Is Unused Home Equity a "Missed Fortune"?

18 July 2005, Reviewed July 10, 2007, Reviewed November 23, 2008, May 1, 2011

"I don’t understand why a Wharton professor would not recognize that unused home equity is a missed opportunity… Isn’t home equity safer in a conservative side fund than buried in the house earning a 0 percent return?"

The New and Old Wisdoms of Household Finance

Your view reflects a new "wisdom" of household finance that has emerged in recent years. It says that if you have excess cash flow, you should purchase financial assets rather than pay down your mortgage balance. And if your house appreciates, you should take a second mortgage or refinance the first for a larger amount ("cash-out"), in order to invest.

This view contrasts sharply with the received wisdom of my father’s generation, which was that a mortgage should be paid off before you retired. That way, you would not have a repayment burden when your income dropped at retirement.

There was a well-grounded exception to that rule: young homeowners in the early stages of building a business had good reason to invest as much cash flow as possible in the business rather than in mortgage repayment. This made sense because such homeowners could often earn a return on investment in their business that was materially higher than the rate on their mortgage. If the business failed, they were young enough to learn from their mistakes and try again.

The received wisdom of old was thus a conservative rule applicable to most homeowners, combined with an exception for the young entrepreneur. The new wisdom in effect converts the exception of the old wisdom into the rule for everyone. Households should manage themselves as if they were businesses, and unused equity is missed opportunity.

Shaky Premises of the New Wisdom

The premise of the new wisdom is that households can invest home equity profitably. If you can earn 13% on your investments and your mortgage only costs 6%, it doesn’t matter that you still have a mortgage when you reach age 70 because your financial assets will more than cover it. What matters is your wealth -- assets less debt -- and that will be higher.

But will it? In my view, the majority of households cannot invest at a profitable spread over the cost of their mortgage without taking significant risk. And this means that they can end up richer or poorer, depending on how their investments turn out.

Consider the borrower with excess cash flow who is choosing between additional mortgage repayment and purchase of financial assets. The rule for maximizing your wealth is to invest in the one yielding the higher after-tax return, adjusted for risk. Investment in loan repayment yields the mortgage rate and has zero risk, which for most borrowers is hard to beat.

It does happen occasionally. A borrower in the 35% tax bracket with a 4.75% mortgage recently asked me whether she should repay the mortgage or invest in a 529 education fund. Her after-tax return on mortgage repayment was only 3.09% -- 4.75x (1-.35) -- and since earnings on a 529 fund are tax free, the yield on that fund had only to exceed 3.09% to be the better choice.

But this was an unusual case: her mortgage rate was low, her tax rate was high, and her preferred investment was tax-exempt. A taxable investment would have to beat 4.75%. If the mortgage rate had been 6%, a taxable investment would have to beat 6%.

The major target of the new wisdom is the homeowner with significant equity, who is being persuaded to borrow against it in order to invest at a profit. The borrowing cost that the investment return must beat is the cost of a new mortgage, either a second mortgage or cash-out refinance. This is usually higher than the rate on the borrower’s existing mortgage, making it that much more difficult to find an investment that will yield a margin over the cost.

The New Wisdom is Driven by Financial Interest

The recent boom in house prices has increased the size of the target market enormously. While few households have a business in which to invest, no problem, the loan officer/planner/financial advisor will advise them about investments.

The new wisdom is supported by an enormous amount of financial self-interest. There is money to be made on the new mortgage, and on the investment. The intermediaries in the process take theirs off the top. For the household to end up richer, however, the investment return must exceed the borrowing cost over a long period. Since investments that yield a return higher than the household’s borrowing cost carry risk, the household can also end up poorer.

In my view, risk-taking of that type is for a business, not a household. The old wisdom made more sense.

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