Why Your Return From Home Equity Is Always Zero

Homes in Newport Beach, Calif., on Jan. 18, 2021. (John Fredricks/The Epoch Times)

Commentary

Now that holiday gifts and toys are in the past and you’ve probably stepped on your last stray Lego piece, it’s time to start thinking about financial resolutions. If you’re a homeowner, the terrific price appreciation that you’ve seen recently means there’s a good chance that you’re sitting on a nice chunk of home equity.

Equity is the difference between how much your home is worth and your mortgage owed. If your home is worth $600,000 and you have a $400,000 mortgage loan balance, this means that you have $200,000 in home equity. Think of equity as your “skin in the game.”

CoreLogic reports that in the third quarter of 2021, the average U.S. homeowner gained approximately $56,700 in equity during the past year. They now enjoy a new national record of $294,000 in home equity. This is astounding when you realize this was 2015’s level of national median home prices. Now it’s the average equity position.

It’s a certain boon, fueling the “wealth effect” from behavioral psychology. This is what makes consumers feel like spending. People simply feel more affluent.

However, I want to share an epiphany with you. Your home equity is: unsafe, illiquid, and its rate of return is always zero. You might wonder, “How can that be true? My home has been a great investment!”

Let’s look at all three of these limitations.

Equity Is Unsafe

Let’s stick with the example that your home is worth $600,000 and has $200,000 of equity in it. If your home’s value falls 33 percent, then it is a complete wipeout of your equity. All $200,000 is gone. You left your equity exposed to the market. In this sense, more equity equals more risk.

If there’s ever litigation charged against you, plaintiff attorneys often look first to see if you have any home equity. It’s a low-hanging fruit. Equity is the top wealth source for many Americans. Homeowners can hedge themselves from calamities with property hazard insurance. But there’s no such thing as home equity insurance.

Equity Is Illiquid

Home equity is often difficult for you to access and convert to liquid dollars. Extracting equity with a full mortgage refinancing or opening a Home Equity Line Of Credit often takes weeks. It can involve loan costs and might even require a lender appraisal.

If you lose your job or have an emergency, it can be exceedingly difficult to access your equity at a time when you need it most. Banks often won’t make loans to unemployed people. Your request to access your equity might be denied completely.

Decades ago, when mortgage interest rates were high (the 30-year rate peaked over 18 percent in 1981), some homeowners thought that it was a good idea to make extra principal payments. This reduced their total loan amount, paving the road for a payoff sooner.

Extra mortgage principal payments hardly make sense for most people now. Today, mortgage interest rates are about half of the rate of inflation. Effectively, many mortgage borrowers are profiting from their debt today.

Across eras, say that you decide to pay an extra $100 toward mortgage principal paydown. Here’s what you’re saying to the bank: “Hey, Big Bank. Don’t pay me any interest on this $100. If I need it back, I’ll pay your fees and wait. I’ll also try to prove to you that I qualify again.”

Equity’s Rate of Return Is Zero

If your $600,000 home appreciates in value 10 percent up to $660,000, congratulations! But did your amount of equity have anything to do with it? No, nothing at all. Yet, as you learned above, leaving equity exposed to the housing market is the first thing to get wiped out in a downturn. Hence, your rate of return from home equity is always zero.

Housing values change regardless of your equity position. Instead, values are based on: inflation, an area’s migration patterns, job growth or contraction, wage growth or contraction, the remaining availability of developable land in an area, and more. Every dollar of accumulated equity actually cuts into your power of financial leverage.

If you’ve wanted to reduce your mortgage debt and build equity through principal paydown, it’s worth pausing to ask yourself why. This gets your home in a “paid off” position faster.

Firstly, there’s the opportunity cost of your money not working for you in other vehicles that create a real return on your investment, like stocks or even buying more rental property.

Secondly, even those that make their last mortgage payment still have a housing payment in perpetuity. Those that own their homes “free and clear” incur ongoing monthly expenses for: property tax, property insurance, maintenance, repairs, utilities, and perhaps homeowners association dues. A “paid off” home merely reduces your housing payment.

Whether your home is paid off or mortgaged to the hilt, you still have the same benefit of enjoying your premises for: dinner parties, yard croquet, gardening, or watching television.

I practice what I preach. I keep minimal equity in my primary residence. When it accumulates, I remove it and put it to work by purchasing more investment property. This way, no equity is lost. Equity is merely harvested and transferred into more properties in various states. I own many properties with small equity positions. This reduces my risk of an economic downturn in one geographic market. It’s still prudent to keep a liquid side fund.

Now you know how to better manage what could be your #1 source of wealth. Homeownership can improve your quality of life. But homes are lousy vehicles for storing cash. Now you know why home equity is: unsafe, illiquid, and its rate of return is always zero.