MortgageHow to Effectively Manage Home EquityA unique mortgage strategy, read one for full details. If you’re the classic home owner the only thing you constantly think about is paying off your mortgage so you can own it free and clear. How about if I told you that there is way to pay off your home sooner by lowering your monthly payments? It’s a strategy that is commonly used by the wealthy, but now you can implement this strategy yourself. Read on for more information. We’ve been taught that one should have at least a 20% down payment for a house. Make extra principal payments in order to pay off your loan as early as possible. This way of thinking is flawed because nothing last forever, let me explain. The rules of money have changed. We will no longer have the same job for 30 years. In many cases you will have four or five different jobs. We can’t depend on a company pension plan for a secure retirement and who knows what’s going to happen to Social Security benefits. The likelihood of you selling your home in less than 10 years is high. Within that time frame you might re-finance a few times. Having a solid financial plan involves having a strategy in place. Owning a home is not the ultimate financial goal.
Why People Fear Mortgages, and Why You Shouldn’tIn order to discover how our parents and grandparents got the idea that a mortgage was a necessary evil at best, we must go back in time to the Great Depression. In the 1920’s a common clause in loan agreements gave banks the right to demand full repayment of the loan at any time. Since this was like asking for the moon and the stars, no one worried about it. When the stock market crashed on October 29, 1929 millions of investors lost huge sums of money, much of it on margin (back then, you could buy $10 of stock for a $1). Since the value of the stocks dropped, few investors wanted to sell so they had to go to the bank and take out cash to cover their margin call. It didn’t’ take long for the banks to run out and cash and start calling loans due from good Americans who were faithfully making their mortgage payments every month. However, there wasn’t any demand to buy these homes, so prices continued to drop. To cover the margin call, brokers were forced to sell stock and once again there wasn’t a market for stocks so the prices kept dropping. Ultimately, the Great Depression saw the stock market fall more than 75% from its 1929 highs. More than half of the nation’s banks failed and millions of homeowners, unable to raise the cash they needed to payoff their loans, lost their homes. Out of this the American Mantra was born: Always own your home outright. Never carry a mortgage. The reasoning behind America’s new mantra was really quite simple, if the economy fell to pieces, at least you still had your home and the bank couldn’t take it away from you. Maybe you couldn’t put food on the table or pay your bills, but your home was secure. Since the Great Depression laws have been introduced that make it illegal for banks to call your loan due. The bank can no longer call you up and say, “We’re running a little short on cash and need you to pay off your loan in the next thirty days.” Additionally the Federal Reserve Bank is now quick to inject money into the system if there is a run on the banks. Also, the FDIC (Federal Deposit Insurance Corporation) was created to insure banks. Still, it’s no wonder the fear of losing their home became instilled in the hearts and minds of the American people, and they quickly grew to fear their mortgage. In the 1950’s and 60’s families would throw mortgage burning parties to celebrate paying off their home. In order to protect yourself in this day and age of credit crisis, job loss or companies going bankrupt, you need to have a lot of money saved up in an emergency fund in case you come across hard financial times. Let’s consider this example: Susan:
-$300,000 – Home
Sally: If you came across financial difficulties in today’s economy, would you prefer to be in Susan’s situation or Sally’s? Sally is obviously in a safer financial situation than Susan even though she has a mortgage that is two times larger than Susan’s mortgage. Susan is more in danger of losing her home if she comes across financial difficulties or if the economy collapses. Sally has the cash to weather the storm while Susan is house rich and cash poor. Remember, in hard times, cash is king! You see many people mistakenly assume that home equity is like cash in the bank. That is a false and very dangerous assumption. Only cash in the bank is like cash in the bank. It is far safer to have a large mortgage and a lot of cash in the bank, than to have little or no mortgage with little or no cash in the bank.
Understand that Everything in Life is 100% FinancedMany people hate their mortgage because they hate paying interest. They make extra principal payments or larger down payment because they think they are saving money and getting out of debt quicker. The truth is that everything in life is 100% financed. This means that you are either paying interest to someone else, or you are losing the opportunity to earn interest on your own money. Consider the effect of using $100,000 of your own money to finance your home, versus using $100,000 of the bank’s money to finance your home. Self Financed As you can see from the illustration, you lose money if you have a mortgage, but you also lose money if you don’t have a mortgage. If you finance the home with the bank’s money, you are losing money by paying interest to the bank. If you finance your home with your own money, your investment of home equity is preventing you from otherwise earning interest on your money in another investment. In other words, you are losing money by not making money. Therefore, the question really becomes, what is a better investment for your money – home equity or an alternative investment? Which strategy is safer and less risky? In order to answer this question, we need to recognize that every investment and every choice in life carries risk. Most people fail to recognize the risks associated with home equity as an investment. Let’s take this step by step and evaluate home equity as would evaluate any other investment. - What is the rate of return?
How profitable is the investment that has no rate of return?Real Estate values will go up or down regardless of the mortgage balance on the property. Therefore, if your home goes up in value, your investment of home equity did not cause it to do so. In fact, your investment of home equity has nothing to do with it. The fact that you own the property is really the investment that is making you money, not how much cash you are storing in the property by way of home equity. In fact, storing your cash in the property by way of home equity is really similar to digging a hole in your backyard and shoveling cash into the hole. The home will go up or down in value regardless of how much cash you bury in that hole. However, it would be safer for you to shovel the cash into that hole as opposed to storing the cash in your home equity because at least you’d be able to get to it if you need it. The concept of “liquidity” (access to your money) is covered in further detail as we move on.
How Safe Is The Investment That Carries Risk of Loss?Although home equity has no rate of return, it can go down in value if the property value declines. If you were offered an investment that could never go up in value, but might go down, how much of it would you want? There are two ways you can lose your home equity: 1. Foreclosure The risk of foreclosure can be avoided by understanding the example of Susan and Sally as illustrated above. The only way to protect your home equity from loss in a foreclosure is to have enough cash sitting in the bank to face financial emergencies. In other words, instead of making extra principal payments, contribute to an emergency reserve account. The reason why real estate investors make money by buying foreclosed properties is because the homeowners who are losing their homes thought that it was smart to make extra principal payments on their mortgages. All the money that investors make with these opportunities is money that is being lost by homeowners who mistakenly assume that home equity is like cash in the bank. Almost everyone who lost their home to foreclosure would have been better off carrying a larger mortgage and keeping a large amount of money in the bank as a "rainy day fund." 2. Property declines in value If your property declines in value, the equity that you once had is no longer there. In order to recover your lost equity, you would need to wait until the property goes back up in value. If you need access to the funds sooner, you would need to either: - Sell your home at a loss and lose the equity forever; or,
How Liquid and Accessible Are Trapped Investment Dollars?The great secret of banking is that banks don’t lend money to people who need it. They lend money to people who can prove that they don’t need it. So, if you come across financial difficulties banks are unlikely to lend you money, even if you have a lot of equity in the home. Chances are that you’ll need to settle for a loan that will be smaller than you need and have terms and interest rates that may be more unfavorable than they would be otherwise. If you suddenly experienced difficult financial times, how important would it be for you to have cash to help you make your payments and pay your bills? How would you feel if you had a lot of equity trapped in your home that won’t do you any good? It is always better to have the cash and not need it; than to need it and not have it.
Be Financially Prudent: Increase Your Safety and LiquidityAccording to a recent study, most Americans have more of their net worth in home equity than in all other investments combined. However, most financial advisors and savvy investors would agree that it is not very wise to have most of your wealth tied up in one single investment. In fact diversification is the key to reducing risk and increasing the safety of principal. Holding large amounts of home equity puts you at unnecessary risk. Your risk could be greatly reduced by separating your equity from your home and diversifying into other investments. When the mortgage balance is high, the bank carries most of the risk. As you pay down your mortgage and make extra principal payments, you are actually transferring the risk from the bank back to yourself. Remember, homes are made to house families, not store cash. Investments are designed to store cash.
The Wise Way to Own a HomeBuying a home can definitely be a great investment. The key is to own the home, but keep your equity safely invested outside of the home. If your home goes up in value, you build wealth through home ownership while keeping your money safe and easily accessible. If your home goes down in value, you will have enough cash to weather the storm and wait for home values to come back up. The rate of home price appreciation in the US has averaged around 6% per year. For the past 50 years. Some years and locations are better than others, and some years and locations are worse than others. In most parts of the country you can count on at least 3% annual home price appreciation. (roughly the same rate as inflation in any given year). If you buy a $300,000 home that goes up in value by 3% per year for 5 years, the home would be worth $348,000 at that time. This represents a gain of 3% per year or 16% compounded over 5 years. On the other hand, if you only use $60,000 of your own money and $240,000 of the bank’s money to buy this home, your gain would be 8% per year or 47% compounded over 5 years. Would you rather earn 3% per year on $300,000 or 8% per year on $60,000? The key to wise home ownership is to manage your investment by applying the same investment principles to home equity as you would apply to any other investments. We can’t honestly say that we believe in investment diversification if we don’t diversify all of our investments, including home equity. We can’t honestly say that we are financially conservative if we take huge risks with our biggest investment by dumping it all into a single property. With this in mind, where can you safely invest your home equity? Home equity is serious money. We are separating it from the home to conserve it, not consume it. Therefore, it should be invested safely and conservatively as part of a properly balanced and diversified investment portfolio. A properly diversified investment portfolio includes businesses (stocks), real estate, bonds, commodities and cash (money market accounts). If you have good experience with direct ownership of real estate, you could reposition some of your home equity into other real estate investments including second homes or income producing properties. Many real estate income properties consistently provide a 15%-25% annual rate of return via positive cash flow and/or appreciation. The key with real estate investment is to never overextend yourself. You should always keep enough cash in the bank in case you come across financial difficulties or if your investments don’t perform as well as you anticipate.
|
