One of the bedrock principles in owning your own home is security for the future, an investmnet that over time will appreciate. (Nationally housing has not declined significantly in value over the last 80 years.)
But what homeowners have being doing over the last decade or so is refinancing their current equity and taking out a new 30 year loan, which in effect, turns their home investment into a real estate credit card and does away with any equity buildup to secure their future. The only way cash-out refinancing might work toward a more secure future is if homeowners were to take the money realized from refinancing and invest it in something that would pay them a higher rate of return than projected future appreciation on their home.
But that's not how most Americans are using their home equity these days.
Yesterday I was counseling a couple about to purchase their first home. They're in their early 30s, both with established careers, just married and now ready to start investing in their future by buying a home. I counseled them that when they're tempted to refinance in order to take equity out for another purpose (paying off credit card debt--which they should be using judiciously, take a cruise, buy that new big screen TV and sound system), they should think twice about depleting their hard-earned equity.
I just received a flyer for a new mortgage program from my regular lender: a 40 year loan for those clients who have "high debt to income ratios, want a larger home, or have been delaying a purchase." I can't counsel buyers just starting out to choose a mortgage like that no matter how attractive it might seem in the present. The future is all too soon here, and they could find themselves without much equity and remembering the real estate agent who suggested this easy way to buy a home.
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Forgive me, but I have a background in finance, work closely with financial planners, and accountants, and do seminars with them on this issue. Allow me to explain the financial concepts. Well, I agree with you at least partially. People should not refinance, pay off credit cards or consumer loans and then go on a buying binge. However, equity in a home fails the three tests of money; safety, liquidity, and rate of return. The old adage about mortgages being bad and equity being good is just completely wrong. The genesis of this myth is from the depression when mortgages were callable. Not the case now.
Is home equity safe? No, just ask the residents of the Gulf Coast from New Orleans to Pensacola. Housing prices (if they had a house left) plummetted and their equity went with it. Only the latest example, try Houston in the 1980's, Detroit after the automobile layoffs as other examples.
Is home equity liquid? Only two ways to get to it, sale the house or refinance. Selling in this market can take up to 9 months. Try to refinance a home if you lose a job, become disabled or some other event happens where you really need the equity. So the answer is no.
And what about the rate of return on equity. Here you totally misunderstand the concept. If you and I have identical houses next to each other worth $200,000. I have a $100,000 mortgage and you have a $160,000 mortgage. They both increase in value over the year at 10% what is the rate of return you have? 10% And I have the same rate of return, 10%. So what is the rate of return on home equity? 0%
You would actually be safer taking the equity in your house and burying it in your back yard; it would be more liquid, safer and give you the same rate of return.
As far as a side fund with your equity, you are correct it is a good move. However, you don't need to get a higher rate of return on the side fund than the mortgage rate. Why? Two reasons, mortgage interest dedection and simple versus compound interest. First, if you are in the 25% marginal tax bracket and have a mortgage rate of 7% your effective rate (or cost of funds) is 5.3%. Next, your mortgage interest payoff is under a simple interest environment, while your side fund is under a compund interest environment. Compound interest not only gives you interest on the principle but after year one gives you interest on your principle + your accumulated interest. A simple example is 7% on $100,000 will make you $7,000 the first year, but increase to $7,490 the second year and $8,035 the third year.
So the true cost of funds for your $100,000 equity finance is $5300 per year ($7,000 X .75) in the 25% tax bracket. After three years if would cost you $15,900. But what would your side fund have made you? After three years it has made you $22,525 or a profit of $6,625 ($22,535 - $15,900). That is assuming same rate of return as mortgage rate. If your mortgage rate is 7% and you get 6% return on the side find then your three year profit is $3,210 and if you can get 8% on your money then the profit is $10,071.
The concept works with almost any rate of return since interest rates are relative. When mortgage interest rates rise the corresponding interest rates on investments also go up.
Agreed financial jellyfish (those that can't stop themselves from spending) can benefit from the forced savings of amortizing mortgages, but for the rest, equity should be liberated from a home. Homes are for families not to house cash!