4.5 A detailed example: after the purchase
Now look at what happens to Meiling’s balance sheet when she buys the home.
Activity 13 Home buying and the balance sheet
Allow about 10 minutes
Recall that Meiling buys a house costing £141,500 and takes out a mortgage of £100,000. She pays the £41,500 deposit out of her savings account. All the remaining money in the savings account is used up on the up-front costs of buying the home.
- Starting with the entries you made into the Balance sheet analyser in Activity 12, adjust them for the new information described above. Select ‘Reveal answer’ to check your entries are correct.
- Comment on how Meiling’s financial position has changed compared to that in Activity 12.
Discussion
Meiling’s balance sheet now looks rather different. Her liabilities have increased by £100,000, the amount of the mortgage.
Her assets have also increased by a net amount of £91,500, with the home adding £141,500, while paying the deposit and home-buying costs out of savings has meant a decrease of £50,000 in them. (£141,500 – £50,000 = £91,500).
These changes have had an effect on her key balance sheet ratios, as shown in Table 11.
Table 9 Meiling’s financial situation before and after buying a home
| Before | After | |
|---|---|---|
| Net worth / wealth | 55,500 | 47,000 |
| Current asset ratio | 52.50 | 2.50 |
| Leverage ratio | 11.90% | 69.58% |
Her financial net worth has fallen slightly because she has had to spend some of her savings on the up-front costs of buying the home. But she still has a healthy level of positive net worth.
Her current asset ratio has fallen dramatically from 52.5 to 2.5. While this is above 1, meaning she could still clear her short-term debts in full in a hurry if need be, it is below the level of 3 or 4 that experts recommend. The fall has occurred because she has swapped most of her liquid savings for a much less liquid asset, the home.
Meiling’s leverage ratio has increased almost six-fold owing to a large increase in liabilities because of the mortgage. The ratio is still much less than 100%, so she is solvent. However, it suggests that, in theory, servicing her debts could put significant pressure on her cash flow. Whether it does in practice depends on interest rates, not just the large amount of the debt.
OpenLearn - Rent or buy? The challenge of access to housing
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