How the Affluent Manage
      Home Equity to
Safely and Conservatively
       Build Wealth

       By Steven Marshall and ...
If you had enough money to pay off your mortgage right now, would you? Many people would. In fact,
the ‘American Dream’ is...
than half the nation’s banks failed and mil-                                                         in the old way of pay...
A Tale Of Two Brothers                                                                                   he has $74,320 of...
ceived a whopping $107,826 in tax savings,       between a 15-year loan and a 30-year loan,     an interest-only loan be b...
need the money before they’ll loan it to us?       These three elements are also commonly
The bank wants to know we have t...
They had the misconception that the              This couple not only had a foreclo-             most importantly, he lear...
diversify to reduce their risk and increase       ahead of schedule. Will you let me coast for a   assistance, “We underst...
“If you were offered
                                                                                                  an ...
life. We give ourselves the opportunity to
mortgage, you still have $1,003,275 left          my investments decline? Do I have reserve        401 VACATION CONDO
in y...
WHERE TO SAFELY INVEST                          couple decided to separate $155,800 of          allows them to pay less to...
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How The Affluent Manage Home Equity To Safely And Conservatively Build Wealth


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

  1. 1. How the Affluent Manage Home Equity to Safely and Conservatively Build Wealth By Steven Marshall and Jim Potts
  2. 2. If you had enough money to pay off your mortgage right now, would you? Many people would. In fact, the ‘American Dream’ is to own your own home, and to own it outright, with no mortgage. If the American Dream is so wonderful, how can we explain the fact that thousands of financially success- ful people, who have more than enough money to pay off their mortgage, refuse to do so. T he answer? Most of what we believe about mortgages and home equity, which we learned from our parents and for a 30-year fixed rate mortgage, when they are likely to only use the first 4.2 years of the mortgage. We can only conclude they holds very important implications for the rest of your financial plan. Although a fine goal, owning a home is not the ulti- grandparents, is wrong. They taught us are operating on outdated knowledge from mate financial planning goal, and in fact to make a big down payment, get a fixed previous generations when there were few how you handle issues of home ownership rate mortgage, and make extra principle options other than the 30 year fixed mort- may well determine whether you achieve payments in order to pay off your loan as gage. Wealthy Americans, those with the financial success.” early as you can. Mortgages, they said, are ability to pay off their mortgage but refuse a necessary evil at best. to do so, understand how to make their WHY PEOPLE FEAR MORTGAGES, mortgage work for them. AND WHY YOU SHOULDN’T The problem with this rationale is it has In order to discover how our parents become outdated. The rules of money have They go against many of the beliefs of tra- and grandparents got the idea that a mort- changed. Unlike our grandparents, we will ditional thinking. They put very little money gage was a necessary evil at best, we must no longer have the same job for 30 years. down, they keep their mortgage balance as go back in time to the Great Depression. In In many cases people will switch careers high as possible, they choose adjustable the 1920’s a common clause in loan agree- five or six times. Also, unlike our grand- rate interest-only mortgages, and most im- ments gave banks the right to demand full parents, we can no longer depend on our portantly they integrate their mortgage into repayment of the loan at any time. Since company’s pension plan for a secure re- their overall financial plan to continually this was like asking for the moon and the tirement. A recent Gallup survey showed increase their wealth. This is how the rich stars, no one worried about it. When the that 75% of workers want to retire before get richer. stock market crashed on October 29, 1929 the age of 60, yet only 25% think they can. millions of investors lost huge sums of The game board is the same, but while money, much of it on margin. Back then, Unlike our grandparents, we will no most Americans are playing checkers, the you could buy $10 of stock for a $1. Since longer live in the same home for 30 years. affluent are playing chess. The good news the value of the stocks dropped, few inves- Statistics show that the average homeowner is the strategies used by the wealthy work tors wanted to sell, so they had to go to the lives in their home for only seven years. And for the rest of America as well. Any home- bank and take out cash to cover their mar- unlike our grandparents, we will no longer owner can implement the strategies of the gin call. It didn’t take long for the banks keep the same mortgage for 30 years. Ac- wealthy to increase their net worth. to run out of cash and start calling loans cording to the Federal National Mortgage due from good Americans who were faith- Association, or Fannie Mae, the average Ric Edelman, one of the top financial fully making their mortgage payments every American mortgage lasts 4.2 years. People planners in the country and a New York month. However, there wasn’t any demand are refinancing their homes every 4.2 years Times Best Selling author, summarizes in to buy these homes, so prices continued to improve their interest rate, restructure this book The Truth About Money, “Too to drop. To cover the margin calls, bro- their debt, remodel their home, or to pull often, people buy homes in a vacuum, kers were forced to sell stocks and once out money for investing, education or other without considering how that purchase is again there wasn’t a market for stocks so expenses. Given these statistics, it’s difficult going to affect other aspects of their lives. the prices kept dropping. Ultimately, the to understand why so many Americans con- This can be a big mistake, and therefore Great Depression saw the stock market fall tinue to pay a high interest rate premium you must recognize that owning a home more than 75% from its 1929 highs. More 2 How the Affluent Manage Home Equity
  3. 3. than half the nation’s banks failed and mil- in the old way of paying off a mortgage, lions of homeowners, unable to raise the Common Home Equity which is as soon as possible. Brother A cash they needed to payoff their loans, Misconceptions bites the bullet and secures a fifteen-year lost their homes. Out of this the American Many Americans believe the following state- mortgage at 6.38% APR and shells out all Mantra was born: Always own your home ments to be true, but in reality they are $40,000 of his savings as a 20% down myths, or misconceptions: outright. Never carry a mortgage. payment, leaving him zero dollars to invest. This leaves him with a monthly pay- Your home equity is a prudent The reasoning behind America’s new investment. ment of $1,383. Since he has a combined mantra was really quite simple: if the econ- FA L S E federal and state income tax rate of 32%, omy fell to pieces, at least you still had your he is left with an average monthly net after- home and the bank couldn’t take it away Extra principal payments on your tax cost of $1,227. Also, in an effort to elimi- from you. Maybe you couldn’t put food on mortgage saves you money. nate his mortgage sooner, Brother A sends the table or pay your bills, but your home FA L S E an extra $100 to his lender every month. was secure. Since the Great Depression Mortgage interest should be laws have been introduced that make it il- eliminated as soon as possible. Brother B, in contrast, subscribes legal for banks to call your loan due. The FA L S E to the new way of mortgage planning, bank can no longer call you up and say, choosing instead to carry a big, long-term “We’re running a little short on cash and Substantial equity in your home mortgage. He secures a 30-year, interest- enhances your net worth. only loan at 7.42% APR. He outlays a small need you to pay off your loan in the next thirty days.” FA L S E 5% down payment of $10,000 and invests Home Equity has a rate of return. the remaining $30,000 in a safe, money- Additionally, the Fed is now quick to infuse making side account. His monthly payment FA L S E money into the system if there is a run on is $1,175, 100% of which is tax deductible the banks, as we saw in 1987 and Y2K. Also, over the first 15 years, and 64% over the the FDIC was created to insure banks. Still, money is not the same as making money. life of the loan, leaving him a monthly net it’s no wonder the fear of losing their home Or, put another way, paying off debt is not after-tax cost of $799. Every month he adds became instilled in the hearts and minds of the same as accumulating assets. By tackling $100 to his investments (the same $100 the American people, and they quickly grew the mortgage pay-off first, and the savings Brother A sent to his lender), plus the to fear their mortgage. In the 1950’s and goal second, many fail to consider the im- $428 he’s saved from his lower mortgage 60’s families would throw mortgage burning portant role a mortgage plays in our savings payment. His investment account earns an parties to celebrate paying off their home. effort. Every dollar we give the bank is a dol- 8% rate of return. And so, because of this fear of their mort- lar we did not invest. While paying off the gage, for nearly 75 years most people have mortgage saves us interest, it denies us the Which brother made the right deci- overlooked the opportunities their mortgage opportunity to earn interest with that money. sion? The answer can be found by look- provides to build financial security. ing into the future. After just five years A TALE OF TWO BROTHERS Brother A has received $14,216 in tax WHY PEOPLE HATE THEIR MORTGAGE Ric Edelman has educated his clients savings, however he made zero dollars in AND WHY YOU SHOULDN’T for years on the benefits of integrating savings and investments. Brother B, on the Many people hate their mortgage because their mortgage into their overall finan- other hand, has received $22,557 in tax they know over the life of a 30 year loan, cial plan. In his book, The New Rules of savings and his savings and investment ac- they will spend more in interest than the Money, Ric tells the story of two brothers, count has grown to $83,513. Now, what if house cost them in the first place. To save each of whom secures a mortgage to buy both brothers suddenly lose their jobs? The money it becomes very tempting to make a $200,000 home. Each brother earns story here turns rather bleak for Brother a bigger down payment, or make extra $70,000 a year and has $40,000 in sav- A. Without any money in savings, he has no principal payments. Unfortunately, saving ings. The first brother, Brother A, believes way to get through the crisis. Even though How the Affluent Manage Home Equity 3
  4. 4. A Tale Of Two Brothers he has $74,320 of equity in his home, he can’t get a loan because he doesn’t have a Adapted from the book, The New Rules of Money Our story begins with two brothers, each earning $70,000 a year. They each have $40,000 in savings and both are buying $200,0000 homes. job. With no job and no savings, he can’t make his monthly payments and has no Brother “A” believes in Brother “B” believes in choice but to sell his home in order to avoid “The Old Way” – paying “The New Way” –carrying off the mortgage as soon a big, long mortgage foreclosure. Unfortunately, at this point it’s as possible a fire sale so he must sell at a discount, and then pay real estate commissions. 15-YEAR MORTGAGE AT 6.38% APR 30-YEAR INTEREST-ONLY LOAN AT 7.42% APR Brother B, while not particularly happy at the prospects of searching for $40,000 BIG DOWN PAYMENT $10,000 SMALL DOWN PAYMENT a new job, is not worried because he $0 LEFT TO INVEST $30,000 REMAINING TO INVEST has $83,513 in savings to tide him over. $1,383 MONTHLY PAYMENT $1,175 MONTHLY PAYMENT He doesn’t need a loan and can eas- (56% IS TAX DEDUCTIBLE FIRST YEAR/33% AVERAGE) (100% IS TAX DEDUCTIBLE FIRST 15 YEARS/64% AVERAGE) ily make his monthly payments, even if he $1,227 MONTHLY NET AFTER-TAX COST $799 MONTHLY NET AFTER-TAX COST is unemployed for years. He has no SENDS $100 MONTHLY TO LENDER IN ADDS$100 MONTHLY TO INVESTMENTS, PLUS reason to panic, as he is still in control. EFFORT TO ELIMINATE MORTGAGE SOONER $428 SAVED FROM LOWER MORTGAGE PAYMENT Remember… Cash is King! WHERE ACCOUNT EARNS 8% RATE OF RETURN Results After 5 Years Now, let’s say neither brother lost his RECEIVED $14,216 IN TAX SAVINGS RECEIVED $22,557 IN TAX SAVINGS job. We’ll check in on them after fifteen HAS $0 IN SAVINGS AND INVESTMENTS HAS $83,513 IN SAVINGS AND INVESTMENTS years have passed since they purchased their homes and evaluate the results of What if both brothers suddenly lost their jobs? their financing strategies. Brother A has HAS NO SAVINGS TO GET HIM THROUGH CRISIS HAS $83,513 IN SAVINGS TO TIDE HIM OVER now received $25,080 in tax savings, he CAN’T GET A LOAN – EVEN THOUGH HE HAS DOESN’T NEED A LOAN has $30,421 in savings and investments $74,320 MORE IN EQUITY THAN HIS BROTHER (once his home was paid off he started sav- – BECAUSE HE HAS NO JOB ing the equivalent of his mortgage payment MUST SELL HIS HOME OR FACE FORECLOSURE CAN EASILY MAKE HIS MORTGAGE PAYMENTS each month), and owns his home outright. BECAUSE HE CAN’T MAKE PAYMENTS EVEN IF HE’S UNEMPLOYED FOR YEARS Not too bad, right? AT THIS POINT – IT’S A FIRE SALE – HE MUST HAS NO REASON TO PANIC SINCE HE’S STILL IN SELL AT A DISCOUNT AND PAY REAL ESTATE CONTROL – REMEMBER... CASH IS KING! COMMISSIONS (6-7 %) Now let’s check on his Brother. Brother B has received $67,670 in tax savings and Results After 15 Years has $282,019 in savings and investments. If RECEIVED $25,080 IN TAX SAVINGS RECEIVED $67,670 IN TAX SAVINGS he chooses to, he can pay off the remaining HAS $30,421 IN SAVINGS AND INVESTMENTS HAS $282,019 IN SAVINGS AND INVESTMENTS mortgage balance of $190,000 and still have OWNS HOME OUTRIGHT REMAINING MORTGAGE BALANCE IS $190,000 $92,019 left over in savings, free and clear. – AND HE HAS ENOUGH SAVINGS TO PAY IT OFF AND STILL HAVE $92,019 LEFT OVER, FREE AND CLEAR Finally, let’s assume that rather than pay off his mortgage at fifteen years, Brother B Results After 30 Years decides to ride out the whole thirty years RECEIVED $25,080 IN TAX SAVINGS RECEIVED $107,826 IN TAX SAVINGS of the loan’s life. While Brother A has still HAS $613,858 IN SAVINGS AND INVESTMENTS HAS $1,115,425 IN SAVINGS AND received only $25,080 in tax savings, his INVESTMENTS savings and investments have grown to OWNS HOME OUTRIGHT OWNS HOME OUTRIGHT – SO STARTS FRESH $613,858, and he still owns his home out- AND ENJOYS THE SAME BENEFITS ONCE AGAIN right. Brother B, on the other hand, has re- 4 How the Affluent Manage Home Equity
  5. 5. ceived a whopping $107,826 in tax savings, between a 15-year loan and a 30-year loan, an interest-only loan be better than an has accumulated an incredible $1,115,425 as well as the tax savings into a safe side amortizing loan? If mortgage money cost in savings and investments, and also owns investment account earning a conserva- you 4-5%, the chances are pretty good that his home outright. He can start over fresh tive rate of return, you will have enough to you can earn 5% on your money. Interest and enjoy the same benefits once again. pay your home off in 13½ years (or in 15 rates are relative. In the 1980’s, money Unfortunately, the majority of Americans years with $25,000 to spare!). Chapter one was costing 15%, but individuals could follow the same path as Brother A, as it’s in Missed Fortune talks about the $25,000 still earn 15% on their money. Due to the the only path they know. Once the path of mistake made by millions of Americans who tax deductibility of mortgage interest and Brother B is revealed to them, a paradigm choose the fifteen-year loan. compounding returns, you can borrow at a shifting epiphany often occurs as they real- higher rate and invest it at a lower rate and ize Brother B’s path enables homeowners to CalPacific Mortgage Consultants teaches still make a significant profit. pay their homes off sooner (if they choose an educational seminar for the public based to), while significantly increasing their net largely on the Missed Fortune concepts. In LARGE EQUITY IN YOUR HOME worth and maintaining the added benefits of the seminar, we break down the four key CAN BE A BIG DISADVANTAGE liquidity and safety the entire way. benefits of integrating your mortgage into By having cash available for emergencies your financial plan (increased liquidity, and investment opportunities, most home- SUCCESSFULLY MANAGING HOME safety, rate of return, and tax deductions) owners are better off than if their equity EQUITY TO INCREASE LIQUIDITY, in order to look at each one in more detail. is tied up in their residence. Large, idle SAFETY, RATE OF RETURN, AND TAX DEDUCTIONS Are you still doing this? In 2003, Doug Andrew, a top finan- “Here is an extra $100 cial planner from Utah, was the first to principal payment Mr. Banker. clearly articulate the strategy the wealthy Don’t pay me any interest have been using for decades in his book, on it. If I need it back, I’ll pay Missed Fortune. The book is based on you fees, borrow it back on your terms, and prove the concepts of successfully managing to you that I qualify.” home equity to increase liquidity, safety, rate of return, and tax deductions. Doug Money you give the bank educates readers to view their mortgage is money you’ll never and home equity through a different lens, see again unless you the same lens used by the affluent. He refinance or sell. shows how relatively minor changes in home equity perception and position- Our goal is to help clients conserve their equity, also called ‘having all your eggs in ing can produce monumental long-term home equity, not consume it. We are one one basket,’ can be risky if the homeowner effects in financial security. of the few financial planning firms who en- suddenly needs cash. While employed and courage clients to secure debt in order to in excellent health, borrowing on a home Many Americans believe the best way to become debt free sooner. is easy, but most people, especially retir- pay off a home early is to pay extra principal ees, unexpectedly need cash when they are on your mortgage. Similarly, many finance In April 1998, The Journal of Financial sick, unemployed or have insufficient in- professors think a 15-year loan saves you Planning (published by the Institute of come. Obtaining a home loan under these money by reducing the interest you pay. Certified Financial Planners) contained circumstances can be either impossible or However, Doug Andrew points out in his the first academic study undertaken on the very expensive. book, Missed Fortune, that this thinking is question of 15-year versus 30-year mort- flawed. If you do the math, you find if you gages. They concluded the 30-year loan is How many of us feel when we go to the set aside the monthly payment difference better. Based on the same logic, wouldn’t bank we almost need to prove we don’t How the Affluent Manage Home Equity 5
  6. 6. need the money before they’ll loan it to us? These three elements are also commonly The bank wants to know we have the ability used as the test of a prudent investment. to repay the loan. You can imagine how a When evaluating a potential investment, ex- conversation might go with your banker: “I perienced investors will ask the following brought up your loan application up to the three questions: board this morning and I explained to them you’re going through some hard financial 1. HOW LIQUID IS IT? times, you’re unemployed, your credit is (Can I get my money back not so good and maybe they could lend when I want it?) you some cash to get through these rough 2. HOW SAFE IS IT? times.” Their response was... ‘Fat chance!’ (Is it guaranteed or insured?) 3. WHAT RATE OF RETURN CAN I EXPECT? What many people don’t realize is that even if they’ve consistently been making Home equity fails all three tests of a prudent “It’s better to have access double mortgage payments for five years in investment. Let’s examine each of these to the equity or value of a row, the bank still has no leniency. If sud- core elements in more detail to better un- your home and not need it, denly they experience a financial setback, derstand why home equity fails the tests of a than to need it and not be the bank will not care. They can go to the prudent investment, and, more importantly, able to get at it.” bank and plead, “I never thought in a mil- why home-owners benefit by separating the lion years this would happen to me, but it equity from their home. enough liquidity you could have weathered did. I’ve been paying my mortgage in ad- the storm. Those with other liquid assets vance for years, how about if I just coast on SEPARATING EQUITY TO were able to remain invested. They were my mortgage payments for a few months?” INCREASE LIQUIDITY rewarded as the market rebounded and They get the same answer every time... ‘Fat What is the biggest secret in real estate? recovered fully within 90 days. However, chance!’ Banks just don’t work that way. Your mortgage is a loan against your in- those without liquidity were forced to sell Regardless of how much you’ve paid your come, not a loan against the value of your while the market was down, causing them mortgage down or how many extra pay- house. Without an income, in many cases to accept significant losses. In Missed ments you’ve made, next month’s payment you cannot get a loan. If you suddenly ex- Fortune, Doug Andrew tells the story of a is still due in its entirety no matter what. perienced difficult financial times, would young couple who learned what he calls your rather have $25,000 of cash to help “The $150,000 Lesson on Liquidity”. In WHY SEPARATE EQUITY FROM you make your mortgage payment, or have 1978 this couple built a beautiful home that YOUR HOME? an additional $25,000 of equity trapped in would be featured in Better Homes and In the book, Missed Fortune, Doug your home? Almost every person who has Gardens. The couple’s home appreciated Andrew suggests people strongly con- ever lost their home to foreclosure would in value, and, by 1982, it was appraised for sider separating as much equity as they have been better off if they had their equity just under $300,000. They had accumulated possibly can from their house, and separated from their home in a liquid, safe, a significant amount of equity, not because place it over in a cash position. Why in conservative side fund that could be used they had been making extra payments on the world would you want to have the to make mortgage payments during their the property, but because market condi- equity removed from your home? There are time of need. tions improved over that four-year period. actually three primary reasons: The importance of liquidity became all This couple thought they had the world 1. LIQUIDITY too clear when the stock market crashed in by the tail. They had a home valued at 2. SAFETY October of 1987. If someone had advised $300,000 with first and second mort- 3. RATE OF RETURN you to sell your stocks and convert to cash, gages owing only $150,000. They had they would have been a hero. Or, if you had “made” $150,000 in four short years. 6 How the Affluent Manage Home Equity
  7. 7. They had the misconception that the This couple not only had a foreclo- most importantly, he learned never to allow equity in their home had a rate of return sure appear on their credit report for a significant amount of equity to accumu- when, in fact, it was just a number on a seven years, the report also showed a late in his property. sheet of paper. deficiency balance owing $30,000 on a home they had lost nearly one year Home equity is not the same as cash in Then, a series of unexpected events earlier. In a time of financial setback they the bank; only cash in the bank is the same reduced their income to almost nothing lost one of their most valuable assets due to as cash in the bank. Being house rich and for nine months. They couldn’t borrow a lack of liquidity. If they had separated their cash poor is a dangerous position to be in. money to keep their mortgage payments $150,000 in home equity and repositioned It is better to have access to the equity or current because without an income they it into a safe side account, they would have value of your home and not need it, than to did not have the ability to repay. Within easily been able to make their mortgage pay- need it and not be able to get at it. Keep- six months they had sold two other ments and prevented this series of events. ing home equity safe is really a matter of properties to bring their mortgage out positioning yourself to act instead of react of delinquency. They soon realized that At this point in the story, Doug admits to market conditions over which you have in order to protect their $150,000 of eq- the young couple was really he and his no control. uity they would have to sell their home. wife, Sharee. Despite objections from his As Murphy’s Law would have it, the editor, Doug insisted the story remain in SEPARATING EQUITY TO previously strong real estate mar- the book because he wanted his readers INCREASE SAFETY OF PRINCIPAL ket turned soft. Although they reduced to know he understands first hand the The Seattle Times, in an article published their asking price several times – from importance of positioning assets in finan- in March 2004, reported, “Remember that $295,000 down to $195,000 – they could cial instruments that maintain liquidity in housing prices can and do level off. not find a buyer. Sadly, they gave up the the event of an emergency. If Doug and They sometimes decline – witness Southern home in foreclosure to the mortgage Sharee had access to their home’s eq- California just a little more than a decade lender. Sometimes sad stories only get uity, they could have used it to weather the ago, when prices took a 20 percent to 30 sadder. The two mortgages on the prop- financial storm until they could get back percent corrective jolt downward.” Real erty were in the amounts of $125,000 and on their feet. Doug learned from his own estate equity is no safer than any other in- $25,000, respectively. The second mort- experience the importance of maintaining vestment whose value is determined by an gage holder outbid the first one at the en- flexibility in order to ride out market lows external market over which we personally suing auction, feeling that, much like the and take advantage of market highs. And, have no control. In fact, due to the hid- original owners, it was in a good position. den “risks of life,” real estate equity is not Knowing that the house had been appraised nearly as safe as many other conservative for $300,000, and the obligation owing investments and assets. A home that is ei- was only $150,000, it thought it could ther mortgaged to the hilt or owned totally turn around and sell the property to cover free and clear provides the greatest safety the investment. It took nine long months for the homeowner. to sell, during which time the lender was forced to pay the first mortgage and also Americans typically believe home equity accrued an additional $30,000 of interest is a very safe investment. In fact, according and penalties. By the time the home finally to a recent study, 67% of Americans have sold, less the $30,000 in accrued indebt- more of their net worth in home equity than edness, guess who got stuck with the defi- “Home equity is not the in all other investments combined. How- ciency balance of $30,000 on their credit same as cash in the bank. ever, if 100 financial planners looked at a report? The original owners, of course! Only cash in the bank is the client portfolio that was 67% weighted in same as cash in the bank.” a single investment, 99 out of 100 of them would immediately recommend the client How the Affluent Manage Home Equity 7
  8. 8. diversify to reduce their risk and increase ahead of schedule. Will you let me coast for a assistance, “We understand you are going safety of principal. Holding large amounts while?” The bank replied, “Fat Chance!” through some tough times, is there anything of home equity puts the homeowner at un- we can do to help you? We really want you necessary risk. This risk could be greatly TO REDUCE THE RISK OF to be able to keep your home.” The last reduced by diversifying their home equity FORECLOSURE DURING UNFORESEEN thing they want to do is take back a home into other investments. SET-BACKS, KEEP YOUR MORTGAGE that they will lose money reselling. BALANCE AS HIGH AS POSSIBLE An example of the necessity of keeping Is your home really safe? Unfortunately, It’s interesting to note, during the Great your home’s equity safely separated from many home buyers have the misconception Depression, the Hilton chain of hotels was your property can be found in Houston, that paying down their mortgage quickly deeply affected by the stock market crash Texas. When oil prices fell to all time lows is the best method of reducing the risk of and couldn’t make their loan payments. in the early 1980’s the city of Houston was foreclosure on their homes. However, in What saved them from financial ruin? They hit hard. Thousands of workers were laid reality, the exact opposite is true. As ho- were so leveraged, in other words they off and ultimately forced to sell their homes. meowners pay down their mortgage, they owed so much more on their property than With a glut of homes on the market, housing are unknowingly transferring the risk from it was worth, that the banks couldn’t afford prices plummeted. Unfortunately, there were the bank to themselves. When the mortgage to bother wasting their time foreclosing far too many sellers and far too few buyers. balance is high, the bank carries the most on it. The Hiltons understood the value of Homeowners were unable to sell and un- risk. When the mortgage balance is low, keeping high mortgage balances thereby able to make their mortgage payments. As a the homeowner bears the risk. With a low keeping the risk on the banks. The Hous- result, 16,000 homes were foreclosed. Did mortgage balance the bank is in a great po- ton homeowners would have been better these 16,000 families suddenly become bad sition, as they stand to make a nice profit if off if they had removed a large portion of people? No, they just couldn’t make their the homeowner defaults. In addition to as- their equity and put it in a safe and liquid mortgage payments. Just prior to this series suming unnecessary risk, many people who side fund, accessible in a time of need. of events many of these people were making scrape up every bit of extra money they can extra principal payments. Unfortunately, they to apply against principal often find them- Ask yourself, if you owned a $400,000 could not coast on those extra payments, selves with no liquidity. When tough times home during an earthquake in California and with so many houses on the market for come, they find themselves scrambling to (and you didn’t have earthquake insur- sale, some people literally had to walk away make their mortgage payments. ance), would you rather have your equity from their home. trapped in the house or in a liquid, safe Assume you’re a mortgage banker look- side fund? If it were trapped in the home, The equity these people had worked so ing at your portfolio, and you have 100 your equity would be lost along with hard to build up was lost completely. They loans that are delinquent. All of the loans the house. learned the hard way that home equity is are for homes valued at $300,000. Some of fragile, and certainly not as safe as they once the loan balances are $150,000 and some SEPARATING EQUITY TO thought. Could this happen today? Just look are $250,000. Suddenly, there is a glut in INCREASE RATE OF RETURN at when the Enron Corporation collapsed the market and the homes are now worth What do you think the rate of return on a few years ago, and thousands lost their $200,000. Which homes do you as the home equity was in San Diego for the last 3 jobs and homes, again in Houston, Texas. banker foreclose on FIRST? The ones owing years? What about El Centro? Careful, this is What would happen in the San Diego area the least amount of money, of course. After a trick question. The truth is, it doesn’t mat- if we had Defense cutbacks, base closures all, as a banker you’d make money taking ter where you live or how fast the homes are and major lay-offs? Money you give the bank back those homes, however you’d lose appreciating, the return on home equity is is money you’ll never see again unless you money trying to sell a home for $200,000 always the same, ZERO. We have a miscon- refinance or sell. When the people in Hous- that still owed $250,000 on it. Banks have ception that because our home appreciates, ton pleaded, “Mr. Banker, I’ve been making been known to call delinquent homeown- or our mortgage balance is going down, extra mortgage payments for years. I’m well ers with high mortgage balances and offer that the equity has a rate of return. That’s 8 How the Affluent Manage Home Equity
  9. 9. “If you were offered an investment that could never go up in value, but might go down, how much of it would you want?” (This is home equity) not true. Home equity has NO rate of return. est is 100% tax deductible, the net cost of to inflation. Few people today bury money Home values fluctuate due to market con- the money is only 3.6%. This produces a in the back yard or under their mattresses, ditions, not due to the mortgage balance. 4.4% positive spread between the cost of because they have confidence in the banking Since the equity in the home has no relation money and the earnings on that money. system. They also understand idle money to the home’s value, it is in no way responsi- loses value while invested money grows ble for the home’s appreciation. Therefore, The story gets much more compelling and compounds. As Albert Einstein said, home equity simply sits idle in the home. It over time, although the mortgage debt “The most powerful force in the universe is does not earn any rate of return. Assume remains constant, through compound in- compound interest.” After all, homes were you have a home worth $100,000 which you terest, the side account continues to grow built to house families, not store cash. In- own free and clear. If the home appreciates at a faster pace each year. The earnings on vestments were made to store cash. 5%, you own an asset worth $105,000 at the $100,000 in year 1 are $8,000. Then in end of the year. year 2, the 8% earnings on $108,000 are Taken from a different angle, suppose you $8,640. In year 3, the earnings on $116,640 were offered an investment that could never Now, assume you had separated the at 8% are $9,331. Since the mortgage debt go up in value, but might go down. How $100,000 of home equity and placed it in remains the same, the spread between much of it would you want? Hopefully none. a safe, conservative side account earning the cost of the mortgage money and the Yet, this is home equity. It has no rate of 8%. Your side account would be worth earnings on the separated equity contin- return, so it cannot go up in value, but it $108,000 at the end of the year. You still ues to widen further in the homeowner’s could go down in value if the real estate mar- own the home, which appreciated 5% and favor every year. If we allow home equity ket declines or the homeowner experiences is worth $105,000. By separating the eq- to remain idle in the home, we give up the an uninsured loss (e.g. an earthquake), dis- uity you created a new asset which was also opportunity to put it to work and allow it to ability, or a foreclosure. able to earn a rate of return. Therefore, you grow and compound. earned $8,000 more than you would have if the money were left to sit idle in the home. Homeowners would actually be better off To be fair, you do have a mortgage payment burying money in their backyards than pay- you didn’t have before. However, since in- ing down their mortgages, since money bur- terest rates are relative, if we are assuming ied in the backyard is liquid (assuming you a rate of return of 8%, we can also assume can find it), and its safe (assuming no one a strategic interest-only mortgage would be else finds it). However, neither is earning a available at 5%. Also, since mortgage inter- rate of return. It’s actually losing value due How the Affluent Manage Home Equity 9
  10. 10. life. We give ourselves the opportunity to put it to work and earn something on it. Assuming a 28 percent tax bracket, the “Homes are designed net employment cost is not 5%, but 3.6%, to house families, or $3,600 per year after taxes (mortgage interest is 100% tax deductible). It’s not not store cash.” too difficult to find tax free or tax deferred investments earning more than 3.6%. Us- ing the tax benefits of a mortgage, you can create your own arbitrage by borrowing at THE POWER OF LEVERAGE The money that’s parked in your home one rate and earning investment returns at Let’s be clear, buying a home can be a doing nothing could be put to work earn- a slightly higher rate. It’s what the banks great investment. However, the wealthy buy ing you something. and credit unions do all the time. They the home with as little of their own money borrow our money at 2% and then loan it as possible, leaving the majority of their Let’s say you had $100,000 of equity in back to us at 5%. It’s what makes million- cash in other investments where it’s liquid, your home that could be separated. Cur- aires, millionaires! Learn to be your own safe, and earning a rate of return. One of rent mortgage interest is 5%, so the cost banker. By using the principles that banks the biggest misconceptions homeowners of that money would be $5,000 per year and credit unions use, you can amass a have is that their home is the best invest- (100% tax deductible). Rather than bury fortune. A bank’s greatest assets are its ment they ever made. If you purchased a the $100,000 in the backyard, we are going liabilities. You can substantially enhance home in 1990 for $250,000 and sold it in to put it to work, or “employ” it. If I were your net worth by optimizing the assets June of 2003 for $600,000, that represents an employer, why would I be willing to hire that you already have. By being your own a gain of 140%. During the same period, an assistant for $35,000 per year? The ex- banker you can make an extra $1 Million the Dow Jones grew from 2590 to 9188, pectation is I am going to be able to grow for retirement. a gain of 255%. The reality here is that my business and earn a profit on it. As a financing your home was the best in- business owner, I believe that by investing HOW TO CREATE AN EXTRA vestment decision that you ever made. in an assistant I will earn a return that’s MILLION DOLLARS FOR RETIREMENT When you purchased the $250,000 house greater than the cost of employing that as- By repositioning $200,000 into an eq- in 1990, you only put $50,000 down. The sistant. If we choose to leave the $100,000 uity management account with a financial $50,000 cash investment produced a profit of equity in our home, we incur almost the advisor you can achieve a net gain of $1 of $350,000. That is a total return of 600%, same cost. The only difference is, instead of million over thirty years. Assume you far outpacing the measly 255% earned by referring to that cost as employment cost, separate the $200,000 of home equity the stock market. it is referred to as an opportunity cost. By using a mortgage with a 5% interest rate. If leaving the equity in the home, we give the $200,000 grows at a conservative rate of THE COST OF NOT BORROWING up the “opportunity” to earn a 5 percent 6.75% per year, it will be worth $1,419,275 (EMPLOYMENT COST VS. return on the money. in 30 years. After deducting the $216,000 OPPORTUNITY COST) By separating the equity we give it new in interest payments and the $200,000 When homeowners separate equity to reposition it in a liquid, safe, side ac- count, a mortgage payment is created. The mortgage payment is considered the “Investments are Employment Cost. What many people designed to don’t understand is when we leave equity store cash.” trapped in our home, we incur the same cost, but we call it a lost Opportunity Cost. 10 How the Affluent Manage Home Equity
  11. 11. mortgage, you still have $1,003,275 left my investments decline? Do I have reserve 401 VACATION CONDO in your account. A net gain of over one funds or a secure income?” In April 2004, Many successful people in Southern million dollars. the following question was posed to the California dream of retiring and buying a NASD, “Where can I find the exact language second home in Arizona or Hawaii. With one This example simply shows a one time prohibiting a broker from recommending million dollars or more saved in their repositioning of equity. Imagine how the that I take a mortgage out on my house and IRA/401Ks, they decide to retire and buy numbers grow for individuals that harvest invest the money in securities?” The writ- the vacation home where they will spend and reposition their home equity every 5 ten answer from the NASD: “Brokers their winters. What a surprise when they years as their home continues to appreci- are not prohibited from making such a discover that to pay cash for a $350,000 ate! This is how the wealthy manage their recommendation per se, so long as the condo they need to withdraw nearly home equity to continually increase their investment is reasonably suitable for in- $500,000 from their 401K/IRA. What if net worth. Conversely, if the same $200,000 vestment in general, and it is suitable instead they had purchased the condo were left to sit idle in the home for 30 years, for the specific customer. In order to 15 years earlier, when it cost $175,000, it would not have earned a dime. determine suitability, a broker should con- by using the equity in their home? sider the client’s investment objectives, Today their net worth would be $175,000 BETTING THE RANCH; RISKING HOME financial status, tax status, and any other higher, due to the condo’s apprecia- EQUITY TO BUY SECURITIES information a firm uses to make suitable cli- tion, and they would have the mortgage Recently the NASD issued an alert, “… ent recommendations. This would include interest deduction to help off-set their because we are concerned that investors adequately explaining the risks of such an IRA/401K withdrawals. In addition to the who must rely on investment returns to investment, which are significant, to the financial advantages, they would have make their mortgage payments could investor.” The NASD simply wants to ensure enjoyed the lifestyle benefits of owning end up defaulting on their home loans consumers are receiving prudent advice. their vacation condo 15 years sooner if their investments decline and they are than they planned. unable to meet their monthly mortgage TAX DEDUCTIONS TO OFFSET payments.” The NASD is absolutely correct 401K WITHDRAWALS MAKING UNCLE SAM YOUR in advising against separating equity if the Most successful retirees have the major- BEST PARTNER client must rely on the returns from their in- ity of their assets in their home equity and Under tax law you can deduct up to one vestment to make the mortgage payments. IRA/401Ks. As they start withdrawing funds million dollars of mortgage interest subject to from their IRA/401Ks, they are hit with a income restrictions. You can also deduct an Home equity is Serious Money. We significant annual tax bill. Moreover, the additional $100,000 from home equity loan don’t gamble home equity. Liquidity and kids have moved out, the mortgage is paid, interest. To take advantage of these deductions, safety are the key philosophies when and tax deductible contributions to 401Ks make sure to secure a large mortgage when separating home equity. Rate of return is a have stopped. When they could use the you buy. Under tax law, mortgage interest is distant third benefit. Also, it is not neces- mortgage interest deduction the most, they deductible only for $100,000 over acquisition sary or recommended to invest in highly don’t have it. As part of long term planning, indebtedness (the mortgage balance when volatile or aggressive investments. You can someone who is preparing for retirement home is purchased). Home improvements are make thousands of dollars by simply bor- may want to have a mortgage going into re- the only exception. For example, if you sell your rowing at 5% and investing at 5% in safe tirement to help offset the annual IRA/401k home for $400,000 and buy a new home for conservative fixed investments without ever tax bill and enhance their overall financial $400,000 with the cash from the sale, you will going into securities. In general, individu- goals. For many, the mortgage interest de- lose the tax break and liquidity. But worse, if als should not invest home equity for “cur- duction offsets taxes due on retirement you later decide to take out a home equity loan, rent income” unless the investment is fixed withdrawals, giving the net effect of tax free only the first $100,000 will be tax deductible. and guaranteed. Individuals interested in withdrawals from their retirement account. Instead, secure a $360,000 mortgage (90%) variable investments should ask themselves, when you buy the home and the entire amount “How will I make my mortgage payment if is deductible. How the Affluent Manage Home Equity 11
  12. 12. WHERE TO SAFELY INVEST couple decided to separate $155,800 of allows them to pay less to their mortgage HOME EQUITY their equity to invest in a safe conservative company each month, thereby enabling Home equity is serious money. We are side account. By using an interest-only ARM them to save or invest more each month. separating it from the home to conserve it, they were able to increase their mortgage For example, a couple in San Diego, Ca. not to consume it. Therefore it should not be balance to separate this chunk of equity followed traditional thinking when they invested aggressively. Rather, home equity is while decreasing their monthly mortgage bought their $400,000 home. They put 20% best invested in safe, conservative invest- payment to $1,656, a monthly cash flow down and obtained a $320,000 30-year ment vehicles. Tax favored safe investments savings of $474 per month. fixed rate mortgage at 6.00% with a payment are ideal. You should consult your financial of $1,919 per month. This is how the vast planner for the best investment vehicles The couple conservatively invested majority of Americans would purchase this for your specific situation. Many financial the $155,800 lump sum and the $474 home. planners prefer the following tax favored per month savings with their financial plan- products for investing home equity: ner. If we assume a conservative 6% rate However, once this couple understood the of return, their investment account will benefits of integrating their mortgage into • INVESTMENT GRADE grow to $520,196 in 15 years. In the 15th their financial plan, they decided to make INSURANCE CONTRACTS year, they will have enough cash in their a change. They moved to a more strategic • ANNUITIES investment account to pay off their mort- interest-only mortgage. They kept the same • REAL ESTATE INVESTMENT TRUSTS gage completely if they want to (15 years loan balance, but were able to reduce their • IRAS earlier than with their original 30 year monthly payments to $1,133 per month, a • 401KS mortgage!). However, armed with their new savings of $786 per month from their previ- • TAX-FREE BONDS equity management knowledge, they plan ous mortgage. The couple invests the $786 • 529 SAVINGS PLAN to keep the mortgage well into retirement savings each month, and assuming a 6% rate so they can keep the tax deduction benefits of return, they will have enough money in CASE STUDY: and keep the money in the investment ac- their investment account to pay off their mort- HOME EQUITY MANAGEMENT count where it’s more liquid, more safe, gage in 19 years (11 years sooner than their There’s a recent case study of a and will continue to grow and compound. previous 30 year schedule!). Therefore, by couple living in a $750,000 home in simply redirecting a portion of their monthly San Diego, CA. They owed $360,000 on CASE STUDY: mortgage payment, they were able to poten- a 30-year fixed mortgage at 5.875% with CASH FLOW MANAGEMENT tially shave 11 years off their mortgage. In a monthly payment of $2,130. They had It’s not necessary to have a large chunk addition, they also received the benefits of $190,000 built up in home equity. A very of equity in your home to benefit from having their cash in a more liquid, more safe common “Brother A”-type traditional sce- using your mortgage to create wealth. position throughout the process. nario. After understanding the liquidity, Many homeowners without a large safety, rate of return, and tax benefits of equity balance have benefited by simply properly managing their home equity, this moving to a more strategic mortgage which About the authors: Steven Marshall is the President & CEO of Bellevue Mutual Mortgage, a company that specializes in helping clients properly manage their home equity and their mortgage to build wealth. Jim Potts is a Branch manager with CalPacific. Jim’s clients know they can depend on him when it comes to analyzing the big picture. As a retirement and mortgage specialist, he helps to evaluate their individual financial needs, and devises a strategy for paying off debt faster, while increasing retirement accounts and enabling clients to retire debt-free in less time than they thought possible. For a free analysis to see how these concepts would apply to your specific situation, please contact Jim Potts at 800-794-7177 or via email at 12 How the Affluent Manage Home Equity