Cutting Edge Insights
with Dr. Lee

Is Home Equity Bad?

Generally, equity is thought to be a positive thing and something to strive for.  Primarily because it means ownership.  And the opposite is encumbrance, or debt.

Q: Is the opposite of good always bad?

A: Semantically, yes.

Q: Is the opposite of something that is generally regarded as good always bad?

A: Heck, no.

The adjective definition of contrarian is “something that goes against popular opinion.”

The contrarian approach to home equity, according to Keith Weinhold of Get Rich Education (www.getricheducation.com) is that “Home equity is unsafe, illiquid, and its rate of return is always zero.”

What?  Those are powerful statements that certainly go against the grain of conventional wisdom!

Let’s unpack them and dissect them.  In fact, let’s analyze them using the “Third side of the story” logic that we introduced back in an earlier blog post (revisit it here).

1.  “Home Equity is Unsafe”

Well, what type of home are you talking about?

Q:  Don’t give me this “It depends” excuse – I want a real answer!

A:  Be patient and keep reading!

If you think debt on your home can be unsafe, you’re correct.  You don’t know if and when something may happen to your ability to service that debt, should you experience an injury or other life-changing event.  So, in that sense, home equity is safe and debt can be viewed as unsafe.  I wouldn’t categorically disagree with Keith Weinhold here, but I’d qualify my “It really depends” response the way I am doing.

Here’s a case in point:  I have a friend who is going to construct a new medical facility.  Another friend is the commercial banker who will finance the deal.  Banker friend advised medical friend against collateralizing the office building with his home equity.  Why?  Because if something went wrong and the bank had to take action to collect, my friend would regret having pledged his home as collateral.  Banks always have to plan for the worst.

Now, if you’re talking about a rental property, any inability to continue to service that debt wouldn’t be connected to your ability to keep a roof over your family’s heads…so it can be said that debt on an investment property is less unsafe than on your primary residence.

Equity in an investment property (beyond the 20% that’s typically required to obtain financing) can be viewed as unsafe because it’s not working for you any longer.  Since you need 20% plus closing costs to invest in and acquire a property (in a commercial situation it is typically somewhat higher), your dollars that comprise that first 20% or 30% are working maximally hard and efficiently.  Once you accumulate more equity, the dollars become lazy within the same property equity because they could serve as a down payment on another property.  To fully understand this, you may want to revisit the powerful concepts of leveraged appreciation and inflation-harnessed debt destruction which we fully explain here, here, and here.

Does that mean you would refinance a property once your equity position reaches 25%?  Not necessarily, because of soft costs/closing costs and other costs that are transactional in nature.  Your mileage may vary.

Does that mean you would refinance a property at 40% if your new prevailing interest rate would be higher?  Not necessarily – you’d want to make sure your cash flow position with the new debt in place didn’t go backward.

Admittedly, some of us simply sleep better if we have no home debt, and I always say life’s too short to do what won’t let you sleep well.

And some of us simply don’t like payments.  Even though “always having a payment” does include an economic eventuality of “higher net worth and greater cash flow” if debt is used responsibly. That, ladies and gentlemen, is the basis for the “equity is unsafe” assertion (in my opinion).

Here’s another example that can be used to underscore this position:  Should the market value of your home plummet because the market went down, you no longer have that amount of home equity.  Sure, the market will probably come back, but you don’t know when.  Equity that accumulates in a home ownership situation depends not only on what you owe, but the current market value.  If you have equity that you plan to extract but don’t get around to it, your equity could vanish into thin air overnight.

As an overall summary, I agree with Keith Weinhold if the topic pertains to debt that 1) could be harvested and leveraged for additional return and cash flow, provided that 2) there is sufficient passive income and an emergency fund in place to service the debt.

No one wants a repeat of the Great Recession and the misadventures experienced by over-leveraged investors.

(As an aside, when financial circumstances cause borrowers to fall behind on their debt obligations, banks typically target homeowners with lots of equity before they attempt to repossess a home with little or no equity.  Why would they go through all the hassle and expense of foreclosing on a home that is barely worth what is owed when they could instead foreclose on a home that has a high amount of equity?)

I would disagree with Keith Weinhold if 1) one is referring to equity in a primary residence AND 2) there is no plan to re-leverage and re-invest any harvested equity or if improved cash flow and an emergency fund are not part of the picture.

2. “Home equity is illiquid.”

It’s hard to disagree with this one.  Real estate in general is illiquid.  If you have 100% equity in your home or any investment property, you have to sell or encumber the property with debt to convert its equity to cash.

Real estate is easy to get into, but hard to get out of.  You don’t know how the market will behave at any given moment, and buyers may or may not want what you have to sell.

If you make a decision to place that cash windfall against your mortgage as a principal payment, you are at the mercy of your mortgage company should you ever want to get it back.  They may give in back – but only on their terms and definitely associated with more costs.

I agree, home equity is illiquid.

3. “The rate of return of home equity is always zero.”

It’s typically easy to argue with a statement that includes “always” or “never”.  That said, I can’t find too much wrong with this statement.

If I were in an argumentative mood, I would point out that:

If you create home equity on your primary residence by paying down extra principal, there is indeed an incremental return you receive by no longer paying interest on the principal balance that was reduced.  Diminished by, of course, your marginal tax rate since home mortgage interest is a tax deduction (subject to certain rules).  And mortgage interest paid on an investment property loan is an expense and deduction for that property.

Indeed, “If I pay an extra $100 toward principal on my 30-year mortgage, I’ll never pay interest in that $100 again” (provided there’s no prepayment penalty).

But…that kind of thinking is representative of a scarcity, or “glass is half full” mindset.  You knew what the payment on your mortgage would be when you signed the mountain of paperwork.  Unless you are really motivated to get rid of that mortgage ASAP and have a plan in place to do it, your extra $100 per month would command a larger return by serving as a down payment on another property.

In summary, I would change the “home equity’s return is always zero” claim to “the return on home equity is incrementally small.”  But in spirit and intent, I agree.

The type of thinking espoused in the “Home equity is unsafe, illiquid, and its rate of return is always zero” mindset goes against the grain of conventional financial advice.  Its contrarian nature is in the same league with Warren Buffet’s “Be greedy when others are fearful, and fearful when others are greedy.”

A tale of two investors:
     
 “Safe Sam” invested in real estate by purchasing cash-flowing, single and multi-family properties with decent cash flow.  Averse to any additional debt, he dutifully paid off each mortgage early if cash flow allowed and stuck every extra dollar into paying them off early.  He only purchased additional real estate when his savings allowed him the opportunity.
 
“Smart Leverage Louie” did the same thing, except that he remained aware of his properties’ market value compared to his mortgage balance.  When there was enough equity to pull out a down payment for another property purchase, he did exactly that. (If circumstances allowed extraction of an amount equal to his initial investment on any property, his return was thereafter infinite!)  He was careful to maintain good monthly cash flow and didn’t ever invest in a speculative manner.  He always maintained an emergency fund to guard against a black swan event or other unknown.  
 
30 years later, “Safe Sam” will have achieved good cash flow, perhaps even enough to satisfy his regular monthly expenses.  He is flirting with financial freedom at that point.
 
“Smart Leverage Louie”, however, will have built substantial, generational wealth due to his harnessing of leveraged appreciation and inflation-based debt destruction.
 
This is not hypothetical – it is a guarantee.

If I had to boil it down, I would make this recommendation:

“Become educated, and then think for yourself.”

That would be my saying.

Until next time,

Dr. Lee Newton

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