Just Say No To Home Equity

Brandon's post about matching home loan payments to income got me thinking about my loan philosophy. I like interest-only loans, because index funds have a substantially higher return than real-estate, so equity is loss as far as I'm concerned. But thinking about the lifecycle of the loan makes me realize that that isn't enough. After all, even an interest-only loan will accumulate equity due to appreciation, and equity is bad!

So in addition to getting an interest-only loan (which I have), I think the consistent thing to do is periodically take 2nd mortgages, and put the proceeds into index funds.

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Theres more to life than EV

Doesn't this strategy have the large downside of increasing your variance due to your lack of diversification into these reasonable independent asset classes?

He'll be fine as long as

He'll be fine as long as he's prepared to pay out of pocket in the odd down-year (or decade)

Getting a return of 2% (real

Getting a return of 2% (real estate return) instead of 8% (something like that for stock market after inflation) is a hell of a price to pay in the name of diversification.

Besides, I'm not holding these assets for their income generation, but for their appreciation to get me to retirement. Which means the time scale in question is long enough to reduce the need for diversification.

Ah, but there's more to real

Ah, but there's more to real estate than diversification. Many people plan to buy a home when they retire, maybe to settle somewhere sunny. Holding real estate asset gives you the correct exposure for the goods you plan to buy when you retire, it's more than diversification, it's a hedge. You can also live in a home you buy which may have a fixed value to you, thus the home embeds a free option.

Of course it's best to invest in equities and hold future contracts on home prices indices, but that's not for everyone.

JFK -- owning real estate

JFK -- owning real estate gives you exposure to the asset class, how much money you owe on it is irrelevant.

This criticism also hits something Patri said: I like interest-only loans, because index funds have a substantially higher return than real-estate, so equity is loss as far as I'm concerned.

The return from real-estate vs. stocks isn't the issue -- if you own a house worth 500k, then you are 500k invested in real estate, whether your equity is 500k, 100k, 10k or 0k.

The relevant comparison is the after tax return on the alternate investment to the after tax cost of capital. It's pretty clear that on first mortgage loans, with deductible interest, leveraging pays handsomely. If you are in a high tax bracket, or if your credit is such that you can get second mortgage loans to 95% or even 100% LTV for similar rates as a first mortgage, then it's a clear win, as long as you have enough net worth or time to stomach the variance. If a second mortgage will cost 8% and you're in the 15% tax bracket, it's a little more questionable whether the stock market provides a better risk/return profile.

You're right, this is a more

You're right, this is a more accurate way of looking at it.

Another Angle

A few years ago when I taught this pitch to my employees in order that they could sell interest-only cash-out refis, I added a little "post 9/11 world" twist to it: the threat of terror could mean realistic radical property devaluations and having your money elsewhere could be the difference between being foreclosed upon with $100,000 bucks in the bank vs. being foreclosed upon with $100,000 in now-gone equity you didn't use. Wait, wouldn't the very stocks you're invested in be affected by the attack just as housing would? That's an excellent question, I'm glad you asked (salesman line): invest in gold.