Is Equity Tied Up In Your House?

I have always been taught that becoming debt free is the thing to strive for. The American philosophy is, “If you can pay off your cars and your house, you can then live stress free.” Why wouldn’t you want to pay your mortgage off early? If you add up the interest you will be paying over the 15 to 30 year term of your mortgage, you will probably become clinically depressed and have to sit in a dark corner and cry. Obviously the thing to do is get it paid off sooner to avoid interest charges. That seemed pretty clear to me, until I read Last Chance Millionaire by Douglas Andrew. The book forced me to re-evaluate my traditional thinking. Think About This Perhaps you fit into this scenario. You purchased a house 10 years ago and have been making double payments on it. You now have 3/4 of you mortgage paid off, and you are looking forward to a mortgage free life in five years. Then one afte oon you come home and find a pipe has broken. Your house is 2 feet under water and many of your things are ruined. You’re not sure if your home owner’s insurance policy covers water damage. And now you do not have any money to fix it, but you do have a lot of equity built up in your house. Eight hours earlier you could have sold your house for a nice profit, now you wonder if you will have the money to survive, let alone rebuild. The Reality Think this situation sounds farfetched? It happens every day to people just like you. Many people work hard to pay off their mortgages early. They have been told it builds equity in their house. But they don’t think about the other option. Did you realize your extra house payment each month could have also gone into a side fund earning returns? And if the money was in a side fund, you would have access to it in the event of an emergency. You could rebuild your house while you fight with the insurance company for payment. But if all of your money is tied up in equity in a now flooded house, you have no money to live on after the emergency. A Common Situation Let's take a more common example. Suppose you purchased a home for $200,000 and lived in it for five years. As you paid down the mortgage, the value of the property increased. Now you learn similar houses to the one you purchased five years ago are selling in your neighborhood for $300,000. You’re excited. If you can sell your house, you just made $100,000 on your home. Not a bad return. What you don’t know is next year the economy is going to take a plunge, and so will the value of the homes in your area. They will drop back to $200,000, and you will have just lost that $100,000 gain. That return is no longer as promising. What you could have done when you found out the value of your home had reached $300,000 was refinanced, or taken out a second mortgage, and put that money in a side fund. Assuming you had paid down the mortgage some over the five years with an 80:20 Loan, you would be sitting on close to $100,000 in a side fund. The obvious downside to this is when the property value drops back down to $200,000, you then owe $300,000 on your home. However, that money is now growing for you. It is not trapped in your home’s equity. Balancing the Numbers Let's use a balance sheet to illustrate. Had you opted to not remove the equity, after the flood, on the asset side you would have a $200,000 house, and on the debt side a $200,000 mortgage loan. Had you removed the equity, on the asset side you would have a $200,000 home and a $100,000 cash fund, and on the debt side a $300,000 mortgage. In the end, you have the same thing. The difference is with the removed equity, you now have $100,000 in cash to grow while you wait for the market to recover. Additionally, your mortgage interest is tax deductable. As long as you earn less interest on your growth account than your loan account, you can beat the system. This is called arbitrage. Arbitrage is how banks make money. It means borrowing money at one rate and earning at a higher rate. Banks pay you two percent on your savings account and they loan out your money at six percent. Now you can use their strategy too. Educate Yourself This solution may not be the best thing for you. But before today, were you even aware it was an option? Educating yourself about your financial future allows you to re-think your beliefs. Think outside the box. [Ed. Note: Share your thoughts about this topic below. Want Dr. Tim to help you get your finances in order? Check out his new audio program.]