A couple of weeks ago, Shailesh (fellow genius) wrote about how equity management is overrated. Personally, I think it is underrated as it is often misunderstood. As many believe, he went on to explain how it is about debt leveraging, putting off paying down your mortgage in order to invest instead. He even went on to mention that it seemed to make sense during the housing boom, but doesn’t anymore. Please read his post as he mentions a lot more about his perspective.
Truth be told, proper equity management goes far beyond the simple debt leveraging. It is really about striking a balance between managing both debt and equity to enhance one’s overall financial and investment plans, putting one’s financial plan on steroids if you will. It is not something that is easily understood in its entirety, so don’t feel left out if you don’t follow what I am talking about.
Due to the rules of money, such as the time value of money and truths about home equity itself, paying off your mortgage can prove detrimental to your finances, costing hundreds of thousands of dollars over time. Mortgage planners (those which supposedly know equity management) provide education on these concepts, then take your situation and create a customized “mortgage plan” that will help you meet all of your financial goals, using your mortgage as a tool.
To add to the confusion, equity management may tell someone it is better to pay off the mortgage, though that is very rarely the case. Most often it does suggest use of those exotic loans that have gotten a bad rap due to their misuse, so keep an open mind. To understand equity management, you have to understand the concepts and why it works. It is also best for those which have the discipline to stick with the plan.
I am sure you are wondering what concepts I am talking about. Some things you may not realize are that home equity has no rate of return and is not a safe investment overall. Every dollar you send to pay off your mortgage is a dollar you have lost access to without refinancing, which in a financial crisis will not be an option. So, a god question to ask yourself would be which would you rather have $50,000 in equity or $50,000 in a safe investment account?
Shailesh says he has never been comfortable with equity management and I respect that. It certainly is not for everyone. He does talk about his concerns and so let me address them…
The first was about mortgaging to the hilt and the market crashing as it has. Well, if the equity was invested properly, that drop in value would be offset by the money in the bank, only now you would have “lost equity” working for you. If you had to sell the home for a loss, it would actually be better to have money in a side investment to pay off the loan than to end up in a short sale or even break even.
The second concern he had was what about life events? Well, as with any financial plan, equity management has to change as things change, which is why you need to revisit your mortgage plan regularly. As for having cash to switch homes if need be, the answer should be yes, again if properly invested.
The third he talks about is studies showing since most families stay in a home only 7 years and refinance every 4 on average, equity in your home is the best way to ensure mobility. I disagree for various reasons, but one would be that during that same time period, little equity is actually built up for most. Another would be the added flexibility, liquidity, etc. that equity management provides.
The last concern he described was that it doesn’t work fro those with tight budgets, erratic spending patterns, those with credit card debt, etc. I again disagree here as proper equity management will develop a plan that works with anyone, catered to the individual. Equity management is not reserved only for the wealthy, and the reality is that it can help the average family become wealthy.
Again, I respect Shailesh and his concerns, but as one who practices equity management myself and has provided many families mortgage plans that are helping them meet their financial goals by using their mortgage as a tool, I have to disagree with it being overrated. The bottom line, as I see it, is equity management can help anyone, regardless of what the markets are doing since it is centered around the individuals financial goals and dreams.
Unfortunately, there are many “mortgage planners” that don’t implement equity management properly, causing more harm than good. If it is done properly, you can reap huge rewards. But as Shailesh is concerned, equity MISmanagement can prove disastrous as well.
Tyler
February 27, 2008 at 9:48 am
Robert – you make many great points in your post. I agree, equity management isn’t suitable for everyone. Some people will always be spenders, and it’s flat out dangerous to give them thousands of dollars. If you have a routine saver or someone that can learn to save, equity management is a wonderful thing to consider.
Great post. I was wondering if anyone was ever going to counter Shailesh’s points.
-Tyler
JB
February 27, 2008 at 12:49 pm
Robert — I was gonna write this post, but decided not to. I don’t argue with amateurs, regardless of their good intent. I don’t way that with a mean spirit, but from long experience.
Arguing that either Equity Management or what I term Purposeful Planning isn’t for everyone is…well, mistaken to say the least.
In 2005 I told a relative’s work buddy to refi his home, which he did. 80% 1st, plus a 90% LTV heloc.
While his home has lost about 20% of its value, all but 10% of that equity is in the bank in the form of cash. He’s now a believer in what you and I preach. Good stuff, Robert — as usual.
Brian Brady
February 27, 2008 at 6:12 pm
“While his home has lost about 20% of its value, all but 10% of that equity is in the bank in the form of cash. He’s now a believer in what you and I preach. Good stuff, Robert — as usual.”
…and guess who’s in the driver’s seat? Him; not the bank
Sean Purcell
February 27, 2008 at 9:27 pm
Robert,
Great post and well argued rebuttal. My only disagreement is with your point #4. The fact that you can create an equity managment plan that is right for everyone does not mean that you should. I imagine all of us have witnessed clients with the best of intentions walk right out the door and run up debt with their new found savings. Although we as lenders do not have a fiduciary obligation to our clients (crazy as that sounds) I still hold myself to those standards and am quite sure you do too. There comes a point when, in good conscience and based on a track record reflecting a lack of discipline, you have to advise your client that there best plan of action does not include a mortgage that provides extra cash each month to invest. There are too many out there that have been eaten alive by fees while they continue to finance their poor habits with even poorer loans.
Denver Mortgage Broker
February 27, 2008 at 10:18 pm
I did a detailed analysis of this issue once. I took two home owners with the same salary, same money in the bank, same everything. For the conservative home owner, I put all his money in his down payment, and he paid off his mortgage in 15 years. I put a minimal down payment for the more aggressive home owner, invested the rest and put him in an interest only loan for 30 years, reinvesting what he would have put into his mortgage using the more conservative approach into stocks. When it all shook out, the more aggressive home owner came out on top by quite a good margin. However, I doubt that most people are disciplined enough to reinvest all that money. Both approaches work, but for most people, I recommend trying to get the home paid off. I will point out, however, that the conservative approach (if no other investments are made) puts the person in a tough spot if they lose their job, for example. However, the guy investing his money with an interest only loan has plenty of cash to fall back on if things get tight. Not being able to take full advantage of the entire home interest deduction is a big drawback to aggressively paying down a home. All angles must be examined for the serious investor. For everyone else, paying off a home in a short a time as possible is probably the best approach. I will also note that there is a psychological component to paying off one’s home. Not having a home paid off after 30 years (even if you have lots of cash in investments) doesn’t sit well with a lot of folks. Knowing that your home is going to be paid off in X number of years is a really psychological boost for most people.
JB
February 27, 2008 at 10:48 pm
Denver — You obviously understand the two approaches, and as you pointed out so well, investing crushes the whole ‘Granpa’ approach.
>Not having a home paid off after 30 years (even if you have lots of cash in investments) doesn’t sit well with a lot of folks. Knowing that your home is going to be paid off in X number of years is a really psychological boost for most people.
I see your point. The problem is they can’t spend their psychological boost when they’re retired. Meanwhile, back at the ranch, their next door neighbors, the investors, are leaving on yet another vacation cruise.
At the point in the conversation when they begin to mumble the psycho-babble about ‘feeling better’ with a free and clear home, I ask them one question.
Your choice — would you prefer $3,500/mo. retirement income along with a free and clear home OR $12,000/mo. along with a $2,000 house payment?
You’d be surprised how many still insist on the former — about 2 of 10 or so. It used to drive me bonzo, but now I just smile and politely usher them out.
Denver Mortgage Broker
February 28, 2008 at 8:24 am
JB — I will point out one flaw in the investment strategy. Some people will laugh, but worldwide financial collapse (or even just depression) throws a monkey wrench in the investing game plan. The truth is that the world economy is very new. One hundred years ago people still used horses for transportation. Even 50 years ago, most adults didn’t have a car. Cars were reserved for the head of household. Houses had one garage if they had a garage. Things really got going after WWII, so the modern world economy is really in its infancy. The six thousand years (or more) prior to the last 50 were pretty crude. Those people didn’t even have antibiotics. What’s more, the world economy is based on PAPER! What is paper good for? Well, you can cover a rock or scissors with it, and if people THINK that it has value, they’ll trade you hard stuff for it. If people ever lose faith in paper, the investment strategy falls apart. It’s important to remember that money isn’t wealth. Stocks aren’t wealth. They are paper, and they can blow away as quickly as they came. What is wealth? Gold, silver, land, homes, etc. Things you can hold in your hand are wealth; everything else is somewhat of an illusion because it has no intrinsic value. If everything goes boom, the guy who paid off his house will be happy that he has a paid for roof over his head. He will also be able to use that home to provide shelter for his extended family who do not have paid off homes of their own. Hopefully, the guy who took out the interest only mortgage and lost everything in the big crash won’t jump out a window. I don’t scoff at either strategy. I see merit to both ways of thinking. I am also not foolish enough to think that everything will be like it is now or better. I hope that we have a thousand years of golden bliss, trending upward and upward, but the reality is that we do not know what lies ahead. Having a paid off home isn’t a bad plan in my book. Because we have a good shot at decade after decade of golden bliss, the investment strategy isn’t a bad plan either, but it does come with a potentially huge downside if things go poorly for the world economy.
Shailesh Ghimire
February 28, 2008 at 12:37 pm
Robert,
Very good points. I’m actually along the line of what Denver said:
“However, I doubt that most people are disciplined enough to reinvest all that money. Both approaches work, but for most people, I recommend trying to get the home paid off.”
It’s certainly a bigger issue for people than just mere numbers. I think the point I was trying to make in my original article was very few people seem to have the discipline to make this work. Also, there are many other investment vehicles open to people to create the kind of wealth you need for retirement without putting your house at risk. Plus I’ve only done research on this topic and been to a seminar so I’ve never seen these concepts in action.
JB – I admit I’m an amateur at this, but I wasn’t trying to argue :-). I’ve very open to hearing your side and appreciated your comments on my blog.
Robert D. Ashby
February 28, 2008 at 2:46 pm
Wow, what a nice discussion we managed to get going here. Denver, one suggestion, break up your points as it is very hard to follow when they are all bunched together, thanks.
It is good to see both sides coming out on the issue, but the real reason borrowers don’t follow the investing strategy is mostly due to lack of education. Most mortgage professionals still advocate paying off the home first, yet the time value of money says that it is the wrong thing to do.
Will you guys still be saying to pay off the mortgage when the tax rates are double, triple, or even quadruple what they are now? I doubt it. And with taxes going up in the near future, millions who have rushed to pay off their mortgages during this low tax season are going to be surprised at the fact they no longer have the deduction and are paying large amounts of taxes in comparison.
Equity management can help everyone, there are even ways to help those that currently lack fiscal discipline. It takes more effort obviously, but it can be done. Now, if someone just doesn’t get it or shows a complete disregard to my process, I turn them away, then pray for them cause they will need it.
@Brian – You hit one of the key points, and that is you being in charge, not the bank.
@JB – Your 2 in 10 is dead on. I actually calculated about 15% based on my own experience, but most of those who come to me already have an idea of what they are in for.
@ALL – Thanks for the discussion.
JB
February 28, 2008 at 3:39 pm
Shailesh — The words I used conveyed a spirit not intended. Please accept my apology for not being clear. I didn’t think you were arguing at all. On the contrary, it appeared to me you were trying to protect folks from themselves.
When a Plan is put into action with a client, we look them right in the eye and tell them any major deviations will yield consequences most likely bitter to the taste. When it happens every now and then, my first question is, ‘Hey, how’d that taste?’ The look of recognition hits their face almost immediately, and they realize I’m not gonna buy anything but reality. In other words, follow the plan or pay the price.
We hold our clients’ hands but refuse to babysit. 🙂