Introduction BEFORE YOU THINK ABOUT BUYING A PROPERTY. . .  
 
For those of you who haven't owned a house or a piece of property, and aren't familiar with mortgages and financing, or those of you who presently own a house but find you need to relocate or want to buy a second property, you have this in common: a need to have a better understanding of how the world of purchase and financing operates. The axiom that knowledge is power is true. Knowing how to play the "mortgage/financing" game will have a positive and powerful impact on the end result. You will be able to select wisely from the options available to you and negotiate the best package for your needs. You will save money, time, and frustration on the one hand, and reduce risk, stress, and uncertainty on the other. This introduction offers an overview of what to expect from this book and covers why you should (and perhaps why you shouldn't) consider owning a home or investment property. Although each chapter is self-contained, all should be read thoroughly because the concepts, tips, strategies, and pitfalls discussed are frequently interconnected.

WHY OWN REAL ESTATE?

There are many advantages to owning real estate, but also drawbacks. The advantages or benefits are discussed first.

LOW RISK

Any investment has a potential risk, and you can indeed lose money in real estate. Real estate, though, has traditionally been a secure, stable investment compared to other investments, especially if you buy prudently. There are various reasons for the relatively low risk, which naturally will vary depending on the area where you buy. The value of a property can rise because of a demand for housing, attractive financing rates, and the fact that land values consistently appreciate faster than rates of inflation. The market is cyclical so values will go up and down, but generally speaking, depending on location and other factors, real estate values increase over time.

YOU DON'T NEED A LOT OF STARTING CAPITAL

You can enter the real estate market with a minimum amount of money, possibly 5% of the purchase price as a down payment, and borrow the rest of the money you need, using the property as security. For example, you could buy a $150,000 condominium, put 10% down, and finance the remaining 90%. Because you are borrowing more than 75% of the cost to purchase the property, this is called high-ratio financing, where the ratio between the debt (mortgage of 90%) and equity (your down payment of 10%) is high. (This is covered in more detail in Part II.)

DON'T BE AFRAID-YOU CAN GET INTO THE MARKET

Compared to other investments, such as investing in the stock market, buying your own home can be relatively easy. You don't need a lot of experience and the knowledge and skills can be learned, regardless of your education, age, or background. It just takes motivation, drive, and a desire to learn.

USING LEVERAGE

Leverage means that you use a small amount of your own money and borrow the rest-other people's money (OPM). Wealth can be achieved by applying the simple principle of leverage. For example, financing 90% of a purchase is an example of a highly leveraged investment. Basically the ratio is 9:1; that is, nine times as much money is borrowed compared to what is invested. The risk, if the lender has to sell, is relatively minimal, in that the net proceeds after sale should at least cover the amount of the mortgage, especially considering the historical appreciation in value. There are exceptions, however. If the property owner levers up the property too high (that is, has a high-ratio debt of say, 95%), and the market moves into a declining part of the cycle, then the owner and the lender could be at risk. That is why the higher the amount of the mortgage, the higher the risk for the lender and therefore the higher the interest rate, unless the mortgage is insured. For example, if you are buying a $200,000 house and have three mortgages-a first at $150,000, a second at $20,000 and a third at $10,000-the respective interest rates on those mortgages could be 6%, 9%, and 14%. The third mortgage carries the highest interest rate and has the highest risk because it is the last to be repaid upon sale of the home. On the other hand, if you have a first mortgage that represents 90% of the purchase price, and it is insured against default and loss as a high-ratio mortgage, your interest rate could be the basic 6% to 7% (current rate at the time of writing). The two companies that insure high-ratio mortgages are CMHC (Canada Mortgage and Housing Corporation) and Genworth Financial Canada. Here is another example to show the power of leverage. Let's say you purchase a house for $200,000, put down 10% ($20,000), and borrow 90% ($180,000). The home appreciates by 10% over a period of a year in a buoyant market. What would be the return on your original investment of $20,000? The answer is 100%. In other words, the increase in value of your home of $20,000 (10% appreciation of the $200,000 original price) is a 100% return on your down payment investment of $20,000. Conversely, if you paid cash for the house, that is, the full $200,000, your return on your original investment, due to appreciation of 10% over the year ($20,000), would be 10%.

APPRECIATION OF VALUE

Appreciation simply means the increase in value of the property over time. It is the growth in value of your original capital investment. In Canada, the national average has been approximately 6% per year over a long period of time. As a caution, it should be stressed that this figure is an average. Certain regions will perform below the average. Conversely, a well-selected, well-located, and well-maintained property in a growing community could perform higher than the average.

HOW YOU BUILD EQUITY IN A PROPERTY

When you make payments on your mortgage, you pay down the principal over time. As you reduce your debt, you are at the same time building up your equity, that is, the portion of your original house price that you no longer owe any debt on. (This is independent of the percentage increase in appreciation or value of the property.) In practical terms, most people commonly refer to equity as the amount of value in the property that the person owns, free and clear of any debt. It is the amount of equity that a lender will lend further money on and place a mortgage on as security. In realistic terms, your true equity is what you would net upon sale, after all real estate commissions and closing costs are taken into account. Lenders realize this as well, which is why they generally do not like to lend on 100% of the equity in order to minimize risk and leave a margin for safety.

OWNING REAL ESTATE IS A HEDGE AGAINST INFLATION

You know that inflation is the increasing cost of buying a product or service. On the flip side, it is the decrease in your purchasing power. An item that cost $5 ten years ago now costs $10 due to the effect of inflation. People on fixed incomes who are not indexed (increased) for inflation are very aware of the eroding purchasing power of the dollar. The inflation rate in Canada varies at different times of the year and in different regions across the country. At one time Canada had double-digit inflation, but current policies have kept inflation to single digits. Naturally, the appreciation of the value of property over time includes an inflation factor. Historically, land appreciation value for residential homes has been about 3% to 4% greater than the inflation rate. Another benefit of real estate investing is that you are paying off the mortgage in inflated dollars. That is, you are probably getting more money now in terms of salary increases to pay off lesser-value money when you took out the original mortgage.

TAX ADVANTAGES OF OWNING REAL ESTATE

There are tax advantages to owning real estate, whether as a principal residence or investment property. It would be hard to find an investment that has as many benefits as real estate. For example, all the interest you receive from your bank account, term deposit, or GIC (guaranteed investment certificate) is fully taxable as income. So, if you are obtaining interest of 6% (the nominal rate) on your deposit, and the inflation rate is 3%, the "effective" or "real" rate of return is 3%. If you are paying tax at a 35% rate (2% based on the 6% nominal rate), then effectively you have a 1% rate of return on your money. Real estate does suffer from these tax hits, so wisely investing in real estate-starting with the principal residence-is clearly an attractive form of investment. Some of the key tax advantages of real estate investment include: Tax-free capital gain on your principal residence. Ability to write off principal residence suite rental income against your home-related expenses. Ability to write off a portion of a home-based business income against your home expenses (the home-based business could even be to manage your residential investment income, if you have other real estate investments-check with your accountant). Reduced tax rate of 50% of a capital gain from investment in real estate. Flow-through of losses from negative cash flow can be applied against other sources of income. Deduction of real estate property investment expenses against income. Write-off of depreciation of the building against income.

INCOME POTENTIAL

If you are investing in real estate, a prudent investment could result in a net positive cash flow...