LOUISE FAIRSAVE: Home equity options
This article is part of a series aimed at understanding the value of home equity, which is the ownership portion of one’s residence being acquired through a mortgage. This series also emphasizes the fact that mortgage debt can be good debt.
Let us consider two different cases. Peter and Janet had decided after the first ten years of their 25-year mortgage, that they would start paying an extra $800 monthly with a view to retiring the mortgage earlier than its 25-year life.
Peter and Janet were both high achievers. They both earned high incomes, had been able to stabilize their finances early in their marriage and were in a position to make extra payments towards the mortgage.
Like many other high achievers, they lived like the jet set. They had accumulated significant consumer debt on credit cards and on the new sport utility vehicle Peter had insisted he must have.
It was Janet’s banker who pointed out to them that it made more sense to pay off the higher interest debt than the mortgage. The banker explained that many couples got so accustomed to running a personal credit line, they did not evaluate the economics of the system.
The banker showed Peter and Janet how redirection of the extra funds could reduce the personal loan that carried a higher interest rate. They were happy to comply. They were confirmed in their earlier assessment that that banker was indeed a very good personal friend.
In the case of Robert and Evelyn, they were astute finance people. They had set their financial goals from the day of their engagement. And so it was that now, in their mid-30s, they had already accumulated significant equity in their home, had no other significant debts, both had good incomes and both were well insured personally as well as through the group insurance plans of their employers.
Robert and Evelyn felt reasonably financially secure – enough to consider borrowing against the equity in their home to finance a fledgling rental business. As would be expected for seasoned financial planners, they had a full business plan set out. The major difference was that they had considered going to themselves for the loan capital rather than approaching a development or merchant bank.
Robert argued the case. If they borrowed from themselves, they would avoid all the typical initiation, commitment and legal fees, and would be accessing a lower interest rate. In addition, the interest paid would also be tax deductible to the maximum limit allowable.
This couple also discussed the risks in financing their commercial activity through the equity in their home. They agreed that because of their financial planning and knowledge of their circumstances, this was a risk they were willing to take. Evelyn also pointed out that should their commercial activity not succeed, both Robert and she were still young enough to rebuild their finances and rebound.
Mortgage debt is good debt, moreso than better or best debt in that the best debt is no debt at all. Residential mortgage debt can be good debt compared to debt of higher interest.
The moral therefore is that it pays continually to review the role a mortgage plays in one’s finances from year to year. And if you must have any debt, make it the most economical kind possible in the circumstances considering the risks.
• Louise Fairsave is a personal financial management advisor, providing practical advice on money and estate matters. Her advice is general in nature; readers should seek advice about their specific circumstances.