Understanding How Home Equity Actually Works

If I have to listen to one more Canadian tell me that their home is, “The best investment I ever made,” I may lose my mi… well, let’s not be hyperbolic – I’ll probably just continue to internally shake my head at this statement.

Yes, in this age of ever-escalating Canadian home values the roof over your head has likely substantially increased in value since you bought it.  This does not make it a good investment for two reasons.

1) If you intend to continue living in the house you own for the foreseeable future your house is not an investment – it’s a shelter that you’ll need for the long-term.

2) Despite what your Realtor has told you there is very little chance our housing market will not realize a significant deflation at some point.  Even the experts calling for a soft landing claim 15-20% is reasonable.  If you look at our income-to-home price ratios across the country it becomes undeniable that this rise in home prices is based on a historical anomaly of sustained low interest rates and speculation on the fact home values will continue to increase.  The spread of rents vs home prices is another great indicator to look at.

Your Home Was a Great Purchase – NOT a Great Investment

How Home Equity Actually WorksIf you got into the housing market before it started going up – awesome!  You got a great product at a decent price and you can now enjoy the fruits of that purchase.  You can build equity in the form of mortgage payments and hope that the demand for your house continues to increase.  However, if you never intend to sell the house does it matter if demand increases or not?  If downsizing and moving isn’t a part of your retirement plan then what does it matter what other houses go for?

As far as an investment goes, I’ll let this passage from a recent Rob Carrick article at the Globe and Mail illustrate the point for me:

Home-buying or investing – which will make you richer?

Gen Y, this could be the defining question of your financial life. Don’t make the mistake of passively accepting the line that housing is a great investment.

Houses are a lovely place to live and raise a family, and they’ve solidly appreciated in price over the past several years. But stocks, even after the mega-crash of five years ago, have been the better long-term investment.

National price data from the Canadian Real Estate Association shows an average annual gain of 5.4 per cent nationally from 2004 through 2013 for resale homes. The comparable average return from stocks was just under 8 per cent. If we go back 20 years, we get an 8.3 per cent gain from Canadian stocks and an increase of 4.5 per cent in the average national house price. Over 30 years, stocks made 8.5 per cent and houses 5.5 per cent.

Stocks, or at least the benchmark for the Canadian market win. Case closed.

Related: How Much Home Can I Afford?

Home Equity Only Builds If You Don’t Borrow It Back Again

Taking out a Home Equity Line of Credit (HELOC) in order to fulfill your HGTV-driven fantasies and putting a master chef-recommended kitchen in your house does not count as an investment!  Do not buy into this theory that investing $70,000 somehow adds $120,000 worth of value to your house.  I don’t care what the beautiful person that has their own show and says they work in construction says.  Study after study shows that most renovations do not add value to a house above what they cost.  In fact, if you can recoup even two-thirds of the cost in a valuation raise then it is considered above average from what I’ve read.  Once again, we also come back to a familiar point – the value of your house that features a kitchen worthy of a reality TV show is irrelevant if you don’t plan to sell it!

Taking out a loan to fund these “renovation investments” or to join the great quest to collect consumer goods means that even as you pay your mortgage you’re not actually paying down your debt.  You’re just moving debt from the mortgage column of your balance sheet to the HELOC column of your net worth – the number is still on the wrong side of the accounting ledger.  It’s not a huge deal right now as you can pay the interest on your loan by turning in last weekend’s empties, but as those interest rates inevitably rise people will be crippled, and we’ll all be treated to a raft of ridiculous media about how no one saw this coming etc.

Here’s a radical idea, if you want granite counter tops and you feel they will truly improve your standard of living (a good purchase – not a good investment) then save up the money until you can buy them outright.  Then move on to the next luxury good you want.

Related: Why Deflation and Falling Home Prices are a Big Deal

Meet Johnny and Jane – Average Canadian Gen Yers

More and more Canadians are at risk of seeing their net worth plummet if they continue to borrow based on the current value of their home, only to see that value evaporate.  Here’s an example of what I’m talking about:

Johnny and Jane are 29, have good jobs, and bought their house four years ago.  Their parents helped them with a down payment (which is good because with their student loan payments, car payments, credit card payments etc., they wouldn’t have been able to do it on their own) and are now so proud of the great upstanding homeowners that their children have grown up to be.  When they get together for family dinners they often talk about how housing prices are rising so rapidly around their neighbourhood and gee – who can afford these prices?  Thank God Johnny and Jane got in before it was too late.

When the happy couple signed their offer to purchase they were able to put down a 20% down payment on their $500,000 new home.  This resulted in a mortgage of $400,000.  These days similar houses on the same street are selling for $580,000.  After 48 months of mortgage payments the bank phones to tell Johnny and Jane that if they want to pay off some of that other nagging debt they have – plus a little more just to treat themselves (after all, they’ve been told they deserve it) – they can do so with a loan at a super low rate of interest.  The product the bank is promoting is called a HELOC and the reason it sounds cool is obviously because it is.  With the mortgage payments and the rise in value their house is now worth $580,000 and has a mortgage of $370,000.  This means they are eligible to take out a HELOC of about $94,000 (80% of the maximum loan-to-value ratio, minus the leftover mortgage).  There’s “no risk” because they have over $200,000 of equity in their house.

Johnny and Jane just have a few little things they want to hire someone to do around the house, plus those pesky credit cards need to be cleaned up once and for all (eventually they’ll get around to changing the spending habits that led to the balances in the first place).  Before they know it Johnny and Jane have some beautiful new cupboards, a kitchen island straight out of a magazine, and a new boat for those priceless summer long weekends.  Sure they have $80,000 or so on their HELOC, but the interest rate is so good and like the guy on TV said – “Money is cheap right now”, so why not enjoy success a little right?

Three years later Johnny and Jane still keep the HELOC around “in case of emergencies” and reason that there is no rush to pay it down, after all, it is a way lower interest rate than the ones on their credit cards that somehow have a balance again.  The housing market cooled because people from China decided that Canadian property values might stop going up soon, interest rates rose back to historically average levels, and people realize the longer they waited in this new housing market the cheaper houses will get.  With some of the new interest building on the HELOC loan, it’s now around $85,000, and while Johnny and Jane have made some progress paying down their mortgage that sits at $350,0000, houses in their neighbourhood are now selling around the $480,000 mark.  Johnny and Jane are now quick to tell everyone that it doesn’t really matter what the value of their house is since they’re going to live there forever and some guy on the internet said their house shouldn’t be considered an investment anyway.

Taking a step back from this plausible and quite likely scenario, Johnny and Jane now own an asset worth $480,000 (or so they believe), have a mortgage of $350,000 and a HELOC of $85.000.  This means they have roughly $45,000 worth of equity – or under half of their initial down payment!  And that’s after making seven years’ worth of mortgage payments.

My point here is not to say never buy a home or never use a HELOC, the main idea is that it is so easy to fool ourselves when it comes to thinking about debt, and how wealthy the “value” of our homes makes us feel.  If you’re using a HELOC to fund a true investment (such as in the Smith Manoeuvre) that’s a whole other conversation – leveraged investing can be a good idea if researched thoroughly and executed correctly – but the general use of HELOCs across Canada combined with the irrationally-viewed incentives driven by a housing bubble (either large or moderate depending on who you listen to) are convincing Canadians to do some pretty crazy things.  Don’t fall into thinking about home equity as an ATM, while at the same time telling yourself that your mortgage payment is basically an investment every month.  Ignore the noise and focus on the basics of personal finance – spend less than you make and invest the rest using easy-to-understand investment products.

20 Comments

  1. spiffikins on October 27, 2014 at 9:27 pm

    My mom owned her house outright, but as she got closer to retirement, when people would say “oh you’re set, you own your house and the value has gone up – what a good investment” – she would reply “yes, except I can’t reach into the wall and pull out groceries, or money for property taxes or utilities”.

    I live in an area of the US where home values skyrocketed – and many, many people used their house as an ATM – to renovate their houses, pay for vacations, pay off credit cards – it didn’t matter, because house prices just kept going up! Until they didn’t.



  2. Kyle on October 27, 2014 at 10:01 pm

    Great insight spiffkins. Thanks for stopping by. Mind if I steal your mom’s line?



  3. spiffikins on October 27, 2014 at 11:10 pm

    Sure 🙂

    My mom was a very savvy lady when it came to common sense thinking about finances – she taught me a lot about how to make good money choices and I miss her every day!



  4. Sean Cooper, Financial Journalist on October 31, 2014 at 10:03 pm

    Great article. This quote pretty much sums up HELOCs: with great power comes great responsibility. An even more worrisome trend than HELOCs in reverse mortgages. It’s sad when people work so hard to pay off their mortgage to only slowly undo their own hard work.



  5. Kyle on November 1, 2014 at 6:25 pm

    Thanks Sean. Anytime you can quote Spiderman in a personal finance article you can’t not do that right?



  6. Rob Brown on November 6, 2014 at 7:34 am

    Excellent post Kyle. We are very aligned on this subject! Check out pages 113-120 and 150-154 of WLR. I think you’ll enjoy them.

    Rob



  7. dano on November 6, 2014 at 10:57 am

    Good summary. BTW it’s recoup, not re-coop.



  8. Thizzle on November 6, 2014 at 2:33 pm

    “Ignore the noise and focus on the basics of personal finance



  9. Chris on November 6, 2014 at 2:52 pm

    Then there are those of us who have done very well in real estate over the last 20 years. I have made a good amount of tax free profit on a few houses over the years leaving my wife and I mortgage free at 40 in a $900k home. We borrowed against the house using our HELOC to invest in our non reg portfolios and have done extremely well with returns plus can write off the interest.

    I do feel sorry for people in their 20’s today looking at the inflated cost of real estate and do think they will be better off renting and investing their cash. I have no doubt prices will be dropping in the near future but for people like me who have significant net worth outside of our principle residence the drop won’t make much difference.



  10. My Own Advisor on November 7, 2014 at 5:19 am

    HGTV has been GOLD for banks and lenders!

    Borrowing money is just that, HELOC or otherwise, and it’s never free.

    I hate debt.

    Signed,
    Slave to my mortgage (Mark)



  11. Jay on November 7, 2014 at 10:56 am

    While I agree with much of the article, I think that home buying vs. investing is a false comparison. While the comparable average return from stocks over the last 30 years may be 8.5 per cent as compared to houses at 5.5 per cent, this comparison omits an important fact. The increase in ones housing price is on the total value of that house, not simply on the money you put into the house.

    I bought my house with 5 per cent down, and sold it four years later. While my house value only increased by 5 per cent a year, my “investment” (or down payment) increased by 270 per cent over the four years. What the comparison does not factor in is that the housing market allows us to use the banks money at a very low interest rate (for now) and keep all of the return when we sell the house. You cannot normally do this in the stock market. After I sold my first house, I had enough case to buy a larger house out of the city and invest 100k in stocks. Obviously, this scenario only works if, like you said, you are willing to either move out of the city or downsize.



  12. pat on November 7, 2014 at 11:10 am

    The word is recoup no re-coop



  13. Kyle on November 8, 2014 at 8:38 pm

    Sure your potential increases are leveraged Jay but so are your potential losses. We’re coming off one of the greatest increases in home value the world has ever seen and returns on equities are still much higher. You could still leverage equity holdings as well if that’s you’re thing (although admittedly not to anywhere near the extent you can with RE).



  14. Kyle on November 8, 2014 at 8:39 pm

    Awesome, simple comment Mark. Love the signature! Thanks as always for stopping by.



  15. Kyle on November 8, 2014 at 8:42 pm

    Glad to hear you played the rising RE tide well Chris. Sounds like you pulled a very conservative version of the Smith Maneuver and made out well. You’re completely right when it comes to housing prices going down btw – who cares what the price of your house is if you’re planning on living in it for the next 20+ years!



  16. Kyle on November 8, 2014 at 8:42 pm

    Thanks Dano… duh!



  17. Kyle on November 8, 2014 at 8:43 pm

    I often ask myself this Thizzle. Some folks think it’s because we’re bad at math, but isn’t this basically grade 7-9 math at most?



  18. Kyle on November 8, 2014 at 8:43 pm

    Oh I did!



  19. Deng on October 12, 2016 at 1:17 pm

    Great read! I am a current university graduate and getting into the “real world.” This was great, because it gave me a different look at the “investment” that many people have told me buying a house is.



  20. Kyle on October 13, 2016 at 12:18 pm

    Glad to hear it showed you a new side to the idea of “investing” Deng!



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