The Difference Between Equity And Cash
One of the most interesting topics I educate on is the difference between equity and cash. We all seem to value our home equity; sometimes we seem to value it more than money. I hear people talk about how much equity they have grown in their homes. In many instances the equity is due to home appreciation though paying a mortgage over time does help the equation. What is the reason behind us valuing home equity? Is it psychological? I think we view it as an option to convert it to cash. It is like a secret savings account that we do not want to touch. I imagine most think at some point when and if it is needed we would convert it. However, when given a chance to convert it the decision takes careful consideration. Nobody wants to go down a path of losing equity without a good cause.
Equity has no value unless converted to cash. In fact the return on equity is zero. If you have a house worth $400,000 and it appreciates 10% you gain $40,000 in equity. The same holds true whether you owe $200,000 on the house or whether you owe nothing on the home. Meaning the person who owes zero has gained no more equity than someone with a mortgage balance. Hence the return on equity is zero regardless of your equity position.We can argue that the person with more equity has more utility because it can be converted to cash, which is true. So it is true there is a value in the equity, but we have to differentiate it from what equity returns to us. Equity is only of value when converted. Think of a rate of return in an investment. Would we keep our money invested in an asset if there was a zero return? What if there was risk on the investment? All investments have a varied level of risk. What risk does your home equity have? Home value fluctuation is the answer. If the home value goes up we gain more equity. If it goes down we lose equity. Though we view our house as a place to live it is also an investment. Not a risk free investment I might add. If we did not think of it as an investment then why buy in the first place– just rent.
So if return on equity is zero, what value does equity have? The answer is none unless it is converted to cash. When equity is converted to cash and used for a given purpose it becomes useful it has utility.
Converting Equity To Cash
There are only three ways to convert equity to cash. Sell the property (but then you need a place to live if it is a primary residence) and buy another property. Refinance and pull out cash (which will increase your payment requirements in most instances) or if you are over 62+ with enough equity you can convert equity to cash with a reverse mortgage.
Turning Cash Into Equity
Lets consider the opposite- turning cash into equity. This is what we do when we are paying a mortgage. If we are age 62+ with sufficient equity, and still paying a mortgage – we can ask why are we converting cash to equity? When we are younger we have no choice in the manner. Moreover, at what rate are we converting cash to equity? If we have a $1600 a month mortgage payment how much is going to principle and how much is lost in interest expense? In a sense we could be paying $1600 per month on a mortgage and only buying $500 worth of equity. Let me remind you if this is the case then we are spending $1600 to buy $500 worth of equity, and equity will earn a zero return forever. Is that a good investment?
About now you might say well with a reverse mortgage I lose equity. That is true, but you gain cash. Two ways you gain cash. Take income from the equity (tax free by the way) or quit making payments and you gain the cash flow equal to the amount of the mortgage payment you were making. By the way you only will lose equity on accumulated interest for money that you use. This loss of equity could be a much slower drain than the loss of cash while paying a mortgage. Have you run the numbers to see?
If I decide to use a reverse mortgage as a financial tool to benefit my finances, I now need to decide what do I do with this money? The answer is what do you typically do with money? Spend it, save it, use it to buy protection (life insurance, long term care), or travel. We consume everyday items that require money each day the question is- Are we consuming these items effectively with our finances? You see it is a closed system. Money comes in and goes out, how we use it is the key. In retirement our choices narrow so far as how we derive income or use money and it is even more important how we consume money because we aren’t going back to work and we may live a long time in retirement and need to stretch money even further than we imagined.
Keep in mind if your home value continues to appreciate there is an offset to the accumulating interest from not paying a reverse mortgage payment. You gained the utility of cash flow and now have an offset to an accumulating balance. If there is zero return on equity then any offset on home appreciation is what is gained, not considering tax benefits we have not even discussed or the growth over time on your money you didn’t take from other investments to pay expenses or a mortgage payment. If this isn’t clear consider home appreciation averaging 4%. If your interest on a reverse mortgage is 5% the erosion of equity is dramatically slowed, yet you gained the utility of cash in the process. Remember equity earns nothing. There is no utility to equity unless converted to cash.