Uncommon Financial Wisdom

One of the most important concepts that has emerged in the last few years for individuals who want to build wealth is equity harvesting.  What is equity harvesting?  First we need to understand what I am referring to when I talk about equity.  Home equity is simply the difference between a homes current market value and the amount of debt on that home.  So if you have a home that is worth $250,000 and the total of all your mortgages is $100,000 you have $150,000 in home equity ($250,000-$100,000= $150,000). According to the Federal Reserve Board (2004), home equity accounts for over 35% of Americans net worth.  Compare this to retirement accounts which account for only 8% of the median family wealth.  In short, Americans carry more wealth in their homes than any other asset.

But is a home a good place to hold your assets?  Let’s take a non-emotional look shall we?  What is the rate of return of home equity?  Most people will confuse the rate of return of home equity with the increase of value of their home.  In fact these are independent items.  Your home appreciates the same whether you have a large mortgage on it or it is mortgage free.  The answer to the question of rate of return on home equity is 0%.  That’s right all that home equity you have built up is languishing in a savings account getting 0% interest!!

All right you say, but it is save sitting there in the brick and mortar (or wood frame) of my home.  Unfortunately it is not as safe as you think.  What happens if real estate values go down in your area?  Well, your home equity goes down accordingly. What if a disaster hits your home?  Yep, once again you face loss or at least temporary loss of your home equity.  What about a personal disaster like sickness or job loss?  If you have a mortgage your equity is at risk.  Banks don’t care about those types of personal problems; they only want their monthly payment.  The truth is that home equity is at risk from a variety of sources.

This is why forward thinking folks suggest you separate your home equity (some call it liberate) from your home.  Now, many folks take out home equity to spend.  If this is your intention, then you are better off leaving it in your home for a forced savings account.  However, for those folks who have the discipline to put the home equity into a savings/retirement vehicle this is a no-brainer. 

What type of account is appropriate?  That depends on your total financial picture.  If you don’t have 6-9 months of expenses set aside into an account you can access with a phone call or mouse click, then take the equity and put it into a money market account or savings account.  If you are further along with your wealth building, then the world opens up for you.  But keep in mind the whole idea is to increase your liquidity, not tie up the money in places you can’t access it.

What about the expense of having a larger mortgage?  This is where the good news is.  Mortgages are the cheapest money you can buy.  In addition, they are generally tax deductible as long as you follow the IRS rules. (See a CPA for specifics on exceptions)  Finally, there is the magic of compound interest.  Most savings/investments accounts use the concept of compounding.  This simply means when your account is credited with interest or capital growth it is based on current value.  If you start with $10,000 and earn 5% you make $500 the first year.  But the second year you start with $10,500 and would make $625 using that same 5% rate of return.  This number keeps growing each year.  However, your mortgage costs remain the same year in and year out.

The bottom line is that even if you only match the true rate of your mortgage with a rate of return on your savings/investment you will make money, lots of money over 10, 20, or 30 years.

Here is the math:

Mortgage rate= 6.5%

Your marginal tax rate=25%

Your rate of return on your investment= 6.5%

True Cost of Mortgage= 4.88% (6.5% X 1-.25) Your cost after your tax deduction

Cost of $100,000 Mortgage = $4,880/year

At the end of year five you have an investment account worth $137,008.  It has cost you $24,400 interest paid to accomplish this.  Is it worth it?  And every year ongoing you are making more money on this strategy than the year before.  Your investment account really starts to add up after ten years.  What about the expense of the refinance you ask?  Well if it costs you $3,000 to refinance is it still worth it?  Of course it is.

Let’s review.  By separating some of your home equity you decrease your risk of loss, increase you liquidity and increase your wealth.  Like I said, it’s a no-brainer.

What if something does happen to me and I can’t make my mortgage payment? Well, you have over $100,000 to make those mortgage payments (and any other expenses).  How much do you have now if something happens?