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18 July 2005
"I don�t understand why a Wharton professor
would not recognize that unused home equity is a missed opportunity� Isn�t home
equity safer in a conservative side fund than buried in the house earning a 0
percent return?"
The New and Old
Wisdoms of Household Finance
Your view reflects a new "wisdom" of
household finance that has emerged in recent years. It says that if you have
excess cash flow, you should purchase financial assets rather than pay down your
mortgage balance. And if your house appreciates, you should take a second
mortgage or refinance the first for a larger amount ("cash-out"), in order to
invest.
This view contrasts sharply with the received
wisdom of my father�s generation, which was that a mortgage should be paid off
before you retired. That way, you would not have a repayment burden when your
income dropped at retirement.
There was a well-grounded exception to that
rule: young homeowners in the early stages of building a business had good
reason to invest as much cash flow as possible in the business rather than in
mortgage repayment. This made sense because such homeowners could often earn a
return on investment in their business that was materially higher than the rate
on their mortgage. If the business failed, they were young enough to learn from
their mistakes and try again.
The received wisdom of old was thus a
conservative rule applicable to most homeowners, combined with an exception for
the young entrepreneur. The new wisdom in effect converts the exception of the
old wisdom into the rule for everyone. Households should manage themselves as if
they were businesses, and unused equity is missed opportunity.
Shaky Premises of
the New Wisdom
The premise of the new wisdom is that
households can invest home equity profitably. If you can earn 13% on your
investments and your mortgage only costs 6%, it doesn�t matter that you still
have a mortgage when you reach age 70 because your financial assets will more
than cover it. What matters is your wealth -- assets less debt -- and that will
be higher.
But will it? In my view, the majority of
households cannot invest at a profitable spread over the cost of their mortgage
without taking significant risk. And this means that they can end up richer or
poorer, depending on how their investments turn out.
Consider the borrower with excess cash flow
who is choosing between additional mortgage repayment and purchase of financial
assets. The rule for maximizing your wealth is to invest in the one yielding the
higher after-tax return, adjusted for risk. Investment in loan repayment yields
the mortgage rate and has zero risk, which for most borrowers is hard to beat.
It does happen occasionally. A borrower in
the 35% tax bracket with a 4.75% mortgage recently asked me whether she should
repay the mortgage or invest in a 529 education fund. Her after-tax return on
mortgage repayment was only 3.09% -- 4.75x (1-.35) -- and since earnings on a
529 fund are tax free, the yield on that fund had only to exceed 3.09% to be the
better choice.
But this was an unusual case: her mortgage
rate was low, her tax rate was high, and her preferred investment was
tax-exempt. A taxable investment would have to beat 4.75%. If the mortgage ratehad been 6%, a taxable investment would have to beat 6%.
The major target of the new wisdom is the
homeowner with significant equity, who is being persuaded to borrow against it
in order to invest at a profit. The borrowing cost that the investment return
must beat is the cost of a new mortgage, either a second mortgage or cash-out
refinance. This is usually higher than the rate on the borrower�s existing
mortgage, making it that much more difficult to find an investment that will
yield a margin over the cost.
The New Wisdom is Driven by
Financial Interest
The recent boom in house prices has increased
the size of the target market enormously. While few households have a business
in which to invest, no problem, the loan officer/planner/financial advisor will
advise them about investments.
The new wisdom is supported by an enormous
amount of financial self-interest. There is money to be made on the new
mortgage, and on the investment. The intermediaries in the process take
theirs off the top. For the household to end up richer, however, the investment
return must exceed the borrowing cost over a long period. Since investments that
yield a return higher than the household�s borrowing cost carry risk, the
household can also end up poorer.
In my view, risk-taking of that type is for a
business, not a household. The old wisdom made more sense.
Copyright Jack Guttentag 2005
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