Julie Rains over at Wise Bread has written a thought-provoking article about how tapping into one’s home equity is like pawning off a gold necklace.
It the article, she draws a number of parallels between the two:
- Collateral is involved and is appraised as part of the transaction
- If the borrower fails to pay, then they lose the collateral
- Fees and interest payments are also part of the transaction
It is a rather interesting view of the two that I tend to agree with. However, I believe that the article understates the real risk: pawn transactions tend to involve non-critical assets such as guns or jewelry, but home equity loans put your home – often your largest asset – at risk.
One of the commenters goes on to suggest that the real problem is not with home equity loans, but how they are used. Borrowers frequently use the proceeds of the load to fund vacations, automobiles or other depreciating assets, which causes an erosion in personal weath. He suggests that as long as the funds are invested or used to purchase more assets, the use of a home equity loan can be a useful tool.
Sorry, but I do not buy that argument. A home equity loan is simply another form of debt. Tapping one’s home equity in order to purchase stocks, investments or to fund a business is simply another way of putting your home at risk.
Imagine, if you will, a scenario where you had taken out a home equity loan last October and used the proceeds to purchase an S&P index fund. Over the intervening year, your “investment” would have lost 15%. So not only would you have lost money, but you would still be on the hook to pay off the original loan.
As another example, the Los Angeles Times recently noted that one of the families from “Extreme Makeover” is losing their house due to foreclosure. Why? Well, they put up the home as collateral to fund a construction business. When the business failed, they could no longer afford their debt.
No matter how you spin it, home equity loans are still a form of debt and should be approached with caution.
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Too narrow a view
"Imagine, if you will, a scenario where you had taken out a home equity loan last October and used the proceeds to purchase an S&P index fund. Over the intervening year, your “investment” would have lost 15%. So not only would you have lost money, but you would still be on the hook to pay off the original loan."
This is a very distorted example, you picked a downturn in the market to illustrate your example. As long as the person doesn't liquidate the S&P Index fund there is no loss, it's all a "paper" loss. Flip the argument, imagine you bought the S&P Index back in October and the market rallied 15%, what would you say then? Having the equity in your home lie dormant is a waste of money if you ask me. At best, homes appreciate 4% annually (over long term average) so gaining anything above 4% is pretty good.
A wise investor will take opportunities like this downturn in the market to take out a home equity and buy. Actually, the market has a bit more to drop before it climbs back up so now is the time to position yourself to borrow money and be ready.
I can pick out multiple examples in the last ten years...
As we've experienced two substantial corrections in the market since the turn of the millennium. Heck, if someone had taken out a home equity loan in August of 2000 and placed it in an S&P index, they would still be holding a loss today, eight years later.
The point that I was making is that the there is risk associated with investing; and tapping your home equity as a form of leverage only amplifies your possible loss, as you risk not only your cash investment, but the roof over your head, as well.
If someone wants to maximize their exposure to the market, then it's probably to their advantage to buy a smaller, less expensive home in the first place.