our home appreciates, or our mortgage balance is going down, thatTherefore, the equity home has a the home’s appreciation. rateequity of return. That’s not true. Home equity simply sits idle in the home. It does rate of Home return.values Assume you hasnot NOearn rateany of return. fluctuate have a home worth $100,000 which due to market conditions, not due toyouthe own freebalance. and clear. If thethe home appreciates mortgage Since equity in the 5%, you own an asset worth $105,000 at home has no relation to the home’s value, the end of the year. it is in no way responsible for the home’s appreciation. Therefore, home equity simply Now, assume you had separated the sits$100,000 idle in theofhome. It does not earn any rate home equity and placed it in of areturn. Assume you haveaccount a home worth safe, conservative side earning $100,000 you own would free and 8%. Yourwhich side account beclear. worthIf the home appreciates ownyear. an asset $108,000 at the5%, endyou of the You worth still own theathome, which appreciated 5% and $105,000 the end of the year. is worth $105,000. By separating the equity
Now, assume a new you asset had which separated the you created was also $100,000 of home and Therefore, placed it in a able to earn a rateequity of return. safe, sidemore account 8%. youconservative earned $8,000 thanearning you would have money werebeleft to sit$108,000 idle Your sideif the account would worth in the home. To be fair, you do have at the end of the year. You still owna the mortgage you didn’t have home, whichpayment appreciated 5% and is before. worth However, since interest rates are relative, $105,000. By separating the equity you if we are assuming a rate of return of 8%, created a new asset which was also able to we can also assume a strategic interestearn a rate of return. Therefore, you earned only mortgage would be available at 5%. $8,000 more mortgage than youinterest would ishave the Also, since 100%if tax
money were left to sit idle in the home. To be fair, you do have a mortgage deductible, the net cost of thepayment money isyou didn’t have before. However, since interest only 3.6%. This produces a 4.4% positive spread betweenif the costassuming of moneyaand rates are relative, we are rate of the earnings on that money. return of 8%, we can also assume a strategic interest-only mortgage would be available at The story gets much more compelling 5%. Also, since mortgage interest is 100% tax over time, although the mortgage debt deductible, the net cost of the money is only remains constant, through compound 3.6%. This produces a 4.4% positive spread interest, the side account continues to between the cost of money and the earnings grow at a faster pace each year. The onearnings that money. on $100,000 in year 1 are $8,000. Then in year 2, the 8% earnings
The story gets much more compelling over on $108,000 are $8,640. In year 3, the time, although the mortgage debt remains earnings on $116,640 at 8% are $9,331. constant, compound interest, Since thethrough mortgage debt remains the the side account continues to grow at aoffaster same, the spread between the cost the pace each year. Theand earnings on $100,000 mortgage money the inearnings year 1 are Then inequity year 2, the 8% on$8,000. the separated continues widen further in the In year 3, earnings on to $108,000 are $8,640. homeowner’s favor every year. If we$9,331. allow the earnings on $116,640 at 8% are home equity to remain idle in the home, Since the mortgage debt remains the same, give up the opportunity to put it to thewespread between the cost of the mortgage work and allow it to grow and compound. money and the earnings on the separated equity continues to widen further in the Homeowners would actually be better off homeowner’s favor everybackyards year. If we burying money in their thanallow
home equity to remain idle in the home, we give updown the opportunity to put since it to work and paying their mortgages, money allow it to grow and compound. buried in the backyard is liquid (assuming you can find it), and its safe (assuming Homeowners would actually neither be better no one else finds it). However, is off burying amoney their backyards than paying earning rate ofinreturn. It’s actually losing down their mortgages, since money buried value due to inflation. Few people today in the backyard liquid (assuming you can find bury money inisthe back yard or under their mattresses, because they have confidence it), and its safe (assuming no one else finds it). in the banking system. They also However, neither is earning a rateunderstand of return. idle money loses value while invested It’s actually losing value due to inflation. Few money grows and compounds. As Albert people today bury money in the back yard or Einstein said, “The most powerful force in under their mattresses, because they have the universe is compound interest.” After all, confidence in the banking system. They also homes were built to house families, not store understand idle money losesto value while cash. Investments were made store cash.
invested money grows and compounds. As Albert from Einstein said, “The mostsuppose powerfulyou force Taken a different angle, in theoffered universe compound interest.” After were an is investment that could never go in value, might down. How not all, up homes werebutbuilt to go house families, much of it would you want? Hopefully store cash. Investments were made tonone. store Yet, cash.this is home equity. It has no rate of
return, so it cannot go up in value, but it could go down in value if the real estate marketyou Taken from a different angle, suppose declines or the homeowner experiences an were offered an investment that could never uninsured loss (e.g. an earthquake), disability, go up in value, but might go down. How much or a foreclosure