Comments on: Return On Equity Is Always Zero

By: Bender

Bender — Sun, 28 Mar 2010 01:26:36 +0000

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.

By: Economy and your Finances Carnival 22nd Nov 2009

Economy and your Finances Carnival 22nd Nov 2009 — Sun, 22 Nov 2009 08:06:25 +0000

[...] Of Wealth presents Return On Equity Is Always Zero posted at Evolution of Wealth, saying, “You are always told to build up equity in your house. [...]

By: Evolution Of Wealth

Evolution Of Wealth — Sat, 21 Nov 2009 00:35:28 +0000

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.

By: Flamingo

Flamingo — Thu, 19 Nov 2009 23:32:48 +0000

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.

By: Evolution Of Wealth

Evolution Of Wealth — Thu, 19 Nov 2009 20:43:42 +0000

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.

By: Flamingo

Flamingo — Thu, 19 Nov 2009 16:16:26 +0000

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.

By: John Scott Smith

John Scott Smith — Thu, 12 Nov 2009 15:12:20 +0000

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.

By: Evolution Of Wealth

Evolution Of Wealth — Thu, 12 Nov 2009 11:30:58 +0000

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.

By: Evolution Of Wealth

Evolution Of Wealth — Thu, 12 Nov 2009 11:27:37 +0000

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?

By: JoeTaxpayer

JoeTaxpayer — Thu, 12 Nov 2009 03:15:55 +0000

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.