our our home home appreciates, appreciates, oror our our mortgage mortgage balance is going down, that the equity has the home’s appreciation. Therefore, balance is going down, thatTherefore, the equityhome has aa the home’s appreciation. home rate of return. That’s not true. Home equity equity simply ininthe does rate of return. That’s not true. HomeItItequity equity simplysits sitsidle idle thehome. home. does not earn any rate of return. Assume you has NO rate of return. Home values fluctuate rate of Home return.values Assume you hasnot NOearn rateany of return. fluctuate have home $100,000 you due totoamarket conditions, not due the have amarket homeworth worth $100,000 which you due conditions, notwhich due to to the own free and clear. If the home appreciates mortgage balance. Since the equity in the own free and clear. If the home appreciates mortgage balance. Since the equity in the 5%, own an $105,000 at 5%,you you own anasset asset worth $105,000 at home has no relation totoworth the value, home hasof no relation the home’s home’s value, the end the year. the of theresponsible year. ititisis ininend nonoway for the home’s way responsible for the home’s appreciation. Therefore, home equity simply appreciation. Therefore, home equity simply Now, assume you had separated the Now, assume you had separated the sits idle in the home. It does not earn any rate sits idle in the home. It does not earn any rate $100,000 $100,000ofofhome homeequity equityand andplaced placed itit in in ofofareturn. Assume you have a home worth return. Assume youside have a home worth account earning asafe, safe,conservative conservative side account earning $100,000 which you free clear. If the 8%. side be worth $100,000 youown ownwould freeand and 8%.Your Yourwhich sideaccount account would beclear. worthIf the home appreciates 5%, you own an asset worth $108,000 atatthe ofofthe You home appreciates 5%, ownyear. an asset worth $108,000 theend endyou the year. You still still own the home, which appreciated 5% $105,000 at the end of the year. own theathome, which appreciated 5% and and $105,000 the end of the year. isisworth worth$105,000. $105,000.By Byseparating separatingthe the equity equity
Now, assume you had separated the you was Now, assumeaanew youasset hadwhich separated the youcreated created new asset which was also also $100,000 of home equity and placed it in a able to earn a rate of return. Therefore, $100,000 of home equity and placed it in able to earn a rate of return. Therefore, a safe, conservative side account 8%. you earned than you safe, conservative sidemore account earning 8%. you earned$8,000 $8,000 more thanearning youwould would have if the money were left to sit idle Your side account would be worth $108,000 have if the money were left to sit idle Your side account would be worth $108,000 the home. beyear. fair, do have a atatinthe end ofofTo the You still own inthe the home. To fair,you you end thebe year. You do stillhave owna the the mortgage payment you didn’t have before. mortgage payment you didn’t have before. home, which appreciated 5% and is worth home, which appreciated 5% and is worth However, since interest are relative, However,By since interestrates rates are relative, $105,000. separating the equity you $105,000. By separating the equity you if ifwe are assuming aarate of return of 8%, we are assuming rate of return of 8%, created a new asset which was also able created aalso newassume asset which was also able to to we can aastrategic interestwe can also assume strategic interestearn a rate of return. Therefore, you earned earn a mortgage rate of return. Therefore, you atearned only would 5%. onlymortgage wouldbe beavailable availableat 5%. $8,000 more than would the $8,000 moremortgage than you youinterest wouldishave have the Also, since 100%ififtax Also, since mortgage interest is 100% tax
money to sit sit idle idle in in the the home. home.To Tobe be money were were left left to fair, you mortgage payment you deductible, the net cost of of the thepayment moneyisisyou fair, you do do have have aa mortgage deductible, the net cost money didn’t have before. However, since interest only produces 4.4% positive didn’t have This before. However, since interest only 3.6%. 3.6%. This produces aa 4.4% positive spread between the cost of money and rates are relative, if we are assuming a rateofof spread betweenif the costassuming of moneyaand rates are relative, we are rate the earnings on that money. return of can also assume aa strategic strategic the earnings oncan thatalso money. return of 8%, 8%, we we assume interest-only mortgage would be available interest-only mortgage would be available atat The story gets much more more compelling The story gets much compelling 5%. Also, since mortgage interest 100%tax tax 5%. Also, since mortgage interest isis 100% over time, although the mortgage debt over time,the although theofmortgage debt deductible, net cost the money is only deductible, the net cost of thecompound money is only remains constant, through remains constant, through compound 3.6%. This produces a 4.4% positive spread 3.6%. Thisthe produces a 4.4%continues positive spread interest, side account to interest, the side account continues to between the cost of money and theThe earnings between the cost of money and the earnings grow at a faster pace each year. grow at a faster pace each year. The on that onearnings that money. money. on $100,000 in year 1 are
earnings on $100,000 in year 1 are $8,000. Then in year year 2, 2, the the 8% 8% earnings earnings $8,000. Thenmuch in The story gets more compelling over The story gets much more compelling on $108,000 are $8,640. $8,640. In In year year 3, 3, the theover on $108,000 are time, although the mortgage mortgage debt remains time, although the debt remains earnings $116,640 at 8% 8% are are $9,331. earnings on on $116,640 at $9,331. constant, through compound interest, the constant, compound interest, Since mortgage debt remains remains the the Since the thethrough mortgage debt the side account continues to grow grow faster same, the between the cost cost the side account continues to atat aaofoffaster same, the spread spread between the the pace each year. The earnings on $100,000 mortgage money and the pace each year. The earnings on $100,000 mortgage money and the in year Then in inequity year 2, 2, the the 8% 8% on the separated separated equity inearnings year 11 are are $8,000. Then year earnings on$8,000. the continues to widen further in the earnings on $108,000 are $8,640. $8,640. In year year3,3, continues widen further in the In earnings on to $108,000 are homeowner’s favor every year. If we allow the earnings on $116,640 at 8% are $9,331. everyatyear. If we$9,331. allow thehomeowner’s earnings on favor $116,640 8% are home equity to remain idle in the home, home to remain in thethe home, Since the mortgage debtidle remains the same, Since theequity mortgage debt remains same, we give the opportunity to to put put itit to to we give up up the opportunity the spread between the cost of the mortgage the spread between thegrow costand of the mortgage work to compound. work and and allow allow itit to grow and compound.
money earnings on on the the separated separated money and and the the earnings equity continues to widen widen further the equity continueswould to inin off the Homeowners actuallyfurther be better better off Homeowners would actually be homeowner’s favor every year. If we allow homeowner’s favor everybackyards year. If we allow burying money in their than burying money in their backyards than
homeequity equitytotoremain remainidle idleininthe thehome, home,wewe home giveup updown theopportunity opportunity putsince ittotowork work and paying down theirmortgages, mortgages, money give the totoput itsince and paying their money allow it to grow and compound. buried inthe thebackyard backyard liquid(assuming (assuming allow itinto grow and compound. buried isisliquid
youcan canfind findit),it),and anditsitssafe safe(assuming (assuming you Homeowners would actually bebetter better off Homeowners would actually be no one else finds it). However, neither no one else finds it). However, neither isis off buryingmoney money theirbackyards backyards than paying earning rateofin ofin return. It’sactually actually losing burying their than paying earning aarate return. It’s losing down their mortgages, since money buried valuedue dueto toinflation. inflation.Few Fewpeople people today inin down their mortgages, since moneytoday buried value thebackyard backyard liquid (assuming youcan can find bury moneyinis inisthe the back yardororunder under their the liquid (assuming you find bury money back yard their mattresses, because they have confidence it),and anditsitssafe safe (assuming noone one elsefinds findsit).it). mattresses, because theyno have confidence it), (assuming else in thebanking banking system. Theyalso also understand However, neither is earning a rate of return. in the system. They understand However, neither is earning a rate of return. idle money loses value while invested idle money while It’sactually actuallyloses losingvalue value duetoinvested toinflation. inflation.Few Few It’s losing value due moneygrows growsand andcompounds. compounds.AsAsAlbert Albert money people today bury money in the back yard people bury in the back yardinoror Einsteintoday said,“The “Themoney mostpowerful powerful force Einstein said, most force under their their mattresses, mattresses,because becausethey theyinhave have under the universe is compound interest.” Afterall,all, the universe is compound interest.” After confidence thebanking banking system.They They also confidence inin the system. also homeswere were built housefamilies, families, notstore store homes built totohouse not understand idle money loses value while understand idle money losestotovalue while cash.Investments Investments weremade made storecash. cash. cash. were store
invested money moneygrows growsand andcompounds. compounds.AsAs invested Albert Einstein said, “The most powerful force Takenfrom fromaadifferent different angle, suppose you Albert Einstein said, “The mostsuppose powerful force Taken angle, you in the the universe is compound interest.” After offered anis investment that couldnever never inwere universe compound interest.” After were offered an investment that could go up in value, but might go down. How all,up homes were built house families, not go in value, but might down. How not all, homes were built totogo house families, much of it would you want? Hopefully none. store cash. Investments were made to store much of it would you want? Hopefully store cash. Investments were made tonone. store Yet, thisisishome homeequity. equity.It Ithas hasnonorate rateofof Yet, this cash. cash. return, so it cannot go up in value, but it could return, so it cannot go up in value, but it could go down thereal real estate market Taken from adifferent different angle, suppose you go down ininvalue ififthe estate market Taken from avalue angle, suppose you declines or the homeowner experiences were offered an investment that could never declines or the anan were offered anhomeowner investment experiences that could never uninsured loss (e.g. an earthquake), disability, goup upininvalue, value, butmight might down.How How much uninsured loss but (e.g. an earthquake), disability, go gogodown. much oraaforeclosure foreclosure or