Equity Management 101

Investing Equity: Safety, Liquidity, Rate of Return

It may be 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: Home Equity is NOT safe or liquid. To understand this point better, let’s start with a few definitions.

Equity: The difference between fair market value and all of the loans against your property (first and second mortgages or home equity loans) combined.

Safety: The risk of loss of your investment
There are two likely ways you can lose the wealth in your house – depreciation and foreclosure. Unlike most investments, you must make regular 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 reasons for foreclosure are 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 (the ability to pay the loan) 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. Properties with the highest equity and lowest mortgages get foreclosed on sooner, as doing so allows banks to recoup most of their initial investment.

Liquidity: The ability to use and/or control your investment
To understand why home equity is not liquid, it is helpful to illustrate the liquidity characteristics of different types of assets and investments.

Cash – This is 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, usually accessible via same day transactions

Home Equity – Getting access to your home equity can take longer than you realize. A home equity line of credit can take at least a few weeks, refinancing easily requires a month or two and selling your home can take between two to six months.

Why is the issue of liquidity so important? Because in times of emergency, you need the ability to get access to your assets as fast as you can.

Return: The earnings on your investment
What if you learned that a large majority of your wealth was earning a “guaranteed” 0% rate of return and because of inflation was most likely earning a negative rate of return? Would you view this asset differently?

Many people have a misconception that because their home appreciates or their mortgage balance decreases 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 equity trapped in your house actually loses value over time. Every year, the prices for goods and services go up. If your equity is simply sitting stagnant in your home, it is not earning anything on behalf. Instead, your equity loses value over time and cannot buy as many goods or services in the future.

In Summary
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 how you can leverage the equity in your home to conserve it ~ not 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. Contact Us to learn more.