Question

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

Answer 1

Step-by-step explanation:

Joe and Mike both purchase identical houses which has a net worth of $200,000.

Down Payment made by Joe: $40,000

Down Payment made by Mike: $10,000

Down Payment is the total of his net worth for both individuals.

A) Who is more highly leveraged?

Mike borrowed $190,000 and Joe borrowed $160,000

Mike is more leveraged because he borrows much more to purchase a $200,000 house.

Mike's leverage ratio:

LR = $200,000/$10,000 = 20.

Joe's leverage ratio:

LR = $200,000/$40,000 = 5.

B) If housing prices in the neighborhood immediately fall by 10%, what would happen to Joe'sand Mike's net worth?

ROE = (ROA) (LR)

Mike:

ROE = (-10%) (20) = -200%

Mike will have a decrease of 200% in his net worth. He will surly go bankrupt as the value of his assets are less than the value of the liabilities on him.

Joe:

ROE = (-10%) (5) = -50%

Mike will have a decrease of 50% in his net worth. He still has the worth of his property because his assets are still greater than his liabilities.