how affluent manage home equity

8/14/2019 How Affluent Manage Home Equity

1/12

How the Affluent ManageHome Equity to Safely and Conservatively

Build Wealth

By Steven Marshall and Patrick Allman


2/12

How the Affluent Manage Home Equit2

he answer? Most of what we believeabout mortgages and home equity,

which we learned from our parents andgrandparents, is wrong. They taught usto make a big down payment, get a xedrate mortgage, and make extra principalpayments in order to pay off your loan asearly as you can. Mortgages, they said, area necessary evil at best.

The problem with this rationale is it hasbecome outdated. The rules of money havechanged. Unlike our grandparents, we willno longer have the same job for 30 years.In many cases people will switch careersve or six times. Also, unlike our grand-parents, we can no longer depend on ourcompanys pension plan for a secure re-tirement. A recent Gallup survey showedthat 75% of workers want to retire before

the age of 60, yet only 25% think they can.

Unlike our grandparents, we will nolonger live in the same home for 30 years.Statistics show that the average homeownerlives in their home for only seven years. Andunlike our grandparents, we will no longerkeep the same mortgage for 30 years. Ac-cording to the Federal National Mortgage Association, or Fannie Mae, the average

American mortgage lasts 4.2 years. Peopleare renancing their homes every 4.2 yearsto improve their interest rate, restructuretheir debt, remodel their home, or to pullout money for investing, education or otherexpenses. Given these statistics, its difcult to understand why so many Americans con-tinue to pay a high interest rate premium

If you had enough money to pay off your mortgage right now, would you? Many people would. In the American Dream is to own your own home, and to own it outright, with no mortgage. If American Dream is so wonderful, how can we explain the fact that thousands of nancially succe ful people, who have more than enough money to pay off their mortgage, refuse to do so.

T for a 30-year xed rate mortgage, whenthey are likely to only use the rst 4.2 yearsof the mortgage. We can only conclude they are operating on outdated knowledge fromprevious generations when there were few options other than the 30 year xed mort-gage. Wealthy Americans, those with theability to pay off their mortgage but refuseto do so, understand how to make theirmortgage work for them.

They go against many of the beliefs of tra-ditional thinking. They put very little money down, they keep their mortgage balance ashigh as possible, they choose adjustablerate interest-only mortgages, and most im-portantly they integrate their mortgage intotheir overall nancial plan to continually increase their wealth. This is how the richget richer.

The game board is the same, but while

most Americans are playing checkers, theafuent are playing chess. The good newsis the strategies used by the wealthy work for the rest of America as well. Any home-owner can implement the strategies of the wealthy to increase their net worth.

Ric Edelman, one of the top nancial

planners in the country and a New York Times Best Selling author, summarizes inthis book The Truth About Money,Toooften, people buy homes in a vacuum, without considering how that purchase isgoing to affect other aspects of their lives.This can be a big mistake, and therefore you must recognize that owning a home

holds very important implications for rest of your nancial plan. Althougne goal, owning a home is not the umate nancial planning goal, and in fhow you handle issues of home ownersmay well determine whether you achinancial success.

W HY P EOPLE F EAR M ORTGAGES , AND W HY Y OU SHOULDN T

In order to discover how our parenand grandparents got the idea that a mogage was a necessary evil at best, we mgo back in time to the Great Depressionthe 1920s a common clause in loan agrments gave banks the right to demand repayment of the loan at any time. Sithis was like asking for the moon and stars, no one worried about it. When stock market crashed on October 29, 19

millions of investors lost huge sumsmoney, much of it on margin. Back th you could buy $10 of stock for a $1. Sithe value of the stocks dropped, few intors wanted to sell, so they had to go tobank and take out cash to cover their mgin call. It didnt take long for the bato run out of cash and start calling loadue from good Americans who were fafully making their mortgage payments e

month. However, there wasnt any demto buy these homes, so prices continuto drop. To cover the margin calls, brkers were forced to sell stocks and onagain there wasnt a market for stocksthe prices kept dropping. Ultimately, Great Depression saw the stock marketmore than 75% from its 1929 highs. M


3/12

How the Affluent Manage Home Equity 3

money is not the same as making money.Or, put another way, paying off debt is not the same as accumulating assets. By tackling

the mortgage pay-off rst, and the savingsgoal second, many fail to consider the im-portant role a mortgage plays in our savingseffort. Every dollar we give the bank is a dol-lar we did not invest. While paying off themortgage saves us interest, it denies us theopportunity to earn interest with that money.

A T ALE OF T WO BROTHERSRic Edelman has educated his clients

for years on the benets of integratingtheir mortgage into their overall nan-cial plan. In his book,The New Rules of Money, Ric tells the story of two brothers,each of whom secures a mortgage to buy a $200,000 home. Each brother earns$70,000 a year and has $40,000 in sav-ings. The rst brother, Brother A, believes

than half the nations banks failed and mil-lions of homeowners, unable to raise thecash they needed to payoff their loans,lost their homes. Out of this the AmericanMantra was born: Always own your homeoutright. Never carry a mortgage.

The reasoning behind Americas new mantra was really quite simple: if the econ-omy fell to pieces, at least you still had yourhome and the bank couldnt take it away from you. Maybe you couldnt put food onthe table or pay your bills, but your home was secure. Since the Great Depressionlaws have been introduced that make it il-legal for banks to call your loan due. Thebank can no longer call you up and say,

Were running a little short on cash andneed you to pay off your loan in the next thirty days.

Additionally, the Fed is now quick to infusemoney into the system if there is a run onthe banks, as we saw in 1987 and Y2K. Also,the FDIC was created to insure banks. Still,its no wonder the fear of losing their homebecame instilled in the hearts and minds of

the American people, and they quickly grew to fear their mortgage. In the 1950s and60s families would throw mortgage burningparties to celebrate paying off their home. And so, because of this fear of their mort-gage, for nearly 75 years most people haveoverlooked the opportunities their mortgageprovides to build nancial security.

W HY P EOPLE H ATE T HEIR M ORTGAGE AND W HY Y OU SHOULDN T

Many people hate their mortgage becausethey know over the life of a 30 year loan,they will spend more in interest than thehouse cost them in the rst place. To savemoney it becomes very tempting to makea bigger down payment, or make extra principal payments. Unfortunately, saving

in the old way of paying off a mortg which is as soon as possible. Brothebites the bullet and secures a fteen-ymortgage at 6.38% APR and shells ou$40,000 of his savings as a 20% dopayment, leaving him zero dollars invest. This leaves him with a monthly

ment of $1,383. Since he has a combinfederal and state income tax rate of 32he is left with an average monthly net atax cost of $1,227. Also, in an effort to enate his mortgage sooner, Brother A sean extra $100 to his lender every month

Brother B, in contrast, subscribto the new way of mortgage plannichoosing instead to carry a big, long-te

mortgage. He secures a 30-year, intereonly loan at 7.42% APR. He outlays a s5% down payment of $10,000 and invthe remaining $30,000 in a safe, monmaking side account. His monthly paymis $1,175, 100% of which is tax deductover the rst 15 years, and 64% over life of the loan, leaving him a monthlyafter-tax cost of $799. Every month he a$100 to his investments (the same $1

Brother A sent to his lender), plus t$428 hes saved from his lower mortgpayment. His investment account earn8% rate of return.

Which brother made the right desion? The answer can be found by loing into the future. After just ve yBrother A has received $14,216 in savings, however he made zero dollarsavings and investments. Brother B, onother hand, has received $22,557 in tsavings and his savings and investmencount has grown to $83,513. Now, whaboth brothers suddenly lose their jobs? story here turns rather bleak for Broth A. Without any money in savings, he ha way to get through the crisis. Even tho

Common Home Equity Misconceptions

Many Americans believe the following state-ments to be true, but in reality they are

myths, or misconceptions:

Your home equity is a prudentinvestment.

FA L S E

Extra principal payments on your mortgage saves you money.

FA L S E

Mortgage interest should beeliminated as soon as possible.

FA L S E

Substantial equity in your homeenhances your net worth.

FA L S E

Home Equity has a rate of return.

FA L S E


4/12


he has $74,320 of equity in his home,cant get a loan because he doesnt havjob. With no job and no savings, he cmake his monthly payments and has choice but to sell his home in order to avforeclosure. Unfortunately, at this pointa re sale so he must sell at a discount, a

then pay real estate commissions.Brother B, while not particula

happy at the prospects of searching a new job, is not worried because has $83,513 in savings to tide him ovHe doesnt need a loan and can eaily make his monthly payments, even iis unemployed for years. He has reason to panic, as he is still in contrRememberCash is King!

Now, lets say neither brother lost job. Well check in on them after ft years have passed since they purchatheir homes and evaluate the results their nancing strategies. Brother A now received $25,080 in tax savings,has $30,421 in savings and investme(once his home was paid off he started sing the equivalent of his mortgage paym

each month), and owns his home outrigNot too bad, right?

Now lets check on his Brother. BrotB has received $67,670 in tax savings has $282,019 in savings and investmenthe chooses to, he can pay off the remainmortgage balance of $190,000 and still h$92,019 left over in savings, free and cle

Finally, lets assume that rather than off his mortgage at fteen years, Brothdecides to ride out the whole thirty yeof the loans life. While Brother A hasreceived only $25,080 in tax savings,savings and investments have grown$613,858, and he still owns his home oright. Brother B, on the other hand, has

A Tale Of Two Brothers Adapted from the book, The New Rules of Money

Our story begins with two brothers, each earning $70,000 a year. They each have $40,000 in savings and both are buying $200,0000 homes.

15- YEAR MORTGAGE AT 6.38% APR

$40,000 BIG DOWN PAYMENT

$0 LEFT TO INVEST

$1,383 MONTHLY PAYMENT (56% IS TAX DEDUCTIBLE FIRST YEAR /33% AVERAGE )

$1,227 MONTHLY NET AFTER -TAX COST

SENDS$100 MONTHLY TO LENDER IN EFFORT TO ELIMINATE MORTGAGE SOONER

RECEIVED $14,216 IN TAX SAVINGS

HAS $0 IN SAVINGS AND INVESTMENTS

What if both brothers suddenly lost their jobs?

HAS NO SAVINGS TO GET HIM THROUGH CRISIS

CAN T GET A LOAN EVEN THOUGH HE HAS $74,320 MORE IN EQUITY THAN HIS BROTHER BECAUSE HE HAS NO JOB

MUST SELL HIS HOME OR FACE FORECLOSURE BECAUSE HE CAN T MAKE PAYMENTS

AT THIS POINT IT S A FIRE SALE HE MUST SELL AT A DISCOUNT AND PAY REAL ESTATE COMMISSIONS(6-7 %)

OWNS HOME OUTRIGHT


HAS $613,858 IN SAVINGS AND INVESTMENTS

OWNS HOME OUTRIGHT

30-YEAR INTEREST -ONLY LOAN AT 7.42% APR

$10,000 SMALL DOWN PAYMENT

$30,000 REMAINING TO INVEST

$1,175 MONTHLY PAYMENT (100% IS TAX DEDUCTIBLE FIRST 15 YEARS /64% AVERAGE )

$799 MONTHLY NET AFTER -TAX COST

ADDS$100 MONTHLY TO INVESTMENTS , PLUS $428 SAVED FROM LOWER MORTGAGE PAYMENT WHERE ACCOUNT EARNS8% RATE OF RETURN



HAS $83,513 IN SAVINGS TO TIDE HIM OVER

DOESN T NEED A LOAN

CAN EASILY MAKE HIS MORTGAGE PAYMENTS EVEN IF HE S UNEMPLOYED FOR YEARS

HAS NO REASON TO PANIC SINCE HE S STILL IN CONTROL REMEMBER ... CASH IS KING!



Results After 15 Years



REMAINING MORTGAGE BALANCE IS $190,000 AND HE HAS ENOUGH SAVINGS TO PAY IT OFF

AND STILL HAVE $92,019 LEFT OVER , FREE

AND CLEAR



OWNS HOME OUTRIGHT SO STARTS FRESH AND ENJOYS THE SAME BENEFITS ONCE AGAIN

HAS $1,115,425 IN SAVINGS AND INVESTMENTS

Brother A believes inThe Old Way paying off the mortgage as soonas possible

Brother B believes inThe New Way carrying a big, long mortgage



5/12


ceived a whopping $107,826 in tax savings,has accumulated an incredible $1,115,425in savings and investments, and also ownshis home outright. He can start over freshand enjoy the same benets once again.Unfortunately, the majority of Americansfollow the same path as Brother A, as its

the only path they know. Once the path of Brother B is revealed to them, a paradigmshifting epiphany often occurs as they real-ize Brother Bs path enables homeowners topay their homes off sooner (if they chooseto), while signicantly increasing their net worth and maintaining the added benets of liquidity and safety the entire way.

SUCCESSFULLY M ANAGINGH OME

E QUITY TO I NCREASE LIQUIDITY ,S AFETY , R ATE OF R ETURN , AND T AX DEDUCTIONS

In 2003, Doug Andrew, a top nan-cial planner from Utah, was the rst toclearly articulate the strategy the wealthy have been using for decades in his book, Missed Fortune.The book is based onthe concepts of successfully managinghome equity to increase liquidity, safety,

rate of return, and tax deductions. Dougeducates readers to view their mortgageand home equity through a different lens,the same lens used by the afuent. Heshows how relatively minor changes inhome equity perception and position-ing can produce monumental long-termeffects in nancial security.

Many Americans believe the best way topay off a home early is to pay extra principalon your mortgage. Similarly, many nanceprofessors think a 15-year loan saves youmoney by reducing the interest you pay.However, Doug Andrew points out in hisbook, Missed Fortune,that this thinking isawed. If you do the math, you nd if youset aside the monthly payment difference

between a 15-year loan and a 30-year loan,as well as the tax savings into a safe sideinvestment account earning a conserva-tive rate of return, you will have enough topay your home off in 13 years (or in 15 years with $25,000 to spare!). Chapter onein Missed Fortunetalks about the $25,000

mistake made by millions of Americans whochoose the fteen-year loan.

Bellevue Mutual Mortgage teaches aneducational seminar for the public basedlargely on the Missed Fortuneconcepts. Inthe seminar, we break down the four key benets of integrating your mortgage into your nancial plan (increased liquidity,safety, rate of return, and tax deductions)

in order to look at each one in more detail.

Our goal is to help clients conserve theirhome equity, not consume it. We are oneof the few nancial planning rms who en-courage clients to secure debt in order tobecome debt free sooner.

In April 1998, The Journal of FinancialPlanning (published by the Institute of Certied Financial Planners) containedthe rst academic study undertaken on thequestion of 15-year versus 30-year mort-gages. They concluded the 30-year loan isbetter. Based on the same logic, wouldnt

an interest-only loan be better than amortizing loan? If mortgage money you 4-5%, the chances are pretty good you can earn 5% on your money. Interates are relative. In the 1980s, mon was costing 15%, but individuals cstill earn 15% on their money. Due to

tax deductibility of mortgage interest compounding returns, you can borrow ahigher rate and invest it at a lower rate still make a signicant prot.

L ARGE E QUITY IN Y OUR H OME C AN BE A BIG DISADVANTAGE

By having cash available for emergenand investment opportunities, most homowners are better off than if their equ

is tied up in their residence. Large, i

equity, also called having all your eggone basket, can be risky if the homeowsuddenly needs cash. While employed in excellent health, borrowing on a hois easy, but most people, especially reees, unexpectedly need cash when theysick, unemployed or have insufcientcome. Obtaining a home loan under thcircumstances can be either impossible very expensive.

How many of us feel when we go tobank we almost need to prove we do

Are you still doing this?Here is an extra $100

principal payment Mr. Banker.Dont pay me any interest

on it. If I need it back, Ill pay you fees, borrow it back on

your terms, and prove to you that I qualify.

Money you give the bankis money youll never see again unless you

renance or sell.


6/12


need the money before theyll loan it to us?The bank wants to know we have the ability to repay the loan. You can imagine how a conversation might go with your banker: Ibrought up your loan application up to theboard this morning and I explained to them youre going through some hard nancial

times, youre unemployed, your credit isnot so good and maybe they could lend yousome cash to get through these rough times.Their response was...Fat chance!

What many people dont realize is that even if theyve consistently been makingdouble mortgage payments for ve years ina row, the bank still has no leniency. If sud-denly they experience a nancial setback,

the bank will not care. They can go to thebank and plead, I never thought in a mil-lion years this would happen to me, but it did. Ive been paying my mortgage in ad- vance for years, how about if I just coast onmy mortgage payments for a few months?They get the same answer every time...Fat chance! Banks just dont work that way.Regardless of how much youve paid yourmortgage down or how many extra pay-

ments youve made, next months payment is still due in its entirety no matter what.

W HY SEPARATE E QUITY F ROM Y OUR H OME ?

In the book,Missed Fortune, Doug Andrew suggests people strongly con-sider separating as much equity as they possibly can from their house, andplace it over in a cash position. Why inthe world would you want to have theequity removed from your home? There areactually three primary reasons:

1. LIQUIDITY 2. S AFETY 3. R ATE OF R ETURN

These three elements are also commonly used as the test of a prudent investment. When evaluating a potential investment, ex-perienced investors will ask the followingthree questions:

1. HOW L IQUID IS I T ?

(Can I get my money back when I want it?)

2. HOW S AFE IS I T ?(Is it guaranteed or insured?)

3. W HAT R ATE OF R ETURN C ANI EXPECT ?

Home equity fails all three tests of a prudent investment. Lets examine each of thesecore elements in more detail to better un-derstand why home equity fails the tests of a

prudent investment, and, more importantly, why home-owners benet by separating theequity from their home.

SEPARATINGE QUITY TO I NCREASE LIQUIDITY

What is the biggest secret in real estate? Your mortgage is a loan against your in-come, not a loan against the value of yourhouse. Without an income, in many cases

you cannot get a loan. If you suddenly ex-perienced difcult nancial times, would you rather have $25,000 of cash to help you make your mortgage payment, or havean additional $25,000 of equity trapped in your home? Almost every person who hasever lost their home to foreclosure wouldhave been better off if they had their equity separated from their home in a liquid, safe,conservative side fund that could be usedto make mortgage payments during theirtime of need.

The importance of liquidity became alltoo clear when the stock market crashed inOctober of 1987. If someone had advised you to sell your stocks and convert to cash,they would have been a hero. Or, if you had

enough liquidity you could have weaththe storm. Those with other liquid ass were able to remain invested. They wrewarded as the market rebounded arecovered fully within 90 days. Howethose without liquidity were forced to while the market was down, causing thto accept signicant losses. In Missed

Fortune, Doug Andrew tells the story o young couple who learned what he cThe $150,000 Lesson on Liquidity1978 this couple built a beautiful home would be featured in Better Homes andGardens. The couples home appreciatin value, and, by 1982, it was appraisedjust under $300,000. They had accumulaa signicant amount of equity, not becathey had been making extra payments

the property, but because market contions improved over that four-year perio

This couple thought they had the woby the tail. They had a home valued$300,000 with rst and second mogages owing only $150,000. They made $150,000 in four short yea

Its better to have accessto the equity or value of

your home and not need it,than to need it and not be

able to get at it.


7/12


They had the misconception that theequity in their home had a rate of return when, in fact, it was just a number on a sheet of paper.

Then, a series of unexpected eventsreduced their income to almost nothing

for nine months. They couldnt borrow money to keep their mortgage paymentscurrent because without an income they did not have the ability to repay. Withinsix months they had sold two otherproperties to bring their mortgage out of delinquency. They soon realized that in order to protect their $150,000 of eq-uity they would have to sell their home. As Murphys Law would have it, the

previously strong real estate mar-ket turned soft. Although they reducedtheir asking price several times from$295,000 down to $195,000 they couldnot nd a buyer. Sadly, they gave up thehome in foreclosure to the mortgagelender. Sometimes sad stories only get sadder. The two mortgages on the prop-erty were in the amounts of $125,000 and$25,000, respectively. The second mort-

gage holder outbid the rst one at the en-suing auction, feeling that, much like theoriginal owners, it was in a good position.Knowing that the house had been appraisedfor $300,000, and the obligation owing was only $150,000, it thought it couldturn around and sell the property to coverthe investment. It took nine long monthsto sell, during which time the lender wasforced to pay the rst mortgage and alsoaccrued an additional $30,000 of interest and penalties. By the time the home nally sold, less the $30,000 in accrued indebt-edness, guess who got stuck with the de-ciency balance of $30,000 on their credit report? The original owners, of course!

This couple not only had a foreclo-sure appear on their credit report forseven years, the report also showed a deciency balance owing $30,000 ona home they had lost nearly one yearearlier. In a time of nancial setback they lost one of their most valuable assets due to

a lack of liquidity. If they had separated their$150,000 in home equity and repositionedit into a safe side account, they would haveeasily been able to make their mortgage pay-ments and prevented this series of events.

At this point in the story, Doug admitsthe young couple was really he and his wife, Sharee. Despite objections from hiseditor, Doug insisted the story remain in

the book because he wanted his readersto know he understands rst hand theimportance of positioning assets in nan-cial instruments that maintain liquidity inthe event of an emergency. If Doug andSharee had access to their homes eq-uity, they could have used it to weather thenancial storm until they could get back on their feet. Doug learned from his ownexperience the importance of maintaining

exibility in order to ride out market lowsand take advantage of market highs. And,

most importantly, he learned never to ala signicant amount of equity to acculate in his property.

Home equity is not the same as cashthe bank; only cash in the bank is the saas cash in the bank. Being house rich a

cash poor is a dangerous position to beIt is better to have access to the equity value of your home and not need it, thaneed it and not be able to get at it. Keing home equity safe is really a mattepositioning yourself to act instead of rto market conditions over which you hno control.

SEPARATINGE QUITY TO

I NCREASE S AFETY OF P RINCIPALThe Seattle Times, in an article publis

in March 2004, reported, Remember thousing prices can and do level off.They sometimes decline witness SouthCalifornia just a little more than a decago, when prices took a 20 percent to percent corrective jolt downward. Restate equity is no safer than any other vestment whose value is determined by

external market over which we personhave no control. In fact, due to the hden risks of life, real estate equity isnearly as safe as many other conservainvestments and assets. A home that ither mortgaged to the hilt or owned totfree and clear provides the greatest saffor the homeowner.

Americans typically believe home eqis a very safe investment. In fact, accorto a recent study, 67% of Americans hmore of their net worth in home equity tin all other investments combined. Hever, if 100 nancial planners looked aclient portfolio that was 67% weightea single investment, 99 out of 100 of th would immediately recommend the cl

Home equity is not the same as cash in the bank.Only cash in the bank is the same as cash in the bank.


8/12


diversify to reduce their risk and increasesafety of principal. Holding large amountsof home equity puts the homeowner at un-necessary risk. This risk could be greatly reduced by diversifying their home equity into other investments.

An example of the necessity of keeping your homes equity safely separated from your property can be found in Houston,Texas. When oil prices fell to all time lowsin the early 1980s the city of Houston washit hard. Thousands of workers were laidoff and ultimately forced to sell their homes. With a glut of homes on the market, housingprices plummeted. Unfortunately, there werefar too many sellers and far too few buyers.

Homeowners were unable to sell and un-able to make their mortgage payments. As a result, 16,000 homes were foreclosed. Didthese 16,000 families suddenly become badpeople? No, they just couldnt make theirmortgage payments. Just prior to this seriesof events many of these people were makingextra principal payments. Unfortunately, they could not coast on those extra payments,and with so many houses on the market for

sale, some people literally had to walk away from their home.

The equity these people had worked sohard to build up was lost completely. They learned the hard way that home equity isfragile, and certainly not as safe as they once thought. Could this happen today? Just look at when the Enron Corporationcollapsed a few years ago, and thousandslost their jobs and homes, again in Hous-ton, Texas. What would happen in theSeattle area if Microsoft or Boeing hadmajor lay-offs? Money you give the bank is money youll never see again unless yourenance or sell. When the people in Houstonpleaded, Mr. Banker, Ive been making extra mortgage payments for years. Im well ahead

of schedule. Will let you let me coast for a while? The bank replied, Fat Chance!

T O R EDUCE THE R ISK OF F ORECLOSURE DURINGU NFORESEEN SET -BACKS , K EEP Y OUR M ORTGAGE B ALANCE AS H IGH AS P OSSIBLE

Is your home really safe? Unfortunately,many home buyers have the misconceptionthat paying down their mortgage quickly is the best method of reducing the risk of foreclosure on their homes. However, inreality, the exact opposite is true. As ho-meowners pay down their mortgage, they are unknowingly transferring the risk fromthe bank to themselves. When the mortgagebalance is high, the bank carries the most

risk. When the mortgage balance is low,the homeowner bears the risk. With a low mortgage balance the bank is in a great po-sition, as they stand to make a nice prot if the homeowner defaults. In addition to as-suming unnecessary risk, many people whoscrape up every bit of extra money they canto apply against principal often nd them-selves with no liquidity. When tough timescome, they nd themselves scrambling to

make their mortgage payments.

Assume youre a mortgage banker look-ing at your portfolio, and you have 100loans that are delinquent. All of the loansare for homes valued at $300,000. Some of the loan balances are $150,000 and someare $250,000. Suddenly, there is a glut inthe market and the homes are now worth$200,000. Which homes do you as thebanker foreclose on FIRST? The ones owingthe least amount of money, of course. Afterall, as a banker youd make money takingback those homes, however youd losemoney trying to sell a home for $200,000that still owed $250,000 on it. Banks havebeen known to call delinquent homeown-ers with high mortgage balances and offer

assistance, We understand you are gothrough some tough times, is there anyth we can do to help you? We really wantto be able to keep your home. The lthing they want to do is take back a hothat they will lose money reselling.

Its interesting to note, during the GrDepression, the Hilton chain of hotels deeply affected by the stock market crand couldnt make their loan paymen What saved them from nancial ruin? T were so leveraged, in other words towed so much more on their property thit was worth, that the banks couldnt afto bother wasting their time forecloson it. The Hiltons understood the valu

keeping high mortgage balances therkeeping the risk on the banks. The Hoton homeowners would have been beoff if they had removed a large portiotheir equity and put it in a safe and liqside fund, accessible in a time of need.

Ask yourself, if you owned a $400,home during an earthquake in Califor(and you didnt have earthquake ins

ance), would you rather have your equtrapped in the house or in a liquid, saside fund? If it were trapped in the ho your equity would be lost along the house.

SEPARATINGE QUITY TOI NCREASE R ATE OF R ETURN

What do you think the rate of returnhome equity was in Seattle for the la years? What about Portland? Careful, ta trick question. The truth is, it doesnt mter where you live or how fast the homesappreciating, the return on home equityalways the same, ZERO. We have a misconception that because our home appreciator our mortgage balance is going dowthat the equity has a rate of return. Th


9/12


not true. Home equity has NO rate of return.Home values uctuate due to market con-

ditions, not due to the mortgage balance.Since the equity in the home has no relationto the homes value, it is in no way responsi-ble for the homes appreciation. Therefore,home equity simply sits idle in the home. It does not earn any rate of return. Assume you have a home worth $100,000 which youown free and clear. If the home appreciates5%, you own an asset worth $105,000 at theend of the year.

Now, assume you had separated the$100,000 of home equity and placed it ina safe, conservative side account earning8%. Your side account would be worth$108,000 at the end of the year. You stillown the home, which appreciated 5% andis worth $105,000. By separating the eq-uity you created a new asset which was alsoable to earn a rate of return. Therefore, youearned $8,000 more than you would have if the money were left to sit idle in the home.To be fair, you do have a mortgage payment you didnt have before. However, since in-terest rates are relative, if we are assuminga rate of return of 8%, we can also assumea strategic interest-only mortgage would beavailable at 5%. Also, since mortgage inter-

est is 100% tax deductible, the net cost of the money is only 3.6%. This produces a

4.4% positive spread between the cost of money and the earnings on that money.

The story gets much more compellingover time, although the mortgage debt remains constant, through compound in-terest, the side account continues to grow at a faster pace each year. The earnings on$100,000 in year 1 are $8,000. Then in year 2, the 8% earnings on $108,000 are$8,640. In year 3, the earnings on $116,640at 8% are $9,331. Since the mortgage debt remains the same, the spread betweenthe cost of the mortgage money and theearnings on the separated equity contin-ues to widen further in the homeownersfavor every year. If we allow home equity to remain idle in the home, we give up theopportunity to put it to work and allow it togrow and compound.

Homeowners would actually be better off burying money in their backyards than pay-ing down their mortgages, since money bur-ied in the backyard is liquid (assuming youcan nd it), and its safe (assuming no oneelse nds it). However, neither is earning a rate of return. Its actually losing value due

to ination. Few people today bury moin the back yard or under their mattress

because they have condence in the banksystem. They also understand idle moloses value while invested money grand compounds. As Albert Einstein sThe most powerful force in the universcompound interest. After all, homes wbuilt to house families, not store cash. vestments were made to store cash.

Taken from a different angle, suppose were offered an investment that could ngo up in value, but might go down. Hmuch of it would you want? Hopefully Yet, this is home equity. It has no ratereturn, so it cannot go up in value, bucould go down in value if the real estate mket declines or the homeowner experienan uninsured loss (e.g. an earthquake), dability, or a foreclosure.

If you were offered an investment that could

never go up in value,

but might go down,how much of it would you want?

(This is home equity)


10/12


T HE P OWER OF LEVERAGE Lets be clear, buying a home can be a

great investment. However, the wealthy buy the home with as little of their own money as possible, leaving the majority of theircash in other investments where its liquid,safe, and earning a rate of return. One of

the biggest misconceptions homeownershave is that their home is the best invest-ment they ever made. If you purchased a home in 1990 for $250,000 and sold it in June of 2003 for $600,000, that representsa gain of 140%. During the same period,the Dow Jones grew from 2590 to 9188,a gain of 255%. The reality here is that nancing your home was the best in-vestment decision that you ever made.

When you purchased the $250,000 housein 1990, you only put $50,000 down. The$50,000 cash investment produced a prot of $350,000. That is a total return of 600%,far outpacing the measly 255% earned by the stock market.

T HE C OST OF N OT BORROWING (E MPLOYMENT C OST VS.OPPORTUNITY C OST )

When homeowners separate equity to reposition it in a liquid, safe, side ac-count, a mortgage payment is created.The mortgage payment is considered theEmployment Cost. What many peopledont understand is when we leave equity trapped in our home, we incur the samecost, but we call it a lost Opportunity Cost.

The money thats parked in your homedoing nothing could be put to work earn-ing you something.

Lets say you had $100,000 of equity in your home that could be separated. Cur-rent mortgage interest is 5%, so the cost

of that money would be $5,000 per year(100% tax deductible). Rather than bury the $100,000 in the backyard, we are goingto put it to work, or employ it. If I werean employer, why would I be willing to hirean assistant for $35,000 per year? The ex-pectation is I am going to be able to grow my business and earn a prot on it. As a business owner, I believe that by investingin an assistant I will earn a return thats

greater than the cost of employing that as-sistant. If we choose to leave the $100,000of equity in our home, we incur almost thesame cost. The only difference is, instead of referring to that cost as employment cost,it is referred to as an opportunity cost. By leaving the equity in the home, we giveup the opportunity to earn a 5 percent return on the money.

By separating the equity we give it new

life. We give ourselves the opportunitput it to work and earn something on Assuming a 28 percent tax bracket, net employment cost is not 5%, but 3.6or $3,600 per year after taxes (mortgainterest is 100% tax deductible). Its too difcult to nd tax free or tax defer

investments earning more than 3.6%. ing the tax benets of a mortgage, youcreate your own arbitrage by borrowinone rate and earning investment returnsa slightly higher rate. Its what the baand credit unions do all the time. Thborrow our money at 2% and then loaback to us at 5%. Its what makes milliaires, millionaires! Learn to be your obanker. By using the principles that ba

and credit unions use, you can amassfortune. A banks greatest assets areliabilities. You can substantially enha your net worth by optimizing the asthat you already have. By being your banker you can make an extra $1 Millfor retirement.

H OW TO C REATE AN E XTRA M ILLION DOLLARS FOR R ETIREMENT

By repositioning $200,000 into an uity management account with a nanadvisor you can achieve a net gain ofmillion over thirty years. Assume separate the $200,000 of home equusing a mortgage with a 5% interest ratthe $200,000 grows at a conservative rat6.75% per year, it will be worth $1,419,in 30 years. After deducting the $216,in interest payments and the $200,0

Homes are designed to house families,

not store cash.

Investments aredesigned tostore cash.


11/12


mortgage, you still have $1,003,275 left in your account. A net gain of over onemillion dollars.

This example simply shows a one timerepositioning of equity. Imagine how thenumbers grow for individuals that harvest

and reposition their home equity every 5 years as their home continues to appreci-ate! This is how the wealthy manage theirhome equity to continually increase theirnet worth. Conversely, if the same $200,000 were left to sit idle in the home for 30 years,it would not have earned a dime.

BETTING THE R ANCH ; R ISKINGH OME E QUITY TO BUY SECURITIES

Recently the NASD issued an alert,because we are concerned that investorswho must rely on investment returns tomake their mortgage payments could end up defaulting on their home loansif their investments decline and they areunable to meet their monthly mortgage payments. The NASD is absolutely correct in advising against separating equity if theclient must rely on the returns from their in-

vestment to make the mortgage payments.

Home equity is Serious Money. Wedont gamble home equity. Liquidity andsafety are the key philosophies whenseparating home equity. Rate of return is a distant third benet. Also, it is not neces-sary or recommended to invest in highly volatile or aggressive investments. You canmake thousands of dollars by simply bor-rowing at 5% and investing at 5% in safeconservative xed investments without evergoing into securities. In general, individu-als should not invest home equity for cur-rent income unless the investment is xedand guaranteed. Individuals interested in variable investments should ask themselves,How will I make my mortgage payment if

my investments decline? Do I have reservefunds or a secure income? In April 2004,the following question was posed to theNASD, Where can I nd the exact languageprohibiting a broker from recommendingthat I take a mortgage out on my house andinvest the money in securities? The writ-

ten answer from the NASD: Brokersare not prohibited from making such a recommendation per se, so long as theinvestment is reasonably suitable for investment in general, and it is suitablefor the specic customer. In order todetermine suitability, a broker should con-sider the clients investment objectives,nancial status, tax status, and any otherinformation a rm uses to make suitable cli-

ent recommendations. This would includeadequately explaining the risks of such aninvestment, which are signicant, to theinvestor. The NASD simply wants to ensureconsumers are receiving prudent advice.

T AX DEDUCTIONS TO OFFSET 401K W ITHDRAWALS

Most successful retirees have the major-ity of their assets in their home equity and

IRA/401Ks. As they start withdrawing fundsfrom their IRA/401Ks, they are hit with a signicant annual tax bill. Moreover, thekids have moved out, the mortgage is paid,and tax deductible contributions to 401Kshave stopped. When they could use themortgage interest deduction the most, they dont have it. As part of long term planning,someone who is preparing for retirement may want to have a mortgage going into re-tirement to help offset the annual IRA/401k tax bill and enhance their overall nancialgoals. For many, the mortgage interest de-duction offsets taxes due on retirement withdrawals, giving the net effect of tax free withdrawals from their retirement account.

401 V ACATION C ONDOMany successful people in the Northw

dream of retiring and buying a secohome in South Florida or Hawaii. Withmillion dollars or more saved in thIRA/401Ks, they decide to retire and the vacation home where they will sptheir winters. What a surprise when tdiscover that to pay cash for a $350,0condo they need to withdraw nea$500,000 from their 401K/IRA. Whinstead they had purchased the con15 years earlier, when it cost $175,00by using the equity in their homToday their net worth would be $175,0higher, due to the condos apprecition, and they would have the mortg

interest deduction to help off-set thIRA/401K withdrawals. In addition tonancial advantages, they would henjoyed the lifestyle benets of owtheir vacation condo 15 years soonthan they planned.

M AKINGU NCLE S AM Y OUR BEST P ARTNER

Under tax law you can deduct up to

million dollars of mortgage interest subjeincome restrictions. You can also deductadditional $100,000 from home equity linterest. To take advantage of these deductimake sure to secure a large mortgage wh you buy. Under tax law, mortgage interedeductible only for $100,000 over acquisiindebtedness (the mortgage balance whhome is purchased). Home improvementsthe only exception. For example, if you sel

home for $400,000 and buy a new home$400,000 with the cash from the sale, youlose the tax break and liquidity. But wors you later decide to take out a home equity lonly the rst $100,000 will be tax deductInstead, secure a $360,000 mortgage (90 when you buy the home and the entire amis deductible.


12/12


W HERE TO S AFELY I NVEST H OME E QUITY

Home equity is serious money. We areseparating it from the home to conserve it,not to consume it. Therefore it should not beinvested aggressively. Rather, home equity isbest invested in safe, conservative invest-ment vehicles. Tax favored safe investmentsare ideal. You should consult your nancialplanner for the best investment vehiclesfor your specic situation. Many nancialplanners prefer the following tax favoredproducts for investing home equity:

I NVESTMENT GRADE INSURANCECONTRACTS

A NNUITIES

R EALESTATEINVESTMENT T RUSTS IRA S 401K S T AX -FREE BONDS 529 S AVINGSPLAN

C ASE STUDY :H OME E QUITY M ANAGEMENT

Theres a recent case study of a couple living in a $550,000 home in

Bellevue, WA. They owed $360,000 ona 30-year xed mortgage at 5.875% witha monthly payment of $2,130. They had$190,000 built up in home equity. A very common Brother A-type traditional sce-nario. After understanding the liquidity,safety, rate of return, and tax benets of properly managing their home equity, this

couple decided to separate $155,800 of their equity to invest in a safe conservativeside account. By using an interest-only ARMthey were able to increase their mortgagebalance to separate this chunk of equity whiledecreasing their monthly mortgagepayment to $1,656, a monthly cash ow

savings of $474 per month.

The couple conservatively investedthe $155,800 lump sum and the $474per month savings with their nancial plan-ner. If we assume a conservative 6% rateof return, their investment account willgrow to $520,196 in 15 years. In the 15th year, they will have enough cash in theirinvestment account to pay off their mort-

gage completely if they want to (15 yearsearlier than with their original 30 yearmortgage!). However, armed with their new equity management knowledge, they planto keep the mortgage well into retirement so they can keep the tax deduction benetsand keep the money in the investment ac-count where its more liquid, more safe,and will continue to grow and compound.

C ASE

STUDY

:C ASH F LOW M ANAGEMENT Its not necessary to have a large chunk

of equity in your home to benet fromusing your mortgage to create wealth.Many homeowners without a largeequity balance have beneted by simply moving to a more strategic mortgage which

allows them to pay less to their mortgcompany each month, thereby enablthem to save or invest more each monFor example, a couple in Redmon Washington followed traditional ting when they bought their $400,0home. They put 20% down and obtai

a $320,000 30-year xed rate mortgage6.00% with a payment of $1,919 per moThis is how the vast majority of Ameri would purchase this home.

However, once this couple understoodbenets of integrating their mortgage their nancial plan, they decided to ma change. They moved to a more strateinterest-only mortgage. They kept the s

loan balance, but were able to reduce thmonthly payments to $1,133 per monthsavings of $786 per month from their prous mortgage. The couple invests the $savings each month, and assuming a 6% of return, they will have enough monetheir investment account to pay off their mgage in 19 years (11 years sooner than thprevious 30 year schedule!). Thereforesimply redirecting a portion of their mon

mortgage payment, they were able to potially shave 11 years off their mortgageaddition, they also received the benethaving their cash in a more liquid, more position throughout the process.

About the authors: Steven Marshall is the President & CEO of Bellevue Mutual Mortgage, a company that specializes in helping clients properly managtheir home equity and their mortgage to build wealth. Bellevue Mutuals unique mortgage planning approach has helped thousands of northwest familuse their mortgage to increase their net worth. Patrick Allman is the Vice President of Bellevue Mutual Mortgage.

For a free analysis to see how these concepts would apply to your specic situation, pleasecontact Patrick Allman at 800-451-4663 or via email at [email protected].

how affluent manage home equity

Documents