Owners Leverage Residential Equity

More homeowners have become comfortable with carrying more debt on their homes and using the residential equity as a cash pool for investment.
And for many homeowners, two of the biggest factors that affect equity growth have remained favorable for the past several years.
While home values trended upward at a sometimes eyebrow-raising pace, interest rates fell and have remained low.
With these two forces in play, leveraging home equity has grown in popularity as a wealth-building tool.
Rod Beckham, branch manager at First Financial Mortgage’s west Little Rock office, said the most common scenario of equity investing he sees involves a homeowner selling a house and buying a nicer one.
This often entails using the sale proceeds to cover 20 percent of the new home’s purchase price and plowing the balance into a stock-market investment.
Beckham said converting home equity to investment cash through a sale is much more common than homeowners staying put and pulling money out through a refinance.
Beckham believes that a home equity loan is the most popular vehicle for freeing up cash to invest among homeowners who are staying put.
Rather than refinance a low-interest, long-term first mortgage into one big loan at a slightly higher rate to convert equity into investment cash, these homeowners are opting to keep the first mortgage intact and take out a home equity loan.
One facet to the increased acceptance of leveraging homes is the growing number of borrowers who finance 100 percent of the purchase price of a home.
Beckham said 100 percent loans accounted for less than 1 percent of First Financial’s residential lending during 2004. That number grew to 4 percent in 2005 and leaped to 12 percent in year-to-date comparison in 2006.
“My guess is that about half of them are first-time home buyers,” he said.
These first-timers are a mix of those who can’t afford to make a down payment on the house or those who simply don’t want to tie up their cash in a house beyond the monthly mortgage payment.
The mathematical considerations of putting money to work instead of leaving it in passive storage in the form of home equity are palatable.
Take for example, a couple who sells a house, makes a 20 percent down payment on a new one and has $100,000 left .
They could use it to buy nicer cars or upgrade their material possessions in some other fashion. They also could use it to make a hefty down payment on the new house and lower their monthly mortgage cost.
But what if they can afford the new house payments without the $100,000 coming into play? What if they invest it in a mutual fund that over 15 years produces an average annual rate of return of 10 percent?
That $100,000 would turn into $339,974. If that average is maintained over 25 years, the number balloons to $768,676.
If that investment yields an annual average rate of return of 12 percent, we’re talking a whopping $1.1 million if the pace holds for 25 years.
Why not borrow more by leveraging the equity and go for a double-digit investment return instead of tying up the money and borrowing less on a 4 percent loan?
Rick Adkins, chief executive officer of The Arkansas Financial Group Inc., evaluates the pros and cons of such a move by calculating an investment barometer such as the net present value of the after-tax cash flow.
But the reality is the decision is more complex than a CPA-spawned number with a long-winded name.
Adkins said he worked with a client who asked him to run the numbers on leveraging his home equity.
They talked through the possible upside and downside, including the basic point that leveraging creates risk and the existence of financial gravity.
Assets that go up in value can go down in value, or at the least not increase in value as quickly as past history or forecasts might indicate.
Forewarned and forearmed, the client made the leap into leveraging his home equity only to be wracked by investor’s remorse when the hoped for returns didn’t pan out according to plan.
“You don’t do this kind of transaction and evaluate it a year later,” Adkins said.
Adkins convinced the client that despite his change of heart, the prudent thing to do was not panic and sell at a loss but to ride out the downturn.
Leonard Hasson, of the Little Rock CPA firm of Mann & Hasson, said while some might consider the debt represented by a mortgage as a bad thing, the repayment structure of home mortgage is a good discipline for creating wealth.
He said practitioners of home equity leveraging remain overshadowed by the mass of homeowners who don’t.
From his observation, many who are taking on more debt through home equity loans aren’t leveraging to build wealth. They are tapping their house to increase their disposable income to buy non-income producing things.