by DUANE DUGGAN Realtor and Author RE/MAX of Boulder
Home prices have increased across the country since the end of the recession in 2012, through the COVID-19 pandemic, and now continuing in 2023. Colorado and the Front Range have seen even more appreciation than the national average. Huge increases in home equity and low-interest rates make it very tempting to pull equity out of your home to buy that zippy new car and big-screen TV.
Initially, the COVID-19 crisis caused job losses, which made much of the country realize they could only pay their bills for a couple of months after income from their job had stopped. In light of that, you might ask yourself, “What can I do to prepare myself for the next crisis?” or “Should I pay off my mortgage or borrow against the house and invest the cash?” Today, we will discuss getting your mortgage paid off on the one hand and refinancing to get cash out on the other. Having a home free and clear of any mortgage or investing the equity in a growth environment can be a benefit if there has been a job loss or other crisis.
My parents grew up in a generation where it was important to get the mortgage paid off—and even have a mortgage-burning party! When I was in college, I learned about the deductibility of mortgage interest, keeping the mortgage balance high, and investing cash from mortgage proceeds. Now, with the mortgage issues of the great recession of 2007 to 2012, many people are in the frame of mind to get their mortgages paid off.
Two techniques homeowners can use to build equity in their homes are known as Mortgage Acceleration and Mortgage Offset accounts.
Mortgage Acceleration is the process of paying off a mortgage earlier than a 30-year amortization schedule would provide. If extra payments are made, the principal goes down faster. But what if you encounter tough times and want your money back? You can’t call the lender and say, “I’ve been paying extra principal, can I have some of it back?” That’s an argument for investing what could have been made in extra principal payments into something that is accessible if cash needs arise.
A Mortgage Offset Account is a process of taking what would have been extra principal payments and placing them in an account to save and receive a return, then taking the cash accumulated and using it to pay down the mortgage when desired. In the meantime, cash is still there for emergency needs.
Using your home equity to increase the velocity of your money
True Home Equity Management takes a little different twist than the techniques described above. Those techniques are used when your goal is simply to pay your house off. Whereas in many cases, homeowners will pull cash equity out of their home to spend on consumer items, vacations, etc., a better alternative would be to invest in what grows not in what shows. You could borrow against your equity and buy more real estate (what grows). You could borrow against your equity and buy more real estate (what grows) instead of that flashy sports car (what shows). True equity management, however, involves pulling equity out of your home through refinancing and INVESTING it in the proper investment vehicles. After all, equity has no rate of return unless you activate it!
Equity in real estate grows as a result of the loan being paid down and values increasing, but remember, equity itself, does not have a rate of return. Combine the proper investments with mortgage acceleration techniques and the deductibility of mortgage interest, and you have a powerful wealth-building tool. That is very confusing because most people believe that the rising prices of houses are giving you a return on your equity.
Maximizing equity management
Interest on a home, which is usually deductible, is simple interest with the loan declining each month. If it is deductible, the effective interest rate is less than the face rate. When equity is pulled out and that cash is invested, it is invested in something that earns compound interest, the opposite of simple interest. To maximize your equity management plan, you want to invest in something that earns compound interest inside a tax-favored environment. Then the growth potential is incredible! Combine all those factors and what you have is activated equity at an increased growth velocity.
So how do you combine all factors in one equity management plan?
The answer is what my financial planner has coined the “OUR” Plan. “OUR” stands for Optimized Universal Life Insurance Supplemental Retirement Plan. This amounts to investing in a life insurance policy.
Advantages of “OUR” Plan:
- You purchase a life insurance policy so you will get a life insurance protection death benefit.
- Your financial planner invests the cash value of your policy where your investment grows tax-free within the life insurance policy.
- You can withdraw without a tax burden up to the original dollar investment OR withdraw tax-free with a policy loan.
The bottom line is that you can build a nice nest egg using this technique. Learning from the pandemic, we can see it is very important to set the stage for financial sustainability in the event of income loss. To design a home equity management plan that works for you, team up with your CPA, financial planner, and attorney to investigate the possibilities.
Duane has been a Realtor since 1982. Living the life of a Realtor and being immersed in real estate led to the inception of his book, Realtor for Life. For questions, e-mail [email protected], call 303.441.5611 or visit boulderco.com.
