Using Home Equity
Though those who are underwater on their mortgages usually top the headlines, in reality, many Americans have significant equity in their homes – – especially if they purchased many years ago and have not previously taken cash out via a refinance. It has been estimated by the Federal Reserve that the total equity in real estate in America is well over $10 trillion. Any way you look at the numbers that is a lot of equity.
During the recession many Americans fell behind on their financial plans and the slow recovery has put many in catch up mode. The good news is that this equity can help you with the recovery process. Keep in mind that all numbers presented in this article are examples only and are not intended to represent your financial situation.
Let’s say that you have purchased your home for $400,000 and procured a mortgage for $340,000. Fifteen years later the home is worth $600,000 and your mortgage is now $300,000. You now have $300,000 in equity, up from $60,000. What should you do with this money? Here are a few options:
Consolidate other debts. While your house was rising in value, chances are your other living expenses were probably rising as well. Let us say that your house payment is $3,000 per month including taxes and insurance. You have another $2,500 per month in bills on a total of $50,000 of revolving debt. If you either refinanced into a new mortgage or applied for a second mortgage, your payments could be reduced from $2,500 to approximately $300. In other words, your total monthly obligations would be reduced from $5,500 to $3,300 or 40.0%! This analysis does not include the potential tax deductibility of the new payment.
One caution regarding this financial strategy. In this fictitious example, you are likely spreading your debt over 30 years instead of from four to seven years. In other words, there is short-term gain but also a long-term cost. This cost can be offset by reducing the savings somewhat and moving to a 20-year mortgage. In essence what you would be doing is taking approximately $350 of the savings and putting it back into pre-payment. Moving into a 15-year mortgage would have even more long-term benefit.
Re-investment of the equity. You could use the equity for investment. Right now all the equity is invested in one place. What are other possibilities?
•Start or fully fund a retirement plan. Many Americans have equity in their home but do not have the money to fund their retirement plan. There is only one tax break in the IRS code which rivals owning a home and that is contributions to a retirement plan. You should work with a financial planner to look at this possible solution and your loan officer might be able to recommend someone if you don’t already have one.
•Re-leverage the equity. You could purchase another investment such as stocks, a business or even another home. We call this re-leveraging and this puts more of your money to use. For example, if you removed $50,000 in equity and purchased a $300,000 investment property, you would now have the same amount of equity, but would own $900,000 in real estate instead of $600,000. Any cash-flow loss on the property may be tax deductible depending upon your income level and we recommend talking to your accountant about this.
If your $900,000 in real estate appreciated 5.0% each year, in ten years your gain would be almost $600,000, instead of just under $400,000 when you owned only your primary residence. We are not trying to predict the future. Many speculate in real estate by flipping property. Our focus is long-term use of your money.
Is there another alternative? Yes, keep paying off your mortgage and building-up equity. If you have enough money to pay your debts off and fund other investments, the home continues to be a forced savings plan. Don’t let anyone tell you that having money is a bad thing; however, it never hurts to explore the possibilities of doing even better things with your money.