The phrase “financial wisdom” is not an oxymoron like “deafening silence” or “jumbo shrimp.” But there are times when generic financial advice can seem almost as contradictory. For example, persistently low interest rates have experts urging homeowners to ponder two diametrically opposed strategies:
- Add to home equity by using cash reserves to pay off a mortgage, or…
- Withdraw home equity, using either a home-equity line of credit or cash-out refinancing.
You can’t get much more opposite than that. But is it possible that both options could be right—or wrong—at the same time?
Maybe. The approaches are similar in their attempt to reallocate assets to be more efficient and profitable. Each strategy has merit, and depending on your circumstances, might seem workable.
The Logic for Adding to Home Equity
You could use savings to make home improvements (by updating a kitchen, building an addition etc.), and these improvements might increase your home’s value. But the simplest way to increase home equity is using cash reserves to pay off a mortgage or home-equity line of credit. In this asset transfer, the payoff may be construed as producing a return equal to the interest costs that are “saved” by retiring the debt. Thus, paying off a $100,000 balance on a mortgage at 5 percent interest, with savings earning less than 1 percent, represents a more efficient use of those funds.
It is important to understand that a loan payoff does not increase overall net worth, or the value of the home. But paying off a loan decreases monthly obligations and increases cash flow. Money once allocated to a mortgage can be redirected to alternative investments, or spent. Even though net worth doesn’t change, the freedom of a paid-off property may accrue additional benefits, both financial and psychological.
The Logic for Drawing From Home Equity
Like rates on savings, loan interest rates also remain near all-time lows. With housing values returning to pre-recession levels in many parts of the country, homeowners may consider tapping their home equity to pursue investments that produce returns greater than the costs of borrowing.
The typical arrangements for accessing real estate equity are either a home-equity line of credit (HELOC), or a cash-out re-finance. An August 28, 2017, a Wall Street Journal article aptly characterizes a HELOC as “similar to a credit card, where a borrower can spend as much or as little of the available credit as they wish—but with the house as collateral.” In a cash-out re-fi, borrowers refinance an existing mortgage into a new one with a higher principal balance, giving them a chunk of cash to spend or invest.
A simple application of this strategy: borrowing $100,000 of home equity at 5 percent, to earn 8 percent. But other cash-out strategies could include a leverage play, where the lump sum is the down payment on the purchase of a rental property or business, etc.
Cash-out re-fi transactions may also reduce monthly obligations and increase cash flow. If the existing mortgage is well along the amortization schedule (say, a 30-year mortgage in its 15th year), homeowners may be able to re-finance an existing balance and receive a lump-sum, while reducing their monthly payment and increasing their tax deductions. These benefits can be accomplished through a combination of lower interest rates, smaller loan amounts (even with a cash-out), longer payoff periods, and a higher percentage of deductible interest because the new loan is at the beginning of its amortization schedule.
So…Add to, or Draw From?
Both approaches to home equity have advantages. Retiring mortgage debt eliminates interest costs, reduces monthly obligations and increases discretionary cash flow. Withdrawing home equity frees up cash for more profitable opportunities, while in some circumstances also reducing monthly payments and increasing tax advantages.
But an evaluation of either approach should be more than an isolated comparison of home equity and an alternative. A decision to transfer in or out of home equity impacts other aspects of your financial eco-system. Among the considerations: how adding to, or withdrawing from, home equity will affect cash reserves and cash flow.
Paying off a mortgage depletes cash reserves. If you have $40,000 in liquid assets and it takes $35,000 to retire a mortgage with $1,500/mo. payments, this transaction leaves almost no protection against a financial emergency. This exposure makes it almost imperative that the improved cash flow from the payoff be used to replenish the reserves—which probably means depositing $1,500/mo. in the same low-yield account that the payoff came from.
Also, while it’s easy to add equity, it’s much harder to withdraw it. A decision to build home equity through a cash transfer incurs an opportunity cost: You may not be able to pursue other financial opportunities without selling the property or getting the permission of a lender to borrow against the equity.
For those withdrawing home equity, a cash-out re-fi or a HELOC often comes with additional interest costs, higher monthly obligations and a longer amortization schedule. If debt service increases $100/mo., but the transaction yields an additional $150/mo. in income, these borrowing costs may be an acceptable trade-off. But what if you’re five to 10 years from retirement? Will higher payments still be affordable when you’re no longer working, but relying on savings for income?
Some financial professionals advocate paying off a mortgage and becoming debt-free as soon as possible. But eliminating debt at the expense of adequate cash reserves actually adds financial risk. In the event of an emergency, the illiquidity of home equity may aggravate an already challenging situation.
Advocates for drawing from home equity may tout profitable opportunities for arbitrage or leverage. But if these transactions add to monthly obligations and are used to acquire additional illiquid assets, there should be an assessment of the impact to current cash flow, and whether the liquidity risks require additional cash reserves.
This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities
products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
PAS is a member FINRA, SIPC.
Submitted by Elozor M. Preil
Neither Guardian, PAS, Wealth Advisory Group, their affiliates/subsidiaries, nor their representatives render tax or legal advice. Please consult your own independent CPA/accountant/tax adviser and/or your attorney for advice concerning your particular circumstances.