Home Equity, Does it Earn a Rate of Return? Is it a Prudent Investment?

“My house is earning a great rate of return, I am so glad I have my equity there.” Many homeowners mistakenly believe this statement is true. They send extra payments to their mortgage company thinking this will enhance their homes appreciation. They ‘invest’ extra mortgage payments in their homes equity. Alternatively, they buy a new home ‘reinvesting’ all their previous home’s equity. In both cases thinking they are earning a great rate of return and making a prudent investment. Unfortunately, they don’t know what they don’t know.

That is, home equity has no rate of return and it is not a prudent investment.

First, let us illustrate why equity has no rate of return with two examples. For simplicities sake we will assume a $100,000 home and a five percent real estate appreciation rate in all the examples.

1. A $100,000 home with 100 percent equity appreciates at 5% over one year to $105,000.
2. A $100,000 home with zero percent equity appreciates at 5% over one year to $105,000.

In both examples, the house appreciated five percent regardless of the amount of equity in the house and was worth $105,000. The amount of equity in the house had no impact on the appreciation of the house. Therefore, keeping your money locked-up in equity in your house is not increasing your rate of appreciation. If the amount of equity does not improve your rate of appreciation, then it has not earned a rate of return. In addition to not earning a rate of return, equity is not a prudent investment because; equity in a house is not safe or liquid. It is not safe because housing prices can drop and your equity does with it. It is not liquid, because the only ways to access your equity is by selling your house or borrowing the equity from the bank. Let us explore these two topics.

Home equity is not safe.

Rate of return aside, let us look at equity from a safe investment standpoint. The point of investing is to make money. To make money on an investment there needs to be a positive rate of return. With a negative rate of return, you lose money, and with no rate of return, your money just sits there. Since equity has no rate of return, which means no interest rate is compounding and making it grow. The only way that equity changes is with the unpredictable fluctuations in the real estate market. In a falling market, equity locked-up in a house can shrink significantly.

Home equity is not liquid.

Liquidity is a big problem with equity and real estate in general. In the worst case, you need the money for an emergency. The only way to access your money is to take out another loan. If you are out of work or disabled, can you qualify for a loan? Fat chance your banker will say yes to a loan. Banks are rarely in the business of lending money to people who really need it. That means the only way to have a chance of getting that money trapped in equity is to sell the house. If you are a buyer and you know the seller is out of work or disabled then are you going to offer them their selling price or will you wait and offer them less? If it sits on the market for too long-the bank, which is fully aware of the amount of equity build-up in your house, swoops in, and repossesses it.

What is the solution for trapped home equity?

The solution is Home Equity Management. This concept is based on four premises:
(1) your home equity should be liberated from the illiquid brick and mortar of your home;
(2) your liberated home equity must be safely and prudently invested;
(3) your liberated home equity must earn a predictable compounding rate of return-better if this is also tax-deferred; and
(4) a positive interest rate arbitrage between the mortgage interest and the investment rate of return.

1. Equity can be liberated–cashed out– either with a home equity loan or refinancing the existing home loan. This is the fist step in protecting your equity from the inherent liquidity problems of brick and mortar real estate.
2. Once liberated it should be prudently invested in liquid financial instruments free from market risk fluctuations. Instruments such as investment grade municipal bonds, tax-deferred annuities, indexed annuities, or investment grade life insurance contracts.
3. All these prudent financial instruments earn a predictable compounded rate of return. These investments also contain guaranteed elements which create predictability in the rate of return. In addition, they all earn either a tax-free or tax deferred rate of return.
4. The compound rate of return on your invested home equity should be equal to or greater than the simple interest on the mortgage to create a positive interest rate arbitrage. If the mortgage’s interest is tax deductible, this enhances the interest rate arbitrage.

Your home equity when properly managed using these four premises becomes a valuable and flexible part of your financial pan. Provided, that is that your cashed-out equity is invested in a safe and predictable vehicle, where there is liquidity and guarantee of principal, compounded interest rates in a tax free environment–such as one option listed-in an investment grade life insurance contracts. Then your equity can grow tax deferred and unaffected by market fluctuations. In this situation, the money is also highly liquid. It can be accessed free from income tax. In many cases, it can be far more valuable than 401(k)’s and IRA’s which are taxable at retirement. Furthermore, when it is all said and done, by investing in a investment grade Universal Life product you leave a sizable death benefit to your heirs, all from money that would otherwise be sitting in some mythical land where it is called equity, earning nothing.