Mortgage Philosophy

How The Affluent Manage Home Equity To Safely And Conservatively Build Wealth

The Answer?

Most of what we believe about mortgages and home equity, which we learned from our parents and grandparents, is wrong. They taught us that mortgages are harmful to us and our long term financial goals.

The problem with this rationale is it has become outdated. The rules of money have changed.

Unlike our grandparents, we will no longer have the same job or live in the same home for 30 years, nor can we depend on our company’s pension plan or even Social Security for a secure retirement.

Wealthy Americans With The Ability To Pay Off Their Mortgage Understand How To Make Their Mortgage Work For Them.

They put very little money down, they keep their mortgage balance as high as possible, they choose adjustable rate interest-only mortgages, and most importantly they integrate their mortgage into their overall financial plan to continually increase their wealth.  This is how the rich get richer.

Ric Edelman, one of the top financial planners in the country and a New York Times Best Selling author, summarizes in his book, The Truth About Money, “How you handle issues of home ownership may well determine whether you achieve financial success.”

Why People Fear Mortgages, And Why You Shouldn’t 

Before the Great Depression, a common clause in loan agreements gave banks the right to demand full repayment of the loan at any time.  And no one worried about it.  No one thought it would happen.

When the stock market crashed on October 29, 1929, banks ran out of cash and started calling loans due from good Americans who were faithfully making their mortgage payments every month.

Additionally, the Fed is now quick to infuse money into the system if there is a run on the banks, as we saw in 1987 and Y2K. Also, the FDIC was created to insure banks. Still, it’s no wonder the fear of losing their home became instilled in the hearts and minds of the American people.  Because of this fear of their mortgage, for nearly 75 years most people have overlooked the opportunities their mortgage provides to build financial security.

Many People Hate Their Mortgage because they know over the life of a 30-year loan they will spend more in interest than the house cost them

To save money it becomes very tempting to make a bigger down payment or make extra principal payments. Unfortunately, saving money is not the same as making money. Or, put another way, paying off debt is not the same as accumulating assets.

By tackling the mortgage pay-off first and the savings goal second, many fail to consider the important role a mortgage plays in our savings effort. Every dollar we give the bank is a dollar we did not invest.

“While paying off the mortgage saves us interest, it denies us the opportunity to earn interest with that money.”

 

A Tale of Two Brothers

Ric Edelman has educated his clients for years on the benefits of integrating their mortgage into their overall financial plan. In his book, The New Rules of Money, Ric tells the story of two brothers, each of whom secures a mortgage to buy a $200,000 home.

Each brother earns $70,000 a year and has $40,000 in savings. The first brother, Brother A believes in the old way of paying off a mortgage, which is as soon as possible. Brother A bites the bullet and secures a 15-year mortgage at 6.38% APR and pays all $40,000 of his savings in down payment, leaving him zero dollars to invest. This leaves him with a monthly payment of $1,383. With a combined tax rate of 32%, he has an average monthly net after-tax cost of $1,227. In an effort to eliminate his mortgage sooner, Brother A sends $100 extra to his lender every month.

Brother B, in contrast, believes the new way of mortgage planning, and carries a big, long-term mortgage. He secures a 30-year, interest-only loan at 7.42% APR. He pays only $10,000 down payment and invests the remaining $30,000 in a safe account. His payment is $1,175, 100% tax deductible for 15 years, and 64% over the life of the loan, giving him a net cost of $799. He adds $100 to his investments (the same as Brother A sent to his lender), plus the $428 he’s saved from his lower mortgage payment. His investment account earns an 8% rate of return.

“Which brother made the right decision?”

 1)  The answer can be found by looking into the future. After just five years, Brother A made zero dollars in savings and investments. Brother B’s savings and investment account has grown to $83,513.

2)  Now, what if both brothers suddenly lose their jobs? The story here turns rather bleak for Brother A. Without any money in savings, he has no way to get through the crisis. Even though he has $74,320 of equity in his home, he can’t get a loan because he doesn’t have a job. With no job and no savings, he can’t make his monthly payments and has no choice but to sell his home in order to avoid foreclosure. Unfortunately, at this point it’s a fire sale so he must sell at a discount and then pay real estate commissions.

Brother B, while not particularly happy at the prospects of searching for a new job, is not worried because he has $83,513 in savings to tide him over. He doesn’t need a loan and can easily make his monthly payments, even if he is unemployed for years. He has no reason to panic, as he is still in control. Remember…Cash is King!

3)  Now, let’s say neither brother lost his job. We’ll check in on them after 15 years have passed since they purchased their homes and evaluate the results of their financing strategies. Brother A has $30,421 in savings and investments (once his home was paid off he started saving the equivalent of his mortgage payment each month), and he owns his home outright. Not too bad, right?

Now let’s check on his Brother. Brother B has $282,019 in savings and investments. If he chooses to, he can pay off the remaining mortgage balance of $190,000 and still have $92,019 left over in savings, free and clear.

4)  Finally, let’s assume that rather than pay off his mortgage at 15 years, Brother B decides to ride out the whole 30 years of the loan’s life. While Brother A has still received only $25,080 in tax savings, his savings and investments have grown to $613,858, and he still owns his home outright. Brother B, on the other hand, has accumulated an incredible $1,115,425 in savings and investments, and also owns his home outright.

He can start over fresh and enjoy the same benefits once again. Unfortunately, the majority of Americans follow the same path as Brother A, as it’s the only path they know.

Once the Path of Brother B is revealed, a paradigm shifting epiphany often occurs, as people realize Brother B’s path enables them to pay their homes off sooner (if they choose to), while significantly increasing their net worth and maintaining the added benefits of liquidity and safety the entire way.

Successfully Managing Home Equity to Increase Liquidity, Safety, Rate of Return, and Tax Deductions

 

A Tale Of Two Brothers Adapted from the book, The New Rules of Money Our story begins with 2 brothers, each earning $70,000 a year. They each have $40,000 in savings and both are buying $200,000 homes.
Brother A believes in “The Old Way” — paying off the mortgage as soon as possible	Brother B believes in “The New Way” — carrying a big, long mortgage
15-year mortgage at 6.38% APR	30-year interest-only loan at 7.42% APR
$40,000 big down payment	$10,000 small down payment
$0 left to invest	$30,000 remaining to invest
$1,383 monthly payment (56% is tax deductible first year/33% average)	$1,175 monthly payment (100% is tax deductible first 15 years/64% average)
$1,227 monthly net after-tax cost	$799 monthly net after-tax cost
Sends $100 monthly to lender in effort to eliminate mortgage sooner	Adds $100 monthly to investments, plus $428 saved from lower mortgage payment where account earns 8% rate of return
Results After 5 Years
Received $14,216 in tax savings	Received $22,557 in tax savings
Has $0 in savings and investments	Has $83,513 in savings and investments
What if both brothers suddenly lost their jobs?
Has no savings to get him through crisis	Has $83,513 in savings to tide him over
Can’t get a loan – even though he has $74,320 more in equity than his brother — because he has no job	Doesn’t need a loan
Must sell his home or face foreclosure because he can’t make payments	Can easily make his mortgage payments even if he’s unemployed for years
At this pint – it’s a fire sale – he must sell at a discount and pay real estate commissions (6–7%)	Has no reason to panic since he’s still in control – remember… CASH IS KING!
Results After 15 Years
Received $25,080 in tax savings	Received $67,670 in tax savings
Has $30,421 in savings and investments	Has $282,019 in savings and investments
Owns home outright	Remaining mortgage balance is $190,000 – and he has enough savings to pay it off and still have $92,019 left over, free and clear
Results After 30 Years
Received $25,080 in tax savings	Received $107,826 in tax savings
Has $613,858 in savings and investments	Has $1,115,425 in savings and investments
Owns home outright	Owns home outright – so starts fresh and enjoys the same benefits once again

Our goal is to help clients conserve their home equity, not consume it.  We are one of the few mortgage-planning firms who encourage clients to only secure debt in order to become debt free sooner.

 In April 1998, The Journal of Financial Planning (published by the Institute of Certified Financial Planners) contained the first academic study undertaken on the question of 15-year versus 30-year mortgages. They concluded the 30-year loan is better. By focusing on borrowing to Make More money at higher returns, one can grow his wealth quicker.

Large Equity in Your Home Can Be a Big Disadvantage

By having cash available for emergencies and investment opportunities, most homeowners are better off than if their equity is tied up in their residence. Large, idle equity, also called ‘having all your eggs in one basket,’ can be risky if the homeowner suddenly needs cash. While employed and in excellent health, borrowing on a home is easy, but most people, especially retirees, unexpectedly need cash when they are sick, unemployed, or have insufficient income. Obtaining a home loan under these circumstances can be either impossible or very expensive.

How many of us feel when we go to the bank we almost need to prove we don’t need the money before they’ll loan it to us? The bank wants to know we have the ability to repay the loan. You can imagine how a conversation might go with your banker: “I brought up your loan application to the board this morning, and I explained to them you’re going through some hard financial times. You’re unemployed, your credit is not so good, and maybe they could lend you some cash to get through these rough times. Their response would be … ‘Fat chance!’”

What many people don’t realize is that even if they’ve consistently been making extra mortgage payments for years, the bank still has no leniency. If suddenly they experience a financial setback, the bank will not care. They can go to the bank and plead, “I’ve been paying my mortgage in advance for years, how about if I just coast on my mortgage payments for a few months?” They get the same answer every time…”Fat chance”’ Banks just don’t work that way. Regardless of how much you’ve paid in advance, next month’s payment is still due in its entirety no matter what.

Why Separate Equity From Your Home?

In the book, Missed Fortune, Doug Andrew suggests people strongly consider separating as much equity as they possibly can from their house and place it over in a cash position. Why in the world would you want to have the equity removed from your home? There are actually 3 primary reasons:

1.  Liquidity
2.  Safety
3.  Rate of Return

These 3 elements are also commonly used as the test of a prudent investment. When evaluating a potential investment, experienced investors will ask the following 3 questions:

1.  How Liquid Is It?  (Can I get my money back when I want it?)
2.  How Safe Is It?  (Is it guaranteed or insured?)
3.  What Rate of Return Can I Expect?

Home equity fails all 3 tests of a prudent investment. Let’s examine each of these core elements in more detail to better understand why home equity fails the tests of a prudent investment and, more importantly, why homeowners benefit by separating the equity from their home.

Separating Equity to Increase Liquidity

What is the biggest secret in real estate? Your mortgage is a loan against your income, not a loan against the value of your house. Without an income, in many cases you cannot get a loan. If you suddenly experienced difficult financial times, would you rather have $25,000 of cash to help you make your mortgage payment or have an additional $25,000 of equity trapped in your home?

Almost every person who has ever lost their home to foreclosure would have been better off if they had their equity separated from their home in a liquid, safe, conservative side fund that could be used to make mortgage payments during their time of need.

 

 

In Missed Fortune, Doug Andrew tells the story of a young couple who learned what he calls “The $150,000 Lesson on Liquidity.” In 1978 this couple built a beautiful home that would be featured in Better Homes and Gardens. The couple’s home appreciated in value, and by 1982, it was appraised for just under $300,000. They had accumulated a significant amount of equity, not because of making extra payments on the property, but because market conditions improved over the 4-year period.

This couple thought they had the world by the tail. They had a home valued at $300,000 with first and second mortgages owing only $150,000. They had “made” $150,000 in 4 short years.

They had the misconception that the equity in their home had a rate of return when, in fact, it was the home itself that gave the return, not the equity trapped in the walls.

Then, a series of unexpected events reduced their income to almost nothing for 9 months. They couldn’t borrow money to keep their mortgage payments current because without an income they did not have the ability to repay.

Within 6 months, they had sold 2 other properties to bring their mortgage out of delinquency. They soon realized that in order to protect their $150,000 of equity they would have to sell their home.

As Murphy’s Law would have it, the oil industry collapsed in Houston, and the previously strong real estate market turned soft. Although they reduced their asking price several times – from $295,000 down to $195,000 – they could not find a buyer. Sadly, they gave up the home in foreclosure to the mortgage lender.

In a time of financial setback, they lost one of their most valuable assets due to a lack of liquidity. If they had separated their $150,000 in home equity and repositioned it into a safe side account, they would have easily been able to make their mortgage payments and prevented this series of events.

At this point in the story, Doug admits the young couple was really he and his wife Sharee.

Doug wanted his readers to know he understands first hand the importance of maintaining liquidity in the event of an emergency. Doug learned from his own experience the importance of maintaining flexibility in order to ride out market lows and take advantage of market highs.

And, most importantly, he learned never to allow a significant amount of equity to accumulate in his property. 

Home equity is not the same as cash in the bank. 

Only cash in the bank is the same as cash in the bank.

Being house rich and cash poor is a dangerous position to be in.

It is better to have access to the equity or value of your home and not need it than to need it and not be able to get at it. Keeping home equity safe is really a matter of positioning yourself to act instead of react to market conditions over which you have no control.

Money you give the bank is money you’ll never see again unless you refinance or sell.

When the people in Houston pleaded, “Mr. Banker, I’ve been making extra mortgage payments for years. I’m well ahead of schedule. Will you let me coast for a while?” The bank replied, “Fat Chance!”

To Reduce the Risk of Foreclosure During Unforeseen Set-backs, Keep Your Mortgage Balance as High as Possible

Is your home really safe? Unfortunately, many homebuyers have the misconception that paying down their mortgage quickly is the best method of reducing the risk of foreclosure on their homes. However, in reality the exact opposite is true.

As homeowners pay down their mortgage, they are unknowingly transferring the risk from the bank to themselves.

When the mortgage balance is high, the bank carries the most risk. When the mortgage balance is low, the homeowner bears the risk. With a low mortgage balance, the bank is in a great position as they stand to make a nice profit if the homeowner defaults.

In addition to assuming unnecessary risk, many people who scrape up every bit of extra money they can to apply against principal often find themselves with no liquidity. When tough times come, they find themselves scrambling to make their mortgage payments.

Assume you’re a mortgage banker looking at your portfolio and you have 100 loans that are delinquent. All of the loans are for homes valued at $300,000. Some of the loan balances are $150,000 and some are $250,000. Suddenly, there is a glut in the market and the homes are now worth $200,000.

Which homes do you as the banker foreclose on FIRST? The ones owing the least amount of money, of course. After all, as a banker you’d make money taking back those homes; however, you’d lose money trying to sell a home for $200,000 that still owed $250,000 on it.

Banks have been known to call delinquent homeowners with high mortgage balances and offer assistance, “We understand you are going through some tough times. Is there anything we can do to help you? We really want you to be able to keep you home.”

The last thing they want to do is take back a home that they will lose money reselling.

It’s interesting to note that during the Great Depression the Hilton chain of hotels was deeply affected by the stock market crash and couldn’t make their loan payments.

What saved them from financial ruin?

They were so leveraged, in other words they owed so much more on their property than it was worth, that the banks couldn’t afford to bother wasting their time foreclosing on it.

The Hiltons understood the value of keeping high mortgage balances, thereby keeping the risk on the banks.

The Houston homeowners would have been better off if they had removed a large portion of their equity and put it in a safe and liquid side fund, accessible in a time of need.

Ask yourself, if you owned a $400,000 home during an earthquake in California (and you didn’t have earthquake insurance), or owned a home in New Orleans before Katrina wiped it out, would you rather have your equity trapped in the house or in a liquid, safe side fund? If it were trapped in the home, your equity would be lost along with the house.

Separating Equity to Increase Rate of Return

What do you think the rate of return on home equity was in Washington DC for the last 3 years? California?  New York? Careful, this is a trick question.

The truth is, it doesn’t matter where you live or how fast the homes are appreciating, the return on home equity is always the same – ZERO.

We have a misconception that because our home appreciates or our mortgage balance is going down the equity has a rate of return. That’s not true. Home equity has NO rate of return.

Home values fluctuate due to market conditions, not due to the mortgage balance. Since the equity in the home has no relation to the home’s value, it is in no way responsible for the home’s appreciation. Therefore, home equity simply sits idle in the home. It does not earn any rate of return. Think of the Tale of Two Brothers, and how their homes appreciated the same, despite the different philosophies about equity.

As Albert Einstein said, “The most powerful force in the universe is compound interest.”

After all, homes were built to house families, not store cash. Investments were made to store cash.

Taken from a different angle, suppose you were offered an investment that could never go up in value but might go down. How much of it would you want?

Hopefully, none. Yet, this is home equity.

 It has no rate of return, so it cannot go up in value, but it could go down in value if the real estate market declines or the homeowner experiences an uninsured loss (e.g. an earthquake), disability, or a foreclosure.

The Power of Leverage

Let’s be clear, buying a home can be a great investment. However, the wealthy buy the home with as little of their own money as possible, leaving the majority of their cash in other investments where it’s liquid, safe, and earning a rate of return.

One of the biggest misconceptions homeowners have is that their home is the best investment they ever made.

If you purchased a home in 1990 for $250,000 and sold it in June of 2003 for $600,000, that represents a gain of 140%. During the same period, the Dow Jones grew from 2590 to 9188, a gain of 255%.

The reality here is that financing your home was the best investment decision that you ever made. When you purchased the $250,000 house in 1990, you only put $50,000 down. The $50,000 cash investment produced a profit of $350,000. That is a total return of 600%, far outpacing the measly 255% earned by the stock market.

Betting the Ranch; Risking Home Equity to Buy Securities

Recently, the NASD issued an alert, “…because we are concerned that investors who must rely on investment returns to make their mortgage payments could end up defaulting on their home loans if their investments decline and they are unable to meet their monthly mortgage payments.” The NASD is absolutely correct in advising against separating equity if the client must rely on the returns from their investment to make the mortgage payments.

Home equity is Serious Money. We don’t gamble home equity. Liquidity and safety are the key philosophies when separating home equity. Rate of return is a distant third benefit. Also, it is not necessary or recommended to invest in highly volatile or aggressive investments.

Making Uncle Sam Your Best Partner

Under tax law, you can deduct up to one million dollars of mortgage interest subject to income restrictions. You can also deduct an additional $100,000 over acquisition indebtedness (the mortgage balance when home is purchased). Home improvements are the only exception. For example, if you sell your home for $400,000 and buy a new home for $400,000 with the cash from the sale, you will lose the tax break and liquidity. But worse, if you later decide to take out a home equity loan, only the first $100,000 will be tax deductible. Instead, secure a $360,000 mortgage (90%) when you buy the home and the entire amount is deductible.

Where to Safely Invest Home Equity

Home equity is serious money. We are separating it from the home to conserve it, not to consume it. Tax favored safe investments are ideal. You should consult your financial planner.