The semantics of personal finance are fun.
Take my retired or not retired argument. On the one hand, we have YOUR BOY Nelly, who thinks that the internet world is filled with digital entrepreneurs who all brag about being “retired” when they’re about as retired as your local 7-11 employee. Hey, they don’t work *that* hard either.
On the other hand, maybe I’m wrong about these people. It’s obvious to anyone with a brain what they’re doing, so why should I care so much what they call it? They could call it “super sexy fun hour” and it would be about as accurate as calling it early retirement. What do I care if they want to call a cat a dog?
We could talk about a thousand different examples, but let’s not. Instead, I’ll just say this. While I think the whole personal finance is personal thing is hogwash designed to justify bad decisions, I’ll admit there’s a whole lot of grey area and differing psychological views when it comes to our finances.
For instance, take debt. I’m generally a fan of it, provided you’re borrowing for something that will either spin-off cash flow or that will increase in value. Borrowing to buy a car so you can get a $20,000 raise is probably good, provided you don’t get the $70,000 BMW. So is borrowing to buy a property or make other investments.
But at the same time, I’m the first to admit I think that way because borrowing worked out well for me back in the day. If you asked someone who bought U.S. real estate in 2006 or someone who’s drowning in student loans the same question, they’ll likely tell you debt is more evil than a kitten. NICE TRY, KITTEN WHO’S CLEARLY TRYING TO KILL ME.
How this applies to home equity
With this in mind, let me take explain home equity in two very different ways.
Home equity is the greatest. Imagine living one day in your beautiful home, knowing that all you have to pay is the taxes and the occasional coat of paint. The security of not owing a nickel to the bank is the kind of feeling money can’t buy. So what are you waiting for? Hurry yo’ ass up and pay that down, son.
Home equity is the worst. Imagine having hundreds of thousands of dollars in value just sitting there in real estate, an asset that doesn’t generate you a cent and is subject to wild market fluctuations. With landlords in Canada willing to accept rental yields of 3-5% and long-term stock market returns probably much higher than that, why are you even paying down your mortgage anyway? Interest only is the ticket, or better yet, just rent.
So which definition of home equity is right? Is it the greatest thing, something that will enable you to live for close to free one day? Or is it an asset that’s barely productive?
Ultimately, I can argue that home equity is useless and that money would be better invested in a number of different vehicles, but that’s not going to matter to someone who loves the feeling of having a paid off house. That psychology is very important to certain people.
Think differently about your assets
There are two types of assets, as outlined nicely by Eddie, the guy who wasn’t me but still wrote here.
The first are assets that generate you cash. Think stock dividends, rental income, or that time your dad paid you $5 to stop talking. These are productive assets.
The second are assets that are worth something, but don’t generate you cash. Examples might be the value of your car, furniture, gold bars, or Bitcoins. These are unproductive assets.
Just kidding. Nobody owns Bitcoins. I’d rather own Enron stock than Bitcoins.
The issue with home equity is until you pay the place off, it’s a non-productive asset. If you own a place in a major Canadian city, you could be sitting on hundreds of thousands of dollars in unproductive house equity.
Let’s run the numbers. Say I buy a place worth $500,000, something I probably would never do, but here we are. I put down $100,000 to avoid CMHC insurance, leading me to borrow $400,000. Say after 10 years I plow my money into the house and the mortgage is now worth $200,000. Let’s ignore interest because I’m lazy and say I paid none, and we’ll say the house increased in value by 2% per year.
So at the end of 10 years, I have $200,000 in home equity and a house that’s worth $609,497. In essence, I’ve made $109,497.
Say I took the $20,000 per year and put it into stocks. These stocks return a total of 7% annually, with 4% coming from price increases and 3% coming from dividends. The total value of my stock portfolio would be $335,015.
But wait. I’ve forgotten about my original down payment. If I invest it along with my $20,000 annually, I’m up to $492,387 after a decade. I could sell everything at that point and pay down a very big chunk of my mortgage.
It doesn’t take a genius to see putting the money to work was a better choice. But here’s the real kicker — the guy who paid down his mortgage faithfully isn’t any further ahead. He’s still got to pay down his mortgage. Meanwhile, stock guy is generating $15,000 per year (ish) in dividends.
This is exactly the reason why I rent, and feel really comfortable doing so for a while longer. The money I’d have tied up in home equity will not be as productive as investing that cash elsewhere. If I’m serious about getting rich, I’ll invest money outside of my house, and then maybe in the future get a mortgage and never pay it down.