Myth: Tapping Home Equity Brings Wealth

The Word on the Street

The latest financial fad has financial planners advocating plans wherein the client (you) takes home equity loans or refinances their house to take out the equity in it, and then invests these funds (preferably in a cash value life insurance policy). These pros contend that this is the best route to riches.

The Truth

Although this plan has academic merits, and can look very appealing on paper, it is also highly risky, not to mention being completely out of the financial capabilities of the large majority of American households.

Doubt Me? Let’s take a long look at the pros and cons of this strategy.

Mortgage Leveraging, What is it?

First of all, let me define what I mean by “leveraging”. Leveraging is when you borrow money to invest it. It has the phenomenal ability to multiply your investment returns. But beware, this multiplicative power works two ways; since your gains are huge, your losses are also huge, should the market turn the wrong way.

The mortgage leveraging plan runs like this: say you have a home on which you owe $200,000, but has recently been appraised for $350,000. This means that you have $150,000 in home equity built up. According to the leveraging plan, you would be well advised to refinance your home, taking out a fresh mortgage of $280,000 and paying off your old loan balance of $200,000. This would leave you with $80,000 of cold hard cash to invest, which you do. Your new loan has an interest rate of 7%, but, after you take your tax deduction, it really only winds up costing you 5.25% (at a 25% tax bracket). This is a low number that is easily beaten by the market, especially if you invest on a tax-deferred basis, such as in an IRA or life insurance policy. Since $80,000 is well beyond the allowable annual contribution allowed for retirement plans, the best remaining option for your home equity money is in a cash value life insurance policy. You invest your money, and, over the long run and on the average, you earn 8% per year. The difference between what you earned and what you paid in interest is called your marginal rate of return, and, in this case, equals a 2.75% gain on your home equity that otherwise would have had none.

The Nutshell

This is an extremely complex financial issue, and the post that fully analyzes it is quite long. Here is the quick-and-dirty breakdown of the ups and downs.

The logic of this strategy is undeniable, and it seems, on the surface, as though it really is as great as they make it out to be. These are the conditions under which a mortgage leveraging strategy might work:

  1. Your investment vehicle must be able to consistently outperform the market as a whole over the long run.
  2. Your mortgage payment is currently a relatively small portion of your income.
  3. In order to get a good rate, you must have good credit. Poor credit leads to higher interest costs on the mortgage and raises the required return on the investment.

Here’s a few of the pitfalls to be aware of:

  1. Inability to make larger mortgage payments on equity loans. If it takes too much of your income to make payments on the equity, then you will place yourself under undue stress.
  2. Tax-sheltered retirement plans have contribution limits. These limits may prohibit you from getting tax breaks on your investment growth, which will make it harder to make a profit on your equity. In 2007, this limit was $5,000/yr for most retirement vehicles. (source)
  3. If you use a life insurance policy as your investment vehicle, be aware that the cost of the life insurance policy may be quite high. Be sure to check into the costs and evaluate what effect they will have on your investment’s ability to outperform your mortgage interest.
  4. Be aware that your investment advisor probably stands to make a huge comission if you choose to invest your home equity, especially if you choose life insurance as the vehicle. If possible, try to get an unbiased second opinion.

That’s the very very short of it. For a more in-depth analysis, keep reading!

Sign Me Up!

Here are some of the arguments used to promote such an investment strategy:

  1. Your home’s value continues to appreciate regardless of how much equity you have in it, so you might as well invest the equity and double the growth.
  2. By pulling out your equity, you provide yourself with some liquidity (ability to convert assets into cash at need). If you should become unable to make your mortgage payment, you can simply pull funds out of the investment account to make your mortgage payment and thus keep your home in hard times.
  3. Since the interest on your mortgage is tax deductible, this can help you pay fewer taxes.
  4. What if interest rates are high? Not to fear, market rates of return tend to run parallel to interest rates, so your investment will always outpace your loan.
  5. Since you do get a tax break on mortgage interest, this lowers the effective rate of interest that you pay.
  6. Life insurance policies grow tax-free, and a lump deposit will buy insurance for life!
  7. You qualify for a loan based not upon your equity, but on your income. Therefore, you should pull out your equity while you are employed so that it can be used when you are unemployed.

Let’s take a look at these arguments.

Argument 1

Very true. Your home will appreciate regardless of how much is owed on it. Since your home equity represents gobs of your of money that is essentially doing nothing, it would seem logical to invest those funds so that they can grow.

Argument 2

My favorite of these arguments. If you have $70k in the bank when you lose your job, you can continue to make all of your critical payments without being foreclosed on. This is definitely a plus of this plan.

Argument 3

Also valid. Tax savings lower your effective interest rate on your mortgage, and put cash back in your pocket. But you still wind up paying more than you save (for a detailed discussion of tax benefits of home ownership, see this post).

Argument 4

Really only vaguely true-ish. What is true, and the source of this “misunderstanding” is that when the Federal Reserve Board meets and establishes a high base interest rate for the economy, this is generally a sign of good economic health. When interest rates are lowered, it is (again, generally) a sign of deteriorating economic conditions. Thus, when rates are low, the stock market performs poorly, and vice-versa.

At least, this is the argument maintained by advocates of mortgage leveraging. But just take a look at the recent economic conditions; interest rates are at all time lows, and the stock market is performing poorly. But the stock market performance is in no way correlated to the actual costs of a mortgage today. If you are paying 6% for your mortgage, you would be disappointed if you expected to see the stock market give you 8% or 10% this year, as some mortgage leveraging proponents would tell you. You would find that you are taking a loss this year, in some cases, a substantial loss. The graph below shows historic mortgage rates superimposed upon historic annual rates of return for the S&P 500 (generally considered by financial professionals to be a fair representation of “the market” as a whole). Do you see strong correlation here? I don’t. There is a general tendency for interest rates to drop when the stock market drops, but it certainly is not a 1:1 correlation, and the market rates are always lower than the mortgage rate.

HSH Market Trends: 30-year FRM, Last Three Years

Argument 5

Also technically true, but deceptive. The tax break does reduce your EFFECTIVE interest rate, but not your ACTUAL interest (the one which determines your payment). The only way the tax break would affect your payment would be if you used it to reduce the amount you must pay out-of-pocket each month. The tax break could be added to your investment portfolio (as I did in my spreadsheet analysis) to increase the effective rate of return there.

Regardless, any returns you get from your investment will be automatically reduced by the amount you pay in interest to the bank. In the example above, the loan was issued at 7%. This means that any return your investment gives automatically gets a -7% tacked onto it. Here is where we get into the dangers of leveraging. In years of moderate growth or small downturns in the market, your equity account can lose a great deal of money. Very high returns are required to overcome the costs of the mortgage (and insurance costs, if you choose an insurance vehicle).

Argument 6

Technically true, but misleading. Even though you are not making regular payments into the fund, you are still paying the cost of insurance every month. These costs are necessary to any life insurance policy and most people do need life insurance. So if you gotta pay for it, why not get some benefit? It’s a good point. The problem, however, is that in their much-touted calculations, the pros fail to account for the draining effect of the cost of insurance on the value of your invested equity. For deposits of the size we are talking about with mortgages, the life insurance policy would have to have a very large death benefit in order to be able to legally accept funds of such magnitude. And a large death benefit naturally incurs a large cost to the investor. Plus, you could get a term insurance policy, which is much cheaper (often 80-90% cheaper) than a cash value policy of any kind, and invest the difference, thus giving your funds a positive boost, rather than a negative drain. To do so, however, you must place your equity investment into a taxable vehicle, and the drains on that are likely to exceed the drains of the life insurance. To sum up; the cost of insurance and the cost of the mortgage both add negative growth to your invested equity, and make it that much harder for you to get ahead.

Argument 7

The twin brother of argument 2. If you do need to access your equity for some emergency, but have lost your source of income, you will find it impossible to obtain your equity because your income has dried up. This is a valid point, and one I agree with. If you are going to pull out your equity, you need to do so while you can, because when you need it, it will not be available to you.

Argument 8

What? You thought there were only 7 arguments? Well, this is an argument in favor of lmortgage leveraging, but not in the way you might think. It’s an important point for any person considering this strategy to consider, but they will never hear it. Why won’t the client hear this argument? Let me tell you the argument, and leave it to you to answer that question.

Financial planners make huge commissions selling cash value life insurance policies, and the bigger the death benefit, the better.

I think it might surprise you to learn where I first heard of the “mortgage leveraging strategy”. As a financial professional, I am obligated to attend continuing education classes to keep my licenses current. I was a little surprised to attend a LIFE INSURANCE continuing education class and have the entire time dedicated to the virtues of mortgage leveraging. Why was this concept taught at a life insurance class? Because the advisers and life insurance companies make tons and tons of money selling high death benefit policies. The commission a planner gets for writing a cash value life insurance policy will give him/her a commission that can be up to 5x greater than the commission for a mutual fund representing an equivalent cash investment.

Let me just add that I am not mentioning this point to frighten you away from using financial advisors. I think a goodly many financial planners and advisers are in the business to help people, but you should be wary because there are planners out there who are somewhat predatory, and will not be afraid to put their interests ahead of yours. I am also not saying that I am opposed to using cash value life insurance policies (in fact, I think the only way I would ever consider mortgage leveraging is within one specific type of cash value life insurance policy). They can be very useful to certain people. But I think it is important for you, the client, to be aware of the potential conflict of interest.

Pit Stop

You may want to pause and get a drink or stretch your legs before you continue. I know this post is very long, but there is a good reason for that. This is an extremely complicated financial issue, affecting almost every single aspect of a personal financial plan. If you are ready, let’s keep going.

The Downside

Let’s take a look now at some of the more problematic areas of the strategy.

It is expensive. One of the troubles of this approach is the massive mortgages that have to be taken out to support it. You may be able to afford a $300,000 mortgage now, but when that has ballooned to $520,000 in ten years and its time to refinance, can you afford a near doubling of your mortgage payment? You can’t take the money out of your investment earnings to make the payment without sacrificing your compound interest, and thus, destroying the whole system. So, who can afford such a system? Only people whose income already vastly outstrips their mortgage payment. How many people do you know who can afford to double their mortgage? Sure, many people’s incomes will increase. But will it be enough? And what about those people who are already at the peak of their careers? Refinancing restrictions. Generally, a bank will not allow you to withdraw more than about 80% of the equity in your home through a refinance or home equity loan. This means that the amount that you will be able to pull out of your home will be substantially reduced, which reduces the amount you have to invest and the subsequent interest you may earn. Closing costs. Ah, closing costs. The great money maker of the mortgage lending machine. I will do another post that goes into detail on what these beauties do to your mortgage. All you need to know now is that you can expect to pay anywhere from 3%-5% of the principal of your loan in closing costs whenever you take out a mortgage. This includes refinances. So, each time you refinance to pull out more equity to invest, you will pay dearly for the right to borrow your own money. It doesn’t seem particularly fair when you think about it that way, but it’s the truth. These closing costs are yet another factor that cuts deeply into the equity investments long-run results. Increased risk. While having some cash in savings from your equity on hand to make your mortgage payment is a good idea and reduces your risk, the overall risk of leveraging your equity is quite high. First of all, if you should experience a drop in value in your equity account at the wrong time, then you may not have the funds you need and you can lose your home easily. Secondly, if you refinance periodically, you run the risk that interest rates will rise. As we have seen earlier, higher interest rates does not promise, in any way, that your investment will return higher yields than your mortgage charges.

But my adviser showed me the numbers and it works, big time!

Have you ever heard the expression “you can prove anything with statistics”? Everybody knows that stats can be tweaked and tortured until they beg for mercy and willingly confess whatever the statistician wishes them to confess. Well, financial calculations can be like that a bit as well. The reason for this is because financial calculations can quickly become extremely complex when you try to incorporate every applicable factor (that’s why financial analysts are so well paid). So, whenever someone wants to try to convince someone of a certain financial “fact”, all they have to do is omit, for the sake of “simplicity”, certain details. Often, long-term averages for market growth are shown, rather than actual results. While the market will PROBABLY tend towards the average, the specific timing of market drops can be crucial, and the regularity of those drops can also be crucial. You will ALWAYS get different results in reality than is shown in projections.

I have seen a number of calculations involving leveraged mortgages, and they all show that the person who pays off their home is stupid and broke, while the savvy, hip, young financial guru is sipping martinis in the Bahamas with their multi-million dollar retirement. In these calculations, all you are shown is the final dollar value of the investment vehicle. You are not shown any costs, losses, or remaining equity (because there presumably is no equity in the home, or very little). But what matters at the end of the day is not just what is in your retirement account.

Perhaps the biggest factor contributing to the deceptive nature of these calculations is their simple incompatibility with each other. In finance, it is very important to put everything into the same terms. In other words, you must compare apples to apples. When the pros show you a calculation that shows $1 million more in the leveraged equity account than in the paid off home, what they are not showing you is the cash flows behind the strategies.

Here is a quick example:

Jill is considering purchasing a $250k home in an area where homes are appreciating at 5% per year, on average. If she gets a 30 year traditional fixed rate mortgage, her payment will be $1,555 each month (at 6.35%). Now consider the alternative. Bill can get a 30 year mortgage that is interest-only for 10 years, and will refinance his home every 10 years. This would give him a payment of $1,322 (at 6.35%). Ten years later, he refinances. His home has appreciated such that his new loan has a principal of $325k, and a payment of $1,723 (at 6.35%). Ten years after that, he refinances again, this time taking a loan of $530k, with a payment of $2,808(at 6.35%). At this point, Bill’s advisor will tell us that the Jill has no savings, while the Bill has $1.2 million in savings.

Seems like a no brainer, right? Well, not really. Consider this: Bill spent/invested $850k while Jill has spent/invested only $560k. That is a huge difference, especially if those funds are placed into interest-bearing accounts. In this scenario, also think about this: since Jill has a significantly smaller payment, why can’t she be investing some each month? Equity leveraging advocates will show you success by using uneven cash flows. How could Jill possibly have as much money in the bottom line if she spent half of what Bill did? If you balance out the cash flows (ie let Jill invest the same amount of money that Bill spends on his mortgages), you will see that Jill comes out with the same funds, or maybe even more. It depends on a large number of variables, but basically, leveraging the home increases your risk, while giving you lukewarm results.

Taking all these factors into consideration, I have tried to incorporate the following principles into my analysis:

  1. Inclusion of ALL costs associated with each approach. I have been equally brutal towards the 30 yr and 15 yr traditional mortgage payoff approaches as I have towards the refinancing approach. I have included closing costs, refinancing restrictions, tax costs (investments are considered to grow in taxable vehicles because life insurance policies may not be the best place for those funds and because taxes are easier to estimate than life insurance premiums).
  2. I have used the actual S&P 500 returns for the past 30 years in my analysis. The reason for this is simple. Often, long-term averages for market growth are shown, rather than actual results. While the market will PROBABLY tend towards the average, the specific timing of market drops can be crucial, and the regularity of those drops can also be crucial. You will ALWAYS get different results in reality than is shown in projections. By using the actual results, I hope to get a more accurate reflection of the market’s tendencies.
  3. Equivalent cash flows. The monthly cash outflow, whether to the investment or to the mortgage, is the same for each mortgage type. This makes it so that each plan spends the same amount of money so that the ending net worth can be profitably compared.
  4. Tax benefits. In my spreadsheet, I have taken account of the advantages of mortgage interest tax deductions for all types of mortgages. In this case, I have taken each year’s tax returns due to the mortgage interest tax-deduction and placed them into the investment account.

Let’s look at the numbers

Use this spreadsheet to run your own numbers, in a way that makes sense to you. I have found that, in general, it takes an exceptional combination of good fortune for the mortgage leveraging to really pay off. Have you noticed that the 30 year fixed rate loan actually returns the highest net worth to the investor? It actually beat the 15 year loan, and I’ll tell you why. I used the actual rates of return for the past 30 years as the interest rate that the invested funds grow at. Because the 15 year loan got a late start, it was more adversely affected by the giant market drops of 2002 and 2003. Notice that if the long-run market average rate of return is used as the growth rate, then the 15 year loan returns jump significantly, and surpass es the 30 year loan (see the sheet for the year-by-year breakdown of the 15 year loan for this comparison). It just goes to show that market volatility never quite mirrors the results you see when an average rate is used for every year.

Equity Leveraging Spreadsheet

Here is a spreadsheet on evaluating the equity leveraging.

Conclusion

While there is a chance that using this strategy will put you on top, the amount by which you come out on top is usually relatively small, and the risk level associated with a leveraging strategy is quite high.

In order for this strategy to work, high investment returns are required. While there are many people in this world who are convinced that they can get very high returns every year over the market rate of return, but as Burton G Malkiel, in his time honored book A Random Walk Down Wall Street, explains, no money manager in the recorded history of the stock market has ever beaten the stock market returns for more than a few years at a time. If you are convinced that you can beat the market by significant amounts, then this approach should definitely bring great wealth. But, if you are wrong, then you could be in serious danger.

The best argument of this theory is the liquidity provided by pulling your home equity while times are good. If you choose to pull your home’s equity, I recommend using an Equity Indexed Universal Life insurance policy for your funds. These are great funds because the insurance company will guarantee that your account will never decrease in value; in exchange, they place a cap (usually around 10% or 11%) on how much your account can grow each year. By using an account like this, you can avoid costly taxes and mitigate much of the risk of losing your equity to a market slump. But be aware of the costs of such a life insurance policy. While you may still wind up losing money, it is likely to be a small loss. This is, in essence, like purchasing mortgage insurance for yourself, just in case times get hard, and and loss you may take should be considered a “cost of insurance”. Of course, you could also make a profit, in which case you may want to buy some champagne and pat yoursel fon the back.

Alternatively, instead of pulling out most of your equity in a lump, you can establish a home equity line of credit to accomplish much of the same purpose. With a line a credit, you can basically use your house as an EMERGENCY credit card, and pull out only as much equity as you need to keep making your payments long enough to get back up on your feet. Be very very careful of the temptation to use your home equity credit line when the need is not terribly dire. Such a casual burning of your equity will put you in grave risk of losing your home.

For more information and ideas on this topic, check out this article.

Posted on 2 Jul 2008