Financial Planning for Businesses

How To Use Your Home Equity To Build A Savings

I’m going to share with you a “neat” idea. There are a lot of “neat” ideas in finance. Not all of them are risk-free. In fact, much of the “neatness” in finance comes with a healthy dose of risk. So, the caveat with what I’m about to say is that this is one of those risky but “neat” ideas. It might work for you. But, it might not. OK, now for some action.

The Basics

An ‘LBO’, or “leveraged buyout” is a financial term used to describe a financial transaction where an asset (usually a large one) is controlled using mostly debt and only a small amount of money (or none at all) from the borrower. These transactions are usually synonymous with the hostile takeovers that occurred in the 1980’s but the same concept of a leveraged buyout is frequently done by most homeowners today – we call it mortgage financing.

What is a house? The perception of a house as an investment has fueled an already burning fire that homes are investments. Yet, what constitutes an investment? Its rate of return? Its Safety? Its Liquidity? Its ability to create wealth for you? Depreciation is a fact of reality for homes. Roofs sag, electrical wires fray, plumbing leaks, wood warps, and furnaces break. The idea that a home should automatically (or over the long-term) appreciate while it is simultaneously depreciating is a contradiction in terms.

Many homeowners forget or simply ignore the cost associated with borrowing, repairing, and remodeling their home when figuring out their profit from selling it. For many homeowners, homes tend to be a net loss, not a net gain – a fact that a homeowner does not want to acknowledge. It’s not always a loss, but there are many times when a homeowner’s costs really get away from him.

Of course, the object of any leveraged buy out is to maximize profits. It is the leveraging that allows higher than usual profits to be obtained. But, it’s the same leverage that proves to be risky if the investment goes south. If you’re OK with some additional risk, you can put your equity to work for you.

In 2003, the Journal Of Financial Planning (published by the Institute of Certified Financial Planners) published the first academic study on the question of a 15 yr. vs. a 30 yr. mortgage. Their conclusion? A 30 year mortgage is better. But, better in what way?

The Meat & Potatoes

Let’s do some math: Let’s assume that you purchased your first home when you were 25 and you are 20 years into your mortgage (so, that means that you are 45 today) and have 25 years until your retirement so that means at age 70, it’s time to call it quits.

You decide that you want to pay off your home first before putting money away for your future. You have roughly $50,000 left on a $100,000 mortgage. Let’s also assume that your payments are $567 per month (at 5.5% – you have a good interest rate), and if you’re like most Americans struggling with other debts, you can only pay the minimum monthly mortgage payment. After 30 years, you have paid $204,120 on your mortgage.

Now it’s time to start saving. You decide to put your old mortgage payment into your savings for retirement. But, paying off the $50,000 balance took you roughly 10 years, so you only have 15 years to save. Not a problem. If you sock away the full $567 that was going to your mortgage payment, in 15 years, assuming an average rate of return of 8%, you could have accumulated $197,511. It’s O.K., but not great.

But wait!

This only covers a certain percentage of homeowners. What about those homeowners that choose a 15 year mortgage? After all, the reason for choosing a 15 year mortgage is that although your payments are higher than a 30 year mortgage, your interest rate is lower and you pay less interest to the bank. Let’s assume with a 15 year mortgage you were able to buy that mortgage at 4%, so you’re monthly payment is $739.69.

At that rate, you’ve paid about $133,144 total on the mortgage after 15 years, so you’ve definitely saved a lot of money vs. the 30 year plan. Now it’s time to save for retirement and you put that $739.69 into savings at 8%. But because you took a 15 year loan instead of a 30 year loan, you have an extra 15 years that you didn’t have before, and if we are still assuming that you purchased your first home at age 25, you’re going to be 40 when you’re finished with the 15 year plan. Assuming that you still retire at age 70, that gives you 30 years to save for retirement.

At the end of those 30 years, you have accumulated a whopping $1,109,753!

However, what if we take a slightly different approach? Remember, the purpose of a mortgage is to leverage a home’s equity (the value of the home) – to be able to take advantage of the equity without putting very much of your own money at stake. By leveraging the equity, you get access to, and ownership of, the home for a small amount of money every month…but could you get more?


Assuming, as before, that you purchased the home for $100,000, let’s leverage all of the equity for the full 45 years (from age 25 to age 70). We do that by choosing a mortgage with an interest-only option. Which means, we carry a standard 30 year fixed mortgage (as opposed to a variable) with an interest-only option for 3, 5, 7, or 10 years. The interest-only option dictates that we only have to pay the interest on the loan and none of the principal for the stated period.

We would likely have to pay a slightly higher rate for the interest only option (as is typical) on a 30 year fixed mortgage, but we could get a monthly payment of $500 @ 6% using an interest-only option. That’s a savings of $239 .69 per month over the 15 year plan and $67 per month vs. the 30 year plan.

The numbers are not staggering, but they do illustrate a point. By investing the $239.69 every month, after 45 years, we’ve accumulated $1,272,682 which is slightly more than what we had under the 15 year plan.

Compared to the traditional 30 plan, we also did better by accumulating $355,750. To be fair, and critics will point this out anyway, there is a cost associated with the interest-only option: you have to keep refinancing at the end of the interest-only period to keep the benefit of those lower payments. Let’s assume $20,000 in additional closing costs over those 45 years. We’re still ahead of the game on all accounts.

If we pay off the mortgage after those 45 years, we also have to deduct that from our retirement savings. At the end of it all, we profited an additional $42,000 (roughly) when compared to the 15 year plan, and $38,000 over the traditional 30 year plan.

That may not sound like much, but it does show that the lower monthly payments did in fact benefit us over the same time period when saving money for retirement. Additionally, it gave us more flexibility and possibly easier access to our money in times of financial crisis. If you became unemployed in this scenario, you’d probably prefer to have all of your equity as cash, instead of trying to convince the bank to let you borrow money to make ends meet.

Of course, we could also choose to use a reverse mortgage at retirement and never pay the home off, in which case, we can keep that $100,000 of equity until we die. A reverse mortgage is a mortgage that offers homeowners (once they attain a certain age) the ability to suspend repayment of the mortgage until the homeowner(s) die or decide to sell the property. At that point, the home can be sold or deeded over to the bank.

When we take a look at other consumer debt, this is where we will notice a big difference (to our advantage) by using a mortgage with an interest-only option. Credit cards, auto loans, and other personal loans that either aren’t or can’t be stretched out for extended periods of time can be leveraged into a 30 year (or longer) mortgage using an interest-only option.

Car loans are normally amortized over 5 years…credit cards typically demand 2-4% of the charged balance per month. These payments can be significantly lowered by refinancing your home. In turn, this frees up “extra” money for saving or investment purposes. In some respects, the interest rate on the mortgage becomes almost irrelevant. As long as you end up with more money in your investment account than what you spent on your mortgage, you’re doing great.

This process doesn’t always work, and there are some real dangers to using this concept (which I’ll cover at the end of this article), but the difference it can make is substantial when it does.

There are two people who will be invaluable during this process. You’ll want to hunt down a really savvy, intelligent mortgage broker or loan officer. What you are looking for is someone who is very familiar with many different types of mortgage loans and how to properly use these mortgages with an interest-only option. Notice I stressed the word “properly”. Some mortgage brokers will try to get you into the biggest home possible for the same monthly payment. You don’t want to work with someone like that when attempting this concept.

The second person you will want to talk with is a good financial advisor that knows a little bit about fixed income investments (like bonds), fixed life insurance, fixed annuities, equity-linked financial products (i.e. corporate notes, life insurance, annuities, cds) and other safe-money investments capable of achieving rates of return that can make this strategy work. By law, brokers can’t invest your savings into variable investments but there are some equity-linked insurance products that can potentially do the job for you which are not considered investments in the traditional sense (in other words, it’s perfectly legal to invest your mortgage proceeds into fixed or equity-indexed insurance products since they guarantee your interest earnings and principal).

Since implementing this strategy requires a certain specific type of knowledge about how to properly fund a fixed or index-linked contract and for maximizing the amount of profit you see from using this leveraging concept, I am going to suggest that you seek the help of a professional to assist you in making sure everything is done properly.

Now for “the catch”…

…every “neat” concept has a “catch”, right? Well, I don’t know about always, but there are a few “catches” with this concept. It is leverage, after all. Leverage can work for you in a big way. But, it can also work against you in a big way.

If you’ll notice, I frequently used “average interest rate” assumptions throughout my explanation. This is where things can really get messed up.

An average rate of return doesn’t always mean that you are getting that actual rate of return. For example, sometimes an average rate of return of 8% turns into a real rate of return of only 5%. Confusing? Yes, it can be. So, in my example, we profited $42,000. In reality, you might not profit as much, or you might even lose money on the deal. That’s the risk of relying on an “average rate of return.”

You can also make much, much, more than an extra $42,000. I’ve seen folks with plans that would earn then a profit of a few hundred thousand after mortgage costs. That can make a huge difference in your retirement. I’ve also seen folks who, despite their best efforts, could not make the concept work for them (and so they decided against trying it).

What makes the concept work is interest rate “arbitrage.” If you want to guarantee that this concept works, you have to work with fixed interest investments. Obviously, you need to be making more money on your investment than you are paying on your mortgage, so using fixed interest investments presents an interesting – though definitely not impossible – challenge.

The general rule of thumb for doing this is that the interest rate on your investment should at least equal your mortgage interest rate if your investment is compounding. If you are investing in a tax-free, or tax-deferred, investment, the interest rate on your investment can be as low as 2% lower than your mortgage interest rate (the compounding and tax deferral will ensure that you’ll still make money, even when your investment rate is lower than your mortgage rate (run the math; it actually works).

The other “catch” is making sure that you are using a fixed mortgage for this concept. A fixed mortgage prevents the payments from working against you over time. Anything that is variable, on the mortgage or the investment side, can work against you in a big way.

Of course, the bigger the positive spread the better. It’s all about minimizing what you pay on your mortgage and other debts and maximizing what you earn on your investments. While there is some risk, this is actually a very old concept used by wall street to make a lot of money in the bond (and other) markets. If you understand the risks, and you are able to manage them, this is a great leveraging concept.

December 2nd, 2011 | by David | No Comments

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