Certain investments not worth the risk

Jack Guttentag
Inman News

Q: “I bought a house two years ago that is now worth $340,000, with a mortgage of $240,000. I am being told that my $100,000 of equity is “dead,” just sitting there doing nothing for me. How can I make my equity work for me? I don’t want to do anything stupid.”

A: “Dead home equity,” with its implication of opportunity foregone, is a meaningless concept. Home equity is equal to property value less all liens on the house, which in your case comes to $100,000. Calling equity “dead” is a distortion of the English language. The fact is that the more equity you have, the better off you are. If you have a car with no car loan, you have dead equity in your car, but no car owner should feel guilty about that. Owning an asset free and clear is an objective to be sought, whether it is a car or a house.

Proponents of the dead-equity idea want to sell you the loans that would deplete your equity, and the investments they claim would more than recover it. There are circumstances where this might make sense. For example, if an investment opportunity comes along in which you have great confidence because it is a project you will be personally involved in, and it requires money you don’t have, consider borrowing against your home equity. It is a calculated risk that may be worth taking, especially by a younger person who will have an opportunity to recover if the project doesn’t pan out. I recommend it less often for seniors.

If you anticipate financial problems in the future that will cut your income and with it your ability to make mortgage and other payments, you want to keep your home equity readily available. Think of it as a reserve account you can tap if you need to. It doesn’t take long to open a home equity line of credit (HELOC) that you can use to keep current on your obligations.

WARNING: Don’t try to do this after you become delinquent, then it will be too late.

What I recommend against is allowing yourself to be persuaded by a third party who wants to sell you both the loan that will deplete your equity, and the investments that will make your fortune. The people who sell these deals make most of their commissions on the transactions, while you take the risks down the road.

I might reconsider if I could find one who would align his/her financial interest completely with mine. This would require a) that he/she provide the mortgage loan at the wholesale price (no broker markup), and remit the full sale commission on the investment to me, and b) He/she would make his/her money as I do, sharing the difference between the income earned on the investment and the interest payment on my mortgage, including a loss if the spread became negative.

Why Do Employers Check Credit?

Q: “Why do employers do a credit check when hiring employees? I don’t think it’s fair because I can’t repair my credit until I get a better-paying job, and I can’t get a better-paying job because of my bad credit.”

A: Employers who check the credit of job applicants believe that applicants who meet their credit obligations are most likely to be conscientious employees who meet their obligations to their employers. In this view, most people are consistent in their behavior across the different aspects of their lives. They are dependable or not dependable, seldom are they dependable about one thing and undependable about another.

Of course, this is unfair because some people have credit problems as a result of circumstances completely beyond their control. But who ever said that life was fair? It is not so unfair, however, as to brand a person forever. You can rebuild your credit, and there are employers who will listen to an explanation of why the low credit score in their case is not indicative of poor character. To make your explanation convincing, however, avoid creating an impression that you feel the system is persecuting you.

Dumb-Question-of-the-Year Award for 2005

Q: “I purchased my home for $480,000 and it is now worth $600,000. Is there any way of cashing out this additional $120,000 of equity and applying it to the loan balance?”

A: You can borrow the $120,000, which will increase your loan balance by that amount, and then use it to pay down the balance by the same amount. Of course, that will leave the balance right where it was, and you will be poorer by the amount of the closing costs on your new loan.

The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com.

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Copyright 2006 Jack Guttentag

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