A few years ago, in the middle of the housing boom, I came across the equity management philosophy of wealth creation. The basic premise is that in order to maximize your wealth over the long term you should not pay off your mortgage. Instead you should leverage the mortgage debt to create wealth. Debt leveraging is where you borrower as much as you can against your house and only pay the interest only portion of the loan. The idea being that you invest the portion you would have paid towards principle and obtain a return.During the housing boom this seemed to make sense, and I know several people who ended up doing exactly that. They cashed out on their homes on interest only mortgages and invested it in the market. I know many who used life insurance vehicles to “maximize” their long term wealth building power. The use of life insurance vehicles is a whole different article all together and I don’t have very kind words for that strategy either.
Advocates insist there are many reasons to follow this equity management strategy. The first is to put to work the asset (equity) trapped in your house. The second is to take advantage of the tax deduction as much as possible. And so on and so forth. There is an entire Brother A and Brother B example used that demonstrates the advantages.
Within our industry anyone who does not believe in equity management strategy is considered a dinosaur. The thinking is that equity management is the wave of the future and takes into consideration the evolved mortgage landscape. As a mortgage professional I have never felt comfortable with equity management. The enthusiasm that I hear about equity management reminds me of the “new economy” arguments of the late 1990s.
Here are my reasons for not fully believing in equity management:
- What happens if you mortgage yourself to the hilt and then the real estate market crashes? Oh wait that may have just happened to a few folks. Add in the fact that the stock market is flat and the cash you dumped into the life insurance vehicle just got chewed up to pay for their fees, leaving you with no cash value. But wait it’s a long term strategy, say proponents – but to quote John Maynard Keynes “in the long run we’re all dead.”
- I’ve read surveys which show that a major event happens in a person’s life every three to four years. This major event could be the birth of a new child, job changes (hired or fired), marriage etc. etc. This event normally causes a major readjustment to a persons financial needs. Now if you’re trapped in a 100% interest only mortgage within a flat real estate market, things don’t look too rosy, do they? Will your steady investment have made enough money to compensate for the cash you need to switch homes? A very fair question to ask in my opinion.
- It has also been found that people do not stay in a mortgage for more than four years and in a house for more than seven years. The best way to ensure your mobility is equity in your home. This is a similar point to the one I just made above.
- Finally, this strategy simply doesn’t work for folks on tight budgets, erratic spending patterns, those with credit card debt etc. It only works for the marginally wealthy with great financial self discipline. Also for those who know what their employment situation will be in five years, who live on a budget, have a comfortable cash reserve and who expect their incomes to rise steadily with time.
Bottom line, the equity management strategy assumes a long term hold of the same real estate with steady long term investment gains. It’s not so bad, if these two aspects were not so completely related together, with one greatly affecting the other. Also, I have found that life is not nearly as stable and predictable as you’d like. You may have to move because your mother needs you closer due to her failing health. Your child may decide to attend an out of state college. Simply put, life happens and equity in your house makes it easier to deal with unforeseen circumstances.
At the personal level the main reason I have a difficult time with equity management is because I can’t turn my primary residence into an investment vehicle. I can’t play dice with the roof over my child’s head. Call me chicken. Go ahead. I don’t know why but I just can’t. I am confident that I can build wealth through other means, but not by leveraging the one assest that is the foundation for every other goal in my life!
Maybe it’s a cultural thing. I am from a fairly conservative background and was taught to pay off all debt and not to owe anybody anything. It may not seem like good advice now, but it’s a time tested principle. Just think of how much less of a problem this credit crunch would have been had people simply bought what they could afford and tried to build some equity in their homes. It would have been a storm in a tea cup and not a tsunami that has chocked the life out of the global economy! In fact the whole thing would have never happened.