Monday, August 16, 2010

Is “Building Equity” In Your House a Good Idea?

Is “Building Equity” In Your House a Good Idea?

Just the other day, a couple came in to run their strategy for funding their kids’ college education by me to see what I thought about it. Basically, they are aggressively paying down their mortgage debt so that they can “build equity” – and when the time comes for their kids to go to college, they’ll simply “cash in” some of those “equity dollars” to pay for college expenses.

Millions of Americans are doing something similar. Others are targeting retirement, instead of college funding, whereby, upon retirement, they intend to downsize to a smaller house and, again, cash in on those “equity dollars.” You may have heard or perhaps read somewhere that this is a very prudent approach. Just last month, AARP offered this very advice to Boomers looking toward retirement

Here was my response to the couple, as well as to all who are following this school of thought: “Your house is NOT a piggy bank.” Folks who take this approach fail to understand two basic facts about equity.

1. Equity in a house is an illusion until it is turned into ACTUAL cash.

Is it possible that just as this couple’s kids are about to enter college, the equity in their house either significantly diminishes or completely evaporates? You bet! And you don’t have to look very far to see this illustrated, because this is precisely what happened – and is still presently affecting millions of Americans – courtesy of the recent real-estate debacle. Many people will be digging out of that one for years to come.

Many retiring homeowners were hoping to sell their houses, downsize, and then use the equity they had built to augment their retirement living. But all those years of building equity didn’t turn out as planned, did it? Always remember this fact: Equity is no different from any other investment over which you have no control – like stocks.

2. Equity in a house – contrary to what anyone thinks or believes – will ALWAYS have a ZERO percent rate of return.

Yes, I said zero. ZIPPO! You see, most people (and sadly, this includes some financial professionals) confuse changes in the value of a house with a rate of return on equity. That couldn’t be further from the truth. Just because you have a reduced mortgage or your house has been paid off does NOT make your house worth more than your neighbor’s. In other words, your mortgage balance does not determine the value of your house. Home values are determined by the market forces of demand and supply, period.
Your house is not a piggy bank!
Some clients of ours told their friends and family that they had not lost their home’s equity when values tanked recently. This did not imply that the values of their homes had not plummeted. They did, just like everyone else’s. BUT these clients’ equity wasn’t “sitting in their houses” – so they avoided the loss. It was, instead, invested in a side account that is linked to, but not directly invested in, the stock market. Doesn’t that seem more like a realistic plan for actually building something?

One more thing. Most homeowners seem to misunderstand that banks and lending institutions do not make loans solely based on the amount of equity you have in your home, but rather, on your ability to repay them. Try getting a loan when you have no source of regular income but a lot of equity, and see what happens. So think about this for a moment. If you were to suddenly experience a major financial setback, would you wish you had, say, $100,000 SAFELY tucked away in an account you could quickly access, or would you prefer to have $200,000 of “equity” trapped in your house?

As for the couple, I sent them a copy of my book on mortgages, Savvy Strategies for Turning Your Mortgage into a Goldmine, and they are scheduled to meet with me soon.  If you’re a homeowner who’s intent on managing your finances wisely, I strongly recommend that you contact us at (301) 949-4449 or to request your copy of this book.

At the end of it all, most people I meet intend to make the most of their money and other assets, but some follow what I call “financial truisms,” instead of proven, time-tested, common-sense, factual – and above all – realistic strategies. 

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