I am writing this blog as a direct retort to the one posted by Robert Ashby titled:
Money Merge Accounts Vs Equity Harvesting: Harvesting Wins by Over $1.5M
I posted 2 responses to this blog and Mr. Ashby deleted the second. Due to this I am now posting my own blog on this topic as I believe people have the right to the truth. The Equity Harvesting strategy that is currently being advocated by many in the mortgage profession has multiple risks associated with it that the people promoting it are either selectively ignoring or are completely ignorant of. I don't know which is worse.
In his blog Mr. Ashby advocates that his supposed "client" refinance their home every five years, extracting equity for the purposes of investment and then proceeds to assume that these people will achieve a rate of return on this money which is greater then that of the rate of interest they will have to pay for borrowing it. He also assumes a 4% appreciation rate on the property itself. He assumes he knows not only the future rate of appreciation on the property and the future rates of returns on these unspecified investment vehicles, but also the future rates of interest on subsequent loans that these "clients" of his will have to pay. That is way too much assumption for my tastes, and we all know what happens when we assume. In addition he makes no mention of the potential tax consequences of enacting this strategy.
In my analysis of Mr. Ashby's assumptive and quite flawed case study I have found multiple egregious suppositions that I am quite frankly, disgusted by. In so being I will now outline the many potential pitfalls this strategy has.
Pitfall #1 - Home Acquisition Indebtedness vs. Home Equity Indebtedness
The vast majority of the "Advisors" recommending people use this strategy base their advice on the fact that mortgage interest is tax deductible. The idea of creating this arbitrage is firmly rooted in this. The key fact that is so conveniently omitted or ignored by these "Advisors" is the difference between what the IRS considers Acquisition Indebtedness and Home Equity Indebtedness. Acquisition Indebtedness is any money that you borrow to acquire the home and the interest on which is tax deductible (as of this writing) on up to $1,000,000.00 of the debt. Home Equity Indebtedness is any money you take out of the home through a cash-out refinance, home equity line of credit or other mortgage not used for making capital improvements to the home and is only tax deductible on the first $100,000.00. In the past the IRS had no way of telling how much of your home loans interest was being paid toward the Acquisition Indebtedness or Home Equity Indebtedness, this however has changed. The IRS is requiring lenders to report how much of the interest they are collecting is for Acquisition Indebtedness and how much is for Home Equity Indebtedness.
So if you bought your home for $100,000.00 and subsequently paid off $10,000.00 of your principle balance and you decided that you wanted to take cash out of your home to invest it, you would only be allowed to deduct the interest paid on the first $190,000.00 of the new debt.
Example: (Acquisition Indebtedness $100,000.00 - Principle Paid $10,000.00 = Remaining Acquisition Indebtedness of $90,000.00 + Maximum Home Equity Indebtedness $100,000.00 = Total Amount of Tax Deductible Debt of $190,000.00)
Without this tax advantaged treatment of the mortgage interest the Equity Harvesting Strategy falls short of producing the desired returns.
Pitfall #2 - The AMT (Alternative Minimum Tax)
Allow me to pre-qualify my following statements as they pertain to the AMT with two disclosures: 1) I am not an accountant and do not provide tax advice. 2) To obtain tax advice on how the AMT or other tax related issues may affect you, please consult a Tax Professional.
The AMT is becoming more and more of an issue for middle class families. One of the places the AMT impacts people is in their ability to deduct their mortgage interest. Individuals and Families who find themselves subjected to the AMT will see their mortgage interest deduction phased out either partially or in its entirety. So again we have a situation where the tax deductible nature of mortgage interest, that this Equity Harvesting Strategy so heavily relies upon, is eliminated from the equation.
Pitfall #3 - Investment Selection
The economic concept behind the Equity Harvesting Strategy is Arbitrage. Borrow money at one rate and invest it in something that gives you a higher rate of return.
Example: Borrow at 6%, Invest and Earn 10% = Profit of 4%
There is nothing wrong with this strategy. Business and banks fuel our economy by enacting this practice on a daily basis. A business uses a line of credit to purchase inventory and incurs interest charges but through having the inventory its customers are frequently buying the interest expense is justified by the speed at which the business is able to turn over that inventory. A bank pays it depositors 4% and lends the money to it's borrowers at 6% and makes 2% on the spread. This happens everyday; this is what these companies are business to do. With enacting the practice of Equity Harvesting into your personal financial plan you are essentially putting yourself into the business of doing the same.
You borrow money through a mortgage that you must pay 6% interest on. You now have to select investments that are going to earn you more then 6% in order to make a profit. If you do not earn more then 6% on your investments then you are taking a loss and no one acquires wealth through the taking of losses. Now many of the so called "Equity Managers" out there will be quick to say ‘you don't have to earn more then 6% because the mortgage interest is tax deductible' even though I have already spent considerable time outlining how this very well may not be the case in Pitfalls 1 & 2. In light of this I will not rehash it here but move forward with the next pitfall.
Pitfall #4 - Taxation
Let's say you have decided that you feel that you are able to achieve a rate of return greater then the interest you would have to pay to service your debt. Is this rate of return still greater then the interest rate after you factor in what you will have to pay in taxes on said investments return? If not then you are once again taking a loss.
Pitfall #5 - Fees, Commissions and Other Costs
Most investment vehicles have some form of cost attached to them. You either have to pay commissions on their purchase and sale or a management fee to an investment advisor or a ticket charge to a discount broker... you get the idea. Does the investment still yield more then what you are paying in interest when this is factored in with your tax liability?
Pitfall #6 - Risk
The investment vehicles that you would need to put your money into in order to achieve a rate of return greater then the rate of interest you would have to pay will carry a capital risk. In this I mean, you could lose the money and in the event that you did lose the money you would still have the debt.
There are many other flaws in the Equity Harvesting Strategy but for fear that I will never get this blog posted I am choosing at to move on to the MMA Strategy at this point.
The MMA Strategy is one that I believe is inherently less risky and is more easily quantified with significantly less supposition. The MMA is a debt reduction strategy while the Equity Harvesting Strategy is one that increases debt. In my professional opinion, there is no other strategy available today that will enable someone to pay off their home sooner without making significant sacrifices to cash flow. Simply put, if you want to own your home free and clear the MMA is the way to go. If you do not care about owning your home free and clear and feel you are able to circumnavigate the pitfalls I have outlined above, then by all means, proceed with an equity harvesting strategy.
Over the coming weeks I will be posting additional blog entries about the MMA and Equity Harvesting. For now if you would like more information on the MMA Program you can visit: http://www.freeandclearinfiveyears.com/
My next blog on Equity Harvesting will be titled - Equity Harvesting; Ask Yourself, Who Does it Benefit? The Cost of Equity Harvesting vs. The Cost of the MMA
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