The COVID-19 crisis has caused significant job losses and many Americans have realized they can only pay their bills for a couple of months after losing income from their jobs. In world of uncertainty, many people are asking, “What can I do to prepare myself for the next crisis? Should I pay off my mortgage or borrow against the house and invest the cash?”
Having a home free and clear of a mortgage can be a benefit if a homeowner is experiencing a job cut or disruption. With current record-low mortgage rates, it can be very tempting to refinance and pull cash out from the equity in your home. Today, we will discuss paying off your mortgage on one hand, and refinancing to get cash out on the other hand.
My parents grew up in the generation when it was important to get the mortgage paid off, and when they did, they celebrated by holding a mortgage burning party. When I was in college, I learned about the deductibility of mortgage interest, keeping the mortgage balance high, and investing the cash from mortgage proceeds. Now, with the mortgage issues of the great recession from 2007 to 2012, many people are of 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 getting a mortgage on a home paid off earlier than a 30-year amortization schedule would provide. If extra payments are made, the principal goes down faster. But what if tough times come around and you want money back? You can’t call up the lender and say, “I’ve been paying extra principal, can I have some of it back?” That is an argument for investing what could have been made in extra principal payments into something that would be accessible if cash needs arise.
A mortgage offset account is the process of taking what would have been extra principal payments and placing them in an account to save and have a return, then taking the cash accumulated and using it to pay down the mortgage when desired. In the meantime, cash is still there if an emergency need arises.
Home equity management has a different meaning than the techniques described above. The techniques above are applied when your goal is simply to pay your house off. However, it is important to learn about true equity management. In many cases, homeowners will pull cash equity out of their home to spend on consumer items, vacations, etc. A better way to manage equity, rather, involves pulling equity out of your home via refinancing, and investing it in the proper financial vehicles. After all, equity has no rate of return unless you activate it. This is very confusing because most people believe that the rising prices of homes provides you with a return on your equity. Nevertheless, a key phrase to remember is to invest in “what grows” not in “what shows.” For example, you could borrow against your equity and buy more real estate instead of a flashy sports car. However, if owning more real estate is not in your plan, here is another idea.
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.
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 of a tax favored environment. Then the potential for growth is incredible. Combine all of those factors and what you have is activated equity!
So how do you combine all factors into one equity management plan?
The answer is what my financial planner has coined the “OUR Plan”. The “OUR” stands for Optimized Universal Life Insurance Supplemental Retirement Plan. This amounts to investing within a life insurance policy.
Advantages with “OUR” plan
• This plan involves the purchase of a life insurance policy so you will get 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 coronavirus crisis, we can see that it is important to have financial sustainability in the event of income loss. You can contact your financial planner to see if this is a program that works for you.
By Duane Duggan. Duane has been a Realtor for RE/MAX of Boulder 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 DuaneDuggan@boulderco.com, call 303.441.5611 or visit boulderco.com.