More on Mortgages, and Money

I got a call today from an old dear friend - the friend's not old, the friendship is; we were fraternity brothers in college (though, during the course of the conversation, I was reminded that next year will be the 30th anniversary of my undergraduate degree, which officially makes me old, I guess).  He had read my blog post last night about bubbles, and about taking equity out of your house by refinancing, and he had some questions.  That made me realize there were some points left out of my post that I ought to address.  So thanks to my friend (I'll call him Paul, because - well, that's his name), I have fodder for another post today.

Heck, I'm just gratified that someone reads this stuff.  And even more gratified that someone actually thinks I might know what I'm talking about (besides my Mom, that is).

The key point I neglected to make relates to the equity in your home.  That's an asset, right?  So why would I recommend reducing it?

For one thing, equity in your home is not a liquid asset.  You hope it's there when you eventually sell the house, but until then, it does nothing for you (except provide some peace of mind, perhaps).  I love being debt-free, don't get me wrong.  But I love having a nice, comfortable liquid cushion even more, especially in these times, with so much uncertainty on the horizon.  And especially if it's not going to cost me much to attain it (more on that later).

Paul and I talked about various scenarios, including the doomsday scenario in which not only do all the myriad bubbles I alluded to in last night's post burst, but banks fail, which could threaten our money on deposit with them.  But wait - that money is safe as long as we don't hold more than $250,000 per account, right?  (That's the current deposit insurance limit, and as I think of it, would make an excellent topic for yet another post.)

Then there's the Armageddon scenario in which our government's financial system fails, and deposit insurance can't cover banks' losses (and if you think Frank-Dodd removed the "too big to fail" risk, you probably also still think "Hope" and "Change" are things you can believe in).

That scenario isn't just the stuff of conspiracy theorists; it's a plausible risk.

So taking equity out of your house can also be seen as a hedge against that risk.  If the bubbles burst and the banks fail and the government collapses, selling your house in a few years to get the equity out probably isn't going to happen.  So why not get some of it out now, and have some cash with which to make your escape to a third-world ex-pat haven?

The other thing about your equity is that taking some of it out of the house by doing a cash-out refi doesn't really reduce your assets.  Let's say you own a $300,000 house free and clear, and you borrow $130,000 in a cash-out refi.  Your house is still worth $300,000, but you now have a $130,000 liability in the form of a mortgage, so the equity in your home is reduced to $170,000.

But you have $130,000 in cash, which is also an asset.  (If you go out and spend it on things that aren't stable assets, you learned nothing from the last decade, and I can't help you much.)  So your overall net worth is unchanged; the only thing that's changed is the portion of your net worth represented by the equity in your home.  In other words, you've merely re-distributed your net worth, reducing homeowner's equity and increasing cash.

That's like selling off part of your stock portfolio and investing in it bonds.  We call this "diversification," and it's a good thing.  So think of it that way.

Now, let's talk about money.  It's a funny thing, something nearly all of us have, and have to deal with, but not many of us understand very well.

Sort of like spouses.

Think of money as a product.  Like any other product, it has utility.  My car has utility; it gets me where I need to go.  My guitar has utility; it gives me enjoyment and lets me provide the same to others (at least I hope they enjoy it).  Food has utility; it keeps me from starving.

Taking that view, saving and borrowing is really just selling and buying money.

For any product that gives us utility, we pay a price - cars, guitars, and food all have a price tag.  So does money.

As savers, we're giving the bank the utility of some of our money, so they pay us a price (interest earned).  As borrowers, the bank is giving us the utility of some of its money, so we pay a price (interest paid).

That takes us back to a point I made last night: if somebody is going to give me the utility of a given product for a certain useful life, I pay a price.  If they offer me that utility for double the useful life, I'd expect to pay roughly double that price.  But in the case of a 30-year vs. a 15-year mortgage, I get the utility of the bank's money for twice as long, and I only pay about 24% more for the additional useful life of that "product."  That's a no-brainer.

Now, there are those who say, "But wait - I only have ten years to pay on my current mortgage.  I'm skittish about taking on a new obligation that won't be paid off for 30 years."  Understandable.  Except most of us won't pay that obligation off in 30 years anyway; we'll sell the house before then, and pay off the mortgage with the proceeds.

So, you might argue, why not just stick with my current mortgage and pay it off in ten years, owning the house free and clear at that time?  Then, when I sell, I get the full value of the house, not the sales price less the mortgage balance.

That's fine, but again, you're not diversifying if you do that - indeed, you're putting all your eggs in one basket.

Besides, your equity is going to keep building.  You're going to pay down the mortgage - albeit slowly on a 30-year loan - and your home's value is going to increase.  The worst of the housing decline is behind us, and even though home prices aren't going to rise by double digits in the future, they're going to rise.  If they only rise at the inflation rate (which theoretically is the rate at which residential real estate should appreciate), and the inflation rate stays around where it is now (which is unlikely; at the rate the government is printing money, it's likely to go much higher, which means real estate values would increase at a faster clip), then in ten years, price appreciation alone will add more than $91,000 to the value of your home (assuming 3% inflation).

At the same time, that $130,000, 3.25% mortgage is going to go down by slightly more than $30,000.  So you now own a $391,000 house, and you owe about $100,000 on it, so your equity is now $291,000 - just $9,000 less than you had before you took out the mortgage.

And if rates on savings accounts average just 1% over that ten years (and granted, they're well below that now, but they're likely to go much higher than that within a few years, if not months), the $130,000 in equity that you took out of your house and stuck in the bank will have grown to about $142,000, netting you $12,000 in interest income (ignoring taxes on both sides, which actually favor the mortgage side).

So your net worth has gone up by $3,000 in ten years.  Not huge, but better than staying the same.  And that's assuming that interest rates on savings stay at 1%.  If that's the case, you're still money ahead by pulling equity now.

If rates are above the 3% appreciation rate on your house, you're better off pulling the equity.  And I'm willing to bet they will be.  If they're above the 3.25% you pay on your mortgage, you have positive arbitrage, which a lot of guys on Wall Street would give their left arm to attain.

And if the Armageddon scenario materializes, you can take your cash cushion and live comfortably in that third-world paradise, and read about the demise of the US in the local newspaper.  If they have one.  If you're lucky, they won't, and you can just focus on your suntan.