I wanted to share with you a lesson I learned from Douglas Andrew and his writings. For anyone that has read his books before Douglas is a little over the top but as with most financial books there are at least some great pieces to take out of it. For anyone who hasn’t read his books he talks about utilizing the equity in your house versus paying off your house in full. If you are interested in learning more about his books a great one to start with is The Last Chance Millionaire. I will warn you that it is definitely extreme and might be a little over the top for you.
To get back to the post…Probably the thing that sticks with me the most when reading Douglas Andrew’s book is his visual representation of separating the equity from your home. Now I’m going to attempt to paraphrase his example in my own worlds and hope not to butcher it too much.
In one hand you have a pitcher with water in it. This will represent you personal accounts and the water being your cash. In the other hand, you have an empty glass. The glass is your house. Let’s say your house is worth $100,000 and you have $100,000 in water (cash) in the pitcher. This means that your total assets are $200,000.
| Assets | Liabilities | ||
| Home | $100,000 | Mortgage | ($100,000) |
| Cash | $100,000 | ||
| Total Assets | $200,000 | ||
| Net Worth = | $100,000 |
Then you pour all your water (cash) into your glass (home). Now the pitcher is empty but the glass is full of water. You’ve reduced your assets by $100,000 and eliminated your liability (mortgage). So your net worth is still $100,000 and you have a full glass of water.
Now let’s assume your house appreciates by 5% next year. It’s now worth $105,000. If you water (cash) is still in your glass (home) that means that your assets are $105,000 and your net worth is $105,000. Now let’s pour the water back into your pitcher (personal account). You still have your house worth $105,000. We brought back the $100,000 liability. How did your cash do? Did it earn 5% as well? Then that asset is also worth $105,000. This is what it looks like now:
| Assets | Liabilities | ||
| Home | $105,000 | Mortgage | ($100,000) |
| Cash | $105,000 | ||
| Total Assets | $210,000 | ||
| Net Worth = | $110,000 |
The point being that when all your cash is in your house you only have one asset working for you versus two. The rate of return on the equity in your home is always zero. The equity isn’t an asset. People want to talk about it and count on having it down the road and maybe even plan on using it. All it is, is imaginary. If you want to make it real at some point you most likely go to a bank and ask the bank’s permission and prove to the bank that you should be allowed to access your equity. Is it really yours?
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| Assets | Liabilities | ||
| Home | $100,000 | Mortgage | ($100,000) |
| Cash | $100,000 | ||
| Total Assets | $200,000 | ||
| Net Worth = | $100,000 |
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{ 10 comments… read them below or add one }
I very much like this example. (In a declining market, however, who wouldn’t have rather had their home paid off than watch their assets evaporate in the stock market over the last twelve months?)
However, I have the same perspective. Aside from an emotional component, I don’t see a benefit to paying off a real estate asset sooner than required, provided that you have a sensible mortgage to begin with. The mortgage on our home is locked at a ridiculously low rate for the next thirty years. I have NO intention of paying it off early or touching it. I’d rather accumulate assets in a different pitcher…
John Scott Smith
@JohnScottSmith
That $100K you pulled out? A year later, it’s $106K owed. There’s no free lunch. Money can’t be in both places at once.
I have to agree with EoW on this one. Within the last few years, I was getting about 4% on an ING money market fund. My thirty year fixed, right now, is at 4.875%. When interest rates head back up (and, they have nowhere to go but up, right now) I think bonds will be paying more than my mortgage charges. Not to mention, ability to access that equity in an emergency can disappear if it’s tied up in the house. You can always cash in your other assets…but, you can’t always borrow against your home.
Surely however the mortgage has associated costs that will eat into the extra money acheived.
Also, mortgage costs are almost always higher than the interest that can be generated by keeping your assets in cash.
And if you do keep your assets in something that is not cash, you lose liquidity…in this example the water could turn to custard…and its harder to transfer custard to other jugs (trading costs/stocks declining etc).
I’d rather have a risk-free equity in the place I’m living.
Thank you for your comments.
I guess the actual risk of this concept is can only be measured when you talk about a specific place to put the equity. I didn’t want to get too far ahead and just wanted to focus on the concept. I also think that the gains could be substantial due to the fact that mortgage interest is simple interest and the place you put the money could be compounding. This could easily be taken into account of 30 years. That could mean some pretty substantial growth.
I admit to not being familiar with the economy and tax situation of the UK so I would have no problem saying that none of this may apply there.
Seriously? Your ROE was 5% (pick up a finance textbook, a real one). If you have a mortage your ROE would exceed 5% but your ROA would still be 5%.
Your right equity isn’t an asset (it is equity). Balance sheet: Assets = equity + liabilities.
The definitions of assets, liabilities, ROE, ROI, ROA, etc., etc., etc. have been around for you decades. When someone decides that they have a different/better definition what does that tell you?
“If you want to make it real at some point you most likely go to a bank and ask the bank’s permission and prove to the bank that you should be allowed to access your equity. Is it really yours?” Yes it is yours. But you’ve given the bank a lien against the asset, which generally means you’ll need their permission to get the equity. This is the way collateral lending works.
Thank you for your comment. You bring up an interesting point. If you only had one asset in a declining market it would definitely be affected. If you had two assets would both of them be affected or just one? Depending on what you do with your liquid money might you be able to slightly offset some losses in your home value? I’m not saying putting the money in the stock market but maybe something, safe, liquid and getting a rate of return?
I’m confused as why you say that. Of course the liability will have interest. Actually in this case it would be tax-favored simple interest competing with your other investment. What if that other investment had tax-favored compound interest which would win? Actually if you made a payment on the liability you very well might have less than $100k instead of more.
What other costs are associated with a mortgage than the interest? You are going to have a mortgage anyways so it’s just a matter of whether the cost of the interest is offset by the ability to have access to such a large sum of money.
You are right that cash doesn’t earn much interest, if any at all. I guess I’ll have to do a post on liquidity so that we can look into the liquidity of different places to keep your money. Thank you for the idea.
I love your custard analogy and I definitely agree that most investments fall under that comparison.
The point of the post is that maybe your equity isn’t risk-free? That’s the misunderstanding.
Thanks for the response.
Rather than saying that equity not being risk-free, I think you are meaning to say that by building equity one is losing the opportunity cost of what that money could be doing in another asset class.
However due to the risk of other asset classes (it couldn’t be cash as any gains could not overcome the mortgage interest), the fluctuating value could trap you in your house.
You are right to say that the equity is not really your own but only if you need the money that one’s equity can provide.
Ultimately though, leveraging equity with other investments is not something worth the risk given the small gains.
One important note: I’m coming from a British perspective so tax on mortgage interest is not deductable here (In the UK, mortgage interest tax relief was abolished in 2000), so your strategy is more viable in the US…although I’m still not sure you’re considering the increased level of risk of not building up equity in a property.
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