Should You Invest Your Home's Equity?
- Michael Milner The Cheapskate Monthly
- 2005 9 Sep
If you are a homeowner, some financial experts and investment magazines say that you may be sitting on "dead equity." They would like to help you bring it back to life — and enrich themselves in the process.
"Too many people simply look at their home as a place to live," says Sheila Delutri of Merrill Lynch Financial Advisors. What follows is a suggestion that homeowners actually withdraw the built-up equity from their homes and invest the proceeds in the stock market.
Dead equity is any equity in your home that isn’t somehow "working harder" for you elsewhere. Sure, your home "works" for you because it is appreciating in value, but this brand of advice suggests you transform that appreciation — namely by borrowing and leveraging it — into even greater rates of return elsewhere. Like municipal bonds. Or the stock market.
That’s just what folks like Ira Carnahan recently had in mind. "When you buy a new house," he advised in the December 2004 issue of Forbes magazine, "Take out the biggest mortgage you can without incurring a higher interest rate, even if you have spare cash. Invest the cash instead."
Carnahan, and other high-rung financial advisors, argue that paying down your mortgage is an inefficient use of money. Mortgage borrowing they advise, allows you access to large amounts of relatively inexpensive money — money that could then be used to your advantage.
Consider that 1) mortgage rates are low compared to other borrowing rates; 2) mortgage rates are effectively made even lower by their tax-deductibility; and 3) over the long term, money (supposedly) works most productively when it’s invested in stocks.
These gurus’ advice? Invest money in stocks before paying extra on your mortgage.
The idea here (borrowing money against your home at low rates and pouring those funds into potentially higher-returning investments) has some merit. Retirement investing via 401(k)s and IRAs probably should be emphasized before making large efforts to pay down one’s mortgage. That home, after all, won’t feed you in retirement.
The annual rates of return you earn on your retirement investments stand a decent chance of surpassing what you’d save yourself in interest if you paid off your mortgage early. And investing in retirement accounts can offer tax advantages and company matches.
But nice ideas can be taken to dangerous extremes.
Financial advisors and investment magazines occasionally suggest that homeowners actually withdraw the built-up equity from their homes and invest the proceeds in the stock market. In doing so ("stripping" in industry jargon), you’re borrowing money against your home at say, 6 or 8 percent. Tax deductibility makes that rate somewhat less, depending on your tax bracket. You then invest the borrowed funds in the market, earning "historical average" returns of 10 percent or better.
Surprise! When Joe Homeowner follows this advice the only guaranteed winner is the financial-services industry. Why? Money flows into the market (large sums of it) for investment. Sales quotas are met. Commissions, sales loads and bonuses are generated. That makes Merrill Lynch and Joe’s mortgage banker very happy.
But will Joe be happy? Successfully leveraging home equity into the stock market is predicated on several factors:
• Your home’s value won’t decline for an extended period of time. (It can happen. Look at Japan.)
• The market won’t decline, or trade sideways, for an extended period of time. (It can happen. Tap redial and check with Japan again.)
• You won’t need the money in a hurry and be forced to cash out your investments at a significant loss.
• You’re already quite affluent.
• Your life needs more risk.
Let’s create two scenarios:
Bob Smith owns his $200,000 home outright. He refinances the house at 7 percent for 30 years, withdrawing $100,000 cash.
He invests this in the mutual funds his broker advises. Mr. Smith is in the 25-percent tax bracket. Since mortgage interest is tax deductible, his effective interest rate on the mortgage is closer to 5.25 percent. His monthly payments are $665. Not having much cash to spare, once each year Smith draws down his investment account to cover 12 monthly payments plus the amount he owes in federal capital gains taxes.
Ten years pass. Mr. Smith has paid not quite $44,000 in mortgage interest, plus $2,500 in closing costs when he initiated the refinance. Even so, after commissions and fees his mutual funds have done quite well — they’ve increased in value by 8 percent per year.
At the end of the decade, his investment gain is $47,300. Subtract the expenses above (mortgage interest and closing costs) and his net profit is only $890. If Mr. Smith’s state taxes capital gains at any rate greater than 1 percent, he will actually lose money.
In this case Mr. Smith is affluent enough to leave the entire $100,000 invested. He pays his mortgage payments ($665 per month) and his annual capital gains taxes (anywhere from $2,000 to $4,000 per year) with income from his job. Now the picture changes significantly.
Here, Mr. Smith enjoys the price appreciation of his home and leverages his home’s equity into an after-tax investment gain of $86,900 by the time the decade is up. Subtract the interest and closing costs, and he’s racked up a net profit of $40,400.
Ah, but the risk
Neither of the scenarios described above account for common what-ifs:
What if Mr. Smith is "downsized" at work and has to relocate while his investments are showing a loss? Hope he has some big cash handy or some seriously eager home buyers.
What if the state where Mr. Smith resides taxes capital gains at 5 percent or more? That being the case, in Scenario 1 he loses at least $3,268. In Scenario 2, his net profits drop to $34,625.
What if the stock market meanders for the next ten years and his investments earn only 4 percent per year? Congrats, Mr. Smith! In Scenario 1, you lost $26,535. In Scenario 2, you’re down to $10,482.
Thanks to the recent period of historically-low interest rates and rocketing home values, many people have amassed nice chunks of home equity.
If you listen to your broker, investing that equity elsewhere looks like easy money — a real no-brainer. But like many things in life, the risk shows up big when you gaze through the magnifying glass of reality.
As for me, I’ll take my "dead equity" over low equity any day.
Michael Milner is a freelance writer who writes a popular personal finance blog (see www.MoneySpot.org). He lives with his wife and baby daughter in Oklahoma, where their home’s equity is alive and doing quite well.
© 2005 The Cheapskate Monthly. All rights reserved. Used with permission.
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