What to do with home equity?

A Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania was asked if home equity is safer in a conservative side fund than buried in the house earning a 0 percent return. He answered that it’s more risky since assets that earn more than the mortgage interest rate are risky.

The major target of the new wisdom is the homeowner with significant equity, who is being persuaded to borrow against it in order to invest at a profit. The borrowing cost that the investment return must beat is the cost of a new mortgage, either a second mortgage or cash-out refinance. This is usually higher than the rate on the borrower’s existing mortgage, making it that much more difficult to find an investment that will yield a margin over the cost.

The recent boom in house prices has increased the size of the target market enormously. While few households have a business in which to invest, no problem, the loan officer/planner/financial advisor will advise them about investments.

The new wisdom is supported by an enormous amount of financial self-interest. There is money to be made on the new mortgage, and on the investment. The intermediaries in the process take theirs off the top. For the household to end up richer, however, the investment return must exceed the borrowing cost over a long period. Since investments that yield a return higher than the household’s borrowing cost carry risk, the household can also end up poorer.

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