With the major boom in housing over the last decade, many long-term homeowners find themselves with significant home equity. For many, it makes up the highest category of their net worth.
If you bought a house 10 years ago in 2013, you might have $200,000 or more in equity with an average house. If you haven’t taken out any money already through refinancing and you bought the house with a significant down payment (say, 20%), then you may even have more than this in equity.
It would be realistic to have bought a house for $200,000 ten years ago with $40,000 down. Now that house is worth over $400,000. With the paydown of principal on the mortgage, you might have $300,000 in equity.
Some people see this as a waste because of opportunity costs. The problem is: Compared to what?
Maybe there was arbitrage opportunity when mortgage rates were 3%, although it is still a significant risk. Mortgage rates are now 7 to 8 percent. In order to put this money to “work”, you would have to take out a loan for almost 8 percent.
You could also take a loan from your credit card company and invest the money in the stock market (or Bitcoin, or whatever). You could make a return higher than the interest paid to your credit card company. But you could also lose a lot of money.
Home Equity is Not Wasteful
Your home equity is not just money sitting there. It is money that you are not borrowing to have an asset that you hopefully want to own. With your home equity, it is money that is there to keep you from paying interest to a bank or some other financial institution.
It is easier to see that this money is working for you when you pay off your mortgage. Your principal and interest will go to zero. You will still have to pay insurance and property taxes if that is part of your monthly mortgage payment.
Let’s say that principal and interest is $1,000 per month. When your mortgage is paid off, you will increase your monthly cash flow by $1,000.
If you never fully pay off your home loan because you sell the house, then you will get access to that money at that time, unless you opt to use it towards another house.
Your home equity is not a waste because it is “just sitting there”. It is helping to reduce your monthly expenses now and in the future.
The Bubble Economy
There is more talk of these kinds of schemes in a bubble economy. Of course, it is more possible in a bubble economy because more people tend to have significant home equity.
But even in rough times, there are people with significant home equity. But it doesn’t cross their mind to take out a loan to invest the money because they see that most things have a negative return at that time.
When stocks and real estate are going higher, that’s when people become clever and think about taking out equity to invest. Perhaps it’s better than using equity to take a vacation, but it is better to not tap into that equity unless you have some kind of very special opportunity cost.
If you are borrowing money to own the business of your dreams, then maybe you will have a case for taking on the risk. But if you are taking out an additional loan to buy penny stocks, or even index funds, then you are probably going to get burned.
The bubble economy gets people to make irrational decisions because they think the good times are going to last. They don’t think a prolonged bear market is going to happen.
When the bubble economy bursts, you don’t want to be in debt. Any debt you do have, you want it to be at a relatively low interest rate, and you want it to be affordable compared to your monthly income and your other expenses.
It is never a good idea to borrow money out of your home equity, but it is especially bad to do in a bubble economy with higher interest rates.