How Should Home Equity Be Used To Build Wealth
Posted on September 7, 2007
One of our Weekend Millionaire students recently sent me an article by Steven Marshall and Patrick Allman titled “How the Affluent Manage Home Equity to Safely and Conservatively Build Wealth.” As officers of Bellview Mutual Mortgage, a company that specializes in helping clients manage their home equity and mortgages to build wealth, they make a compelling case that the equity in your home is of little use and a non-productive asset that if properly managed can create wealth.
They use a hypothetical example of two brothers, each earning $70,000 per year and each buying a $200,000 home. One brother makes a 20% down payment of $40,000 and gets a 15 year mortgage at 6.38% APR. The other brother puts down $10,000 which is a 5% down payment and gets a 30 year interest only mortgage at 7.42% APR. The brother with the interest only mortgage invests the difference between his payment and his brother’s and they track their financial progress for 30 years.
They point out that over time the brother with the larger mortgage will receive $107,826 in tax savings as compared with only $25,080 in tax savings his brother will receive. They claim that after 30 years both brothers will own their home outright, with no mortgage. In their example, they say that after 30 years the brother with the 15 year mortgage will have $613,858 in savings and investments, while the brother with the 30 year mortgage will have more than $1,115,400. No where in the example do they tell you how much tax will be due on the brother’s additional earnings.
Since Mr. Marshall and Mr. Allman are professionals, I won’t attempt to verify their calculations, but their assumptions do bring some questions to mind. Where can you find a lender who will give you an interest only mortgage for 30 years with only a 5% down payment? I can’t understand how it benefits you to pay out a dollar in interest just to save twenty to forty cents in tax. If the brother with the interest only mortgage invested the difference between his payment and his brother’s, and his investments earned the dollar he paid in interest, isn’t he spending an entire dollar to avoid paying twenty to forty cents in tax? Once a mortgage is paid off, aren’t you better off paying the tax on the dollar and keeping the difference?
Unless you are an accountant or investment counselor, I’d be willing to bet that you’re as confused by these numbers and percentages as I am. I’d also be willing to bet that most ordinary working people feel a bit uneasy about speculating with their home equity. Granted, it does little more than provide a bit of personal security unless invested elsewhere, but there’s a way to do this that’s more comfortable than handing it over to a money manager to speculate with it in the stock market.
Technically, Mr. Marshall and Mr. Allman are correct that payments are much less on an interest only mortgage than one that is fully amortizing, but realistically, it is a rare exception to find someone with the discipline to regularly invest this difference over a period of 30 years. The lure of new cars, boats, expensive clothes and other similar enticements have a way of attracting the extra dollars that should be invested. The fact that home equity is not readily accessible offers some protection from impulse purchases and is probably the reason it is most people’s largest asset.
Here’s a tip! Home equity may seem like a dead asset, but there’s a way to use it that’s much less speculative than putting it in the stock market. Suppose you owned a $250,000 home free and clear. You could use it as collateral to establish a revolving line of credit in the amount of $200,000 and use this line of credit as seed money to purchase income producing rental properties. Even with conventional financing, where you put down 20% and finance the balance, the combination of rent increases, mortgage reductions and appreciation builds equity rapidly. Within two to five years you can usually refinance and pull out enough cash repay the line of credit and continue using it as seed money to add additional properties to your portfolio.
Using home equity to buy income properties, not only keeps this valuable asset invested in real estate where it’s not so easy to tap into, but it also uses it to create a growing stream of income you can enjoy for the rest of your life. There’s a reason you can borrow 80% or more to purchase real estate and only 50% to purchase stocks. It’s because real estate is a much safer investment. With $200,000 of home equity, you could buy $1,000,000 or more worth of real estate that would almost assuredly appreciate 3-5% per year.
While your equity is growing through appreciation, the properties are also generating income to pay off the mortgage. The longer you own them the more cash flow they will produce. Real estate is not only a great wealth builder; it is also a tremendous tax shelter. A friend of mine used his home equity to build an income stream of more than $100,000 per year in just over five years.
Contrast this with the $400,000 worth of stock you could purchase with $200,000 of home equity and the inherent risks associated with the stock market. Marshall and Allman may be disciplined enough to manage home equity and invest it in the stock market, but I don’t believe that is the case with most ordinary working people.
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