Money Management and the Economy

Thursday, May 24, 2018

The Myth of Taking Equity from Your House

You aren't smarter than the market. It really is that simple.

The idea that you can "take money" out of your home is a common myth that gets a lot of people in trouble in a hot real estate market. It is a myth that is based on several misunderstandings that are often repeated.

Myth 1: When an investment you own goes up in value you have "made money."

In fact, you only make money from an asset's appreciation when you sell the asset. Until then, the current valuation is just an estimate of how much money you will make when you actually sell it. As long as you still own the asset, the value you will get is still in play. It isn't money. This is particularly important with a home. If you want to take your profit out of your house you have to sell it and that usually means replacing it with another home.

Myth 2:  Refinancing  "takes your equity" out of your house.

This myth is particularly pernicious. In fact, the description of people "using their home like an ATM" feeds the notion that you are simply using money you already have.  But a more apt comparison for getting cash by refinancing your home or taking out a home equity loan is that it is like using your credit card for a cash advance. Like a cash advance on your credit card, you are simply taking out a loan on which you will have to make payments, including interest.

Of course the advantage of a home equity loan, or a refinance, is that the interest you pay is lower and the term of the loan is often longer. This means lower payments and lower total costs than a similar cash advance on your credit card.  Those advantages result from your putting up your home as collateral. If you don't make the payments, the lender takes your house and sells it to get repaid.

Myth 3: You will at least get a tax deduction for interest on a home loan

Even before the recent tax law eliminated the tax deduction for home equity loans that weren't used for home improvements, the value of this tax deduction was misunderstood. Almost 80% of taxpayers do not itemize, instead they take the standard deduction, currently $24,000 for a married couple. So they have no ability to take a deduction on their mortgage interest.

But even many people who do itemize are only recovering a small part of their loan interest. This is because they don't have $24,000 in other deductions. The result is that a substantial part of the interest deduction is just replacing a portion of the standard deduction they would have received anyway.  Consider that 5% interest on a $500000 loan is $25,000 and if you have no other deductions, that is only $1000 added deduction. The tax savings in the 24% tax bracket are less than 1% of the interest paid or .05% of the loan value.

Refinancing your home, home equity loans and home equity lines of credit all have their purposes. They are often a low cost way to borrow money. But you are borrowing money, not harvesting the proceeds of your investment. As many people have discovered when a hot housing market turned cold and they were stuck with a house they couldn't afford to sell. Or worse, lost their home when they couldn't make the payment on all that "equity" they "harvested".

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