Equity Management 101

Understanding Safety, Liquidity and Rate of Return

Why home equity is not a prudent investment

It's surprising to hear that home equity is a risky investment, but it's true. One of the largest assets on a family's balance sheet is their home, yet many people continue to mismanage the equity in their home.

Every homeowner should know this important fact: home equity is not safe or liquid. To clearly understand this issue, it helps to start with a few definitions:

• Equity is the difference between fair market value and all of the loans against your property.                       

          For example     $500,000.00 Fair Market

                                - 400,000.00 Value Loans

                                =100,000.00 Equity

• Saftey is the risk of loss of your investment
• Liquidity is the use and control of your investment
• Return is the earnings on your investment

Regarding Safety: There are two likely ways you can lose the wealth in your house - depreciation and foreclosure. Unlike most investments, you must make regular debt service payments to retain access to the wealth in your house. If you can't make these payments, you can lose control of your equity. The most common reason for foreclosure is disability, with other factors including loss of job, divorce, or death of spouse.

One of the biggest secrets in real estate is that your mortgage is a loan against your income, not a loan against the value of your house. As your home appreciates and your loan-to-value ratio goes down, you become less safe. Real properties with the highest equity and lowest mortgages get foreclosed on sooner, as doing so allows banks to recoup more of their initial investment.

Regarding Liquidity: To understand why home equity is not liquid, it's helpful to illustrate the liquidity characteristics of different types of assets and investments:

• Cash - this is obviously the most liquid of your assets. You can access it instantly via check, debit card or cash in hand.
• Stocks and Bonds - these are also fairly liquid assets, usually accessible via same day transactions.
• Home Equity - getting access to home equity can take longer than you think. A home equity line of credit can take at least a few weeks, refinancing easily requires a month or two, selling your home can often take two to six months. Why is this important? Because in times of emergency, the waiting period to get access to your home equity makes it illiquid - meaning you don't have use or control of it in times of emergency.

Regarding Return: What if you learned that a large majority of your wealth was earning a "guaranteed" 0% return and because of Inflation most likely earning a negative rate of return? How might you view this asset differently?

Many people have a misconception that because their home appreciates or their mortgage balance is going down that the equity in their home has a rate of return, but it doesn't. Since the equity in your home has no relation to your home's value, the equity is in no way responsible for your home's appreciation.

Due to inflation, the wealth trapped in your house actually losses value over time. Every year prices for goods and services go up and if your equity is simply sitting stagnant in your home, it is not earning anything on your behalf. Instead, your equity looses value over time and cannot buy as many goods and services in the future.

The takeaway?

When investing in assets or liabilities, you typically want the highest possible safety, the highest liquidity, and the highest return. We encourage you to contact us to find out how you can leverage the equity in your home to conserve it - not to consume it. By paying little down and using interest-only loans to leverage tax deductibility, you can be in a better position for your financial future.

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