Thursday, August 7, 2008

Your House as ATM

“Cause I love to live so pleasantly,
Live this life of luxury,
Lazing on a sunny afternoon,
In the summertime.”
- Sunny Afternoon – The Kinks

There haven’t been too many sunny afternoons here this year, but that hasn’t stopped many homeowners from wanting to live pleasantly. Rising home prices over the last several years created large increases in home equity, prompting many - insert your town name here - homeowners to treat their home like a cash machine via home equity loans (HELOCs) or re-financed mortgages.

In the financial world, borrowed money is called leverage. In a leveraged transaction, the borrower invests borrowed money, and if successful, repays the loan, keeps the profit, minus the cost of borrowing. If unsuccessful, the borrower still has to repay the loan plus interest, but since the investment was a loser, she doesn’t have all of the borrowed funds to repay the loan and must cover the loss from other funds. This can be very painful financially.

The problem for - insert your town name here - homeowners leveraging the equity in their homes is that a good portion of the money borrowed is not invested in appreciating assets. Many - insert your town name here - homeowners spent the money in one of three ways: home improvements, experiences (vacations and trips) and depreciating assets (cars, boats, home furnishings, etc). Spending borrowed money on home improvements can work out successfully – if the home is increasing in value at a rate higher than the cost of borrowing. To be fair, there can be intangible rewards too, e.g., increased satisfaction with one’s living space. But, spending borrowed money on lifestyle choices (experiences or depreciating assets) is a poor use of leverage because neither experiences nor depreciating assets can be used to repay the loan. Long after the experience is over or the car is sold, the borrower is still making payments on the home loan. When the value of homes stops increasing or even declines, equity-leveraged homeowners can find themselves with little or no equity but – you guessed it - they still have loan payments. Home values in my local area have been fairly stable after the large run up in 2004 - 2006 unlike many other regions in the U.S., lulling local homeowners into perhaps a false sense of complacency. I can only imagine what people in parts of the country where housing values are diving are doing: working second and third jobs, cutting out all the extras and in the end, walking away (“jingle mail” - that's where you put your keys in an envelope and mail them to the bank).

Rainy Day Advice: if you haven’t tapped the equity in your home, don’t start now. If you have, review your decision and develop a strategy to repay the loan. If home values keep falling, today’s home equity party can easily become tomorrow’s home equity hangover.


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