth ?

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litteacher8 | Middle School Teacher | (Level 1) Distinguished Educator

Posted February 24, 2012 at 12:11 PM (Answer #2)

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Mike still has a larger loan than Joe.  If the houses drop in value, his loan will constitute even more of the house's worth.  However, Joe might lose more money if both of them are forced to go bankrupt when the houses drop another 60%.

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

Posted February 24, 2012 at 12:31 PM (Answer #3)

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Assuming that everything else is equal, Mike is more highly leveraged.  This is because the term refers to the amount of money that you have borrowed relative to your assets.  We are assuming the two have the same level of assets.  Therefore, Mike is more highly leveraged because he has more debt.

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readerofbooks | College Teacher | (Level 2) Educator Emeritus

Posted February 24, 2012 at 1:15 PM (Answer #4)

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This is a pretty straightforward answer. As post 3 states Mike is much more leveraged, because he has the larger loan. Here is the benefit of this. If there is inflation, low interest rates, and Mike's salary increases, then he will be in better shape than Joe eventually. If home prices go up eventually, Mike is also better poised to make more money, because he only put down 10,000. For example, if they both sell their homes for 300,000, Mike made 100,000 with 10,000, whereas Joe make 100,000 with 40,000.

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justaguide | College Teacher | (Level 2) Distinguished Educator

Posted February 24, 2012 at 2:06 PM (Answer #5)

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As Joe and Mike purchase identical house for 200,000 but Joe's down payment is 40,000, while Mike only has a down payment of 10,000, Mike is in a position with a higher leverage. In the future if both of their income drops, the effect it would have on Mike would be more harsh than the effect on Joe as he has a smaller amount left to repay.

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accessteacher | High School Teacher | (Level 3) Distinguished Educator

Posted February 24, 2012 at 2:25 PM (Answer #6)

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As other editors make clear, Mike is the individual who is more leveraged because of the amount of debt that he has taken on compared to Joe. Because Joe has put down a bigger desposit, he has less debt and therefore will be impacted less with any future drop in the value of their property.

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vangoghfan | College Teacher | (Level 2) Educator Emeritus

Posted February 24, 2012 at 3:06 PM (Answer #7)

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I would prefer to be in Joe's situation rather than Mike's, I would try to pay down the loan as quickly as possible so that I would own the property clear and free as soon as possible. I realize that Mike is in a position to make investments that  Joe might not be able to make, but I would prefer to own the property as soon as possible and be free from the mortgage payments as soon as possible.

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belarafon | High School Teacher | (Level 2) Educator Emeritus

Posted February 25, 2012 at 2:16 PM (Answer #8)

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While Joe was able to make a larger payment up front, there is no guarantee that he will continue paying large amounts; the fact that the housing market falls almost instantly leads me to believe that Joe's financial situation might be falling as well. Still, the bare bones of the question are as others have put: Mike is more leveraged.

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ranger1980 | Student, Undergraduate | Valedictorian

Posted February 25, 2012 at 11:15 PM (Answer #9)

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To all,

Thanks for all your post, it being very helpful for me to have an understanding on the book and implemente into those questions

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