PODCAST EPISODE 183: What Is Your ROR On Home Equity? (Part 1)

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Paul 0:34

Hello and welcome to your business your wealth My name is Paul Adams I’m the CEO and founder of sound Financial Group and I’m joined as always by Corey. All he has to do to keep our podcast episode short is not let me use the restroom before we start recording Shepard.

Cory 1:00

At sound financial group that if Paul goes to the bathroom, we all go to the bathroom because what’ll happen is he’ll go to times mid meeting, and then all of a sudden, we’re ready at the end of the hour, we all gotta go. And then he has no rush to get done, or he wants to keep talking. And then I’m in pain. So it’s just like, if he goes, we all go. See, that’s leadership. Anyway, I’m so excited for today. Today, we’re kicking off the new series, the asset class investing series, and we’re going to do is talk about different kinds of asset classes and the way they impact your life and the differences that it can make in your financial future. But today, we’re gonna be talking about that beginning piece that really hits most people’s lives. People do it several times over their entire lifetime, and that’s buying a house and how much should we put down when they go buy a house and I just as the Chief Compliance Officer of sound Financial Group, which I got that title

Paul 0:01

Welcome to your business your wealth where your host Paul Adams and Corey Shepherd teach founders and entrepreneurs how to build wealth beyond their business balance sheets.

Unknown Speaker 0:49

So good to have

Cory 0:50

you. Great to be back. It’s a it is very true. I’ve just come to expect Well, we have a rule and

I was on vacation in Italy, the day that they picked who that was going to be. I really need this stress, I probably am the better choice for it, let’s be honest. But I really want to stress that no matter what you say, or things that we talked about, we’re not at all recommending anyone take any equity out of their house to invest in the in the stock market. We’re going to be talking about money in your house, money on the side and rates of return. But we really want to be clear that this is not the recommendation we’re making. we very rarely make blanket recommendations. This is a blanket anti recommendation.

Paul 2:35

Well said, I think bases have been covered.

Cory 2:40

Right now. With that in mind, we all want to be financially responsible. And especially when it relates to our home. This often comes with this unsaid societal commitment that being debt free, as soon as possible, is more responsible. So we’re often attracted to paying off mortgages early or putting down larger and larger amounts as a down payment. And our next episode Not today is specifically on 15 versus 30 year mortgage. But today we’re going to talk about down payments, and home equity. And, Paul, I think you’ve got some beautiful visuals to get us kicked off on that. And that’s

Paul 3:19

indeed, though my my favorite part about this new series core is that we’re really getting a chance to roll out brand new content never used with clients before, or where we would have scribbled it before. And now we’ve actually got some incredible visuals. So you can go see these on YouTube or hit the page for this episode. And you can request to download these slides if you’re just listening. So let’s just kick off and we’re gonna use an example like we use in many parts of our planning of an individual with a choice point. And we’re going to just look at them at this beginning point, track them going forward and kind of think about who shoes Would you rather be in. As you can see on the screen we have two women Both of them have $800,000. And they’re going to make a decision. Both women are going to buy in the same neighborhood, a house that has the same floor plan is painted the same on the outside. And they’re just going to make a different choice as to how they deploy their downpayment money.

Cory 4:18

Now, these are not twin sisters, in this example, where they’re just friends. They’re just friends that want to live close to each other. Okay, good. That’s,

Paul 4:25

they look a lot alike. So, so, again, these these two women, both buying houses for their family, what are they going to do? Well, they’re making two different decisions. One person has been told that what you should do is pay off your home as soon as possible. Therefore, put as much down on this home as you can. And the other says, Well, what I’m going to do is put down 20% so I get a good mortgage rate. But I’m not going to put all my money into the house. And so this is kind of our beginning point. One woman put $800,000 down the house has 200 Thousands of equity and another person puts $200,000 down on the house and as $800,000 in mortgage. Now, the reason we like to stop and pause here really quick is that idea that we know not everybody’s making this kind of decision, nearly enough money to buy a house and pay cash for it. But by expanding the distance between these two women, in terms of the amount of downpayment that they’re going to make, will allow us to really amplify the problem that they run into, because it’s the same if you’re putting an extra $50,000 down or not. So here’s the difference between our two women though, one has a home with 800,000 of equity, the other has a home with 200,000 of equity, and $600,000 invested somewhere else on her balance sheet. So to just kind of pause there for a second, Cory, when people first start thinking about this well That’s one of the first things you notice happens to them just on an emotional experience when they’re thinking about putting a lot of money down, versus being the person on the right side of the screen, who’s kept control their money?

Cory 6:13

Well, the person on the left if they contemplate that of putting 800,000 down on a $1 million home, and only a 200,000 mortgage, they feel like they own the home more like they have more ownership, less likelihood that it’s going to be taken away from them, which may not be the case, in the worst happens, which we’ll talk about, and the person on the right feel either way, though, or liability.

Paul 6:41

I definitely don’t want to skate over that. Because I think what you said there is so true as the person who put more money down feels safer. But as a particular conservative podcast host says all the time, that facts don’t care about Your feelings, I think we might find something like that here is that it might feel good. But it could be an incredibly costly decision that didn’t get us any closer to safety. Right? And then you kind of mentioned Cory, the second person feels like well, I feel like I owe a lot more money. But if we look at the net worth of the two households, they’re both exactly the same. Both people have net, they owe 200,001 person just decided to position their money in another account. And the other person positioned all their money in their home.

Cory 7:34

Of course, the other piece that comes up and and we’re not going to get super deep into it, this will be for the 15 versus 30. But the they’ll think about interest, oh, well, I’m paying a lot more interest and payments on that 800,000 mortgage versus the person only has 200,000. mortgage. Agreed. So that’s got to be considered too.

Paul 7:58

So So now let’s think about that. Now both people feel like they put down their downpayment, they have one person, as many of us decide the other person put all their money into the down payment on the house. I want you to imagine it for those who just listen to the podcast, just think to yourself, imagine both million dollar homes go up 10% value over the next year. The question is, whose home is worth more money? Now, that seems kind of obvious. You’d say well, they’re both worth the same. Moment. Yeah, they both $1 million home is now worth 1.1 million. The person who had $800,000 of equity now has 900 and the person that had $200,000 of equity now has 300,000. Not to mention,

Cory 8:51

all the math wizards out there. Yes, it’s a year later. So they would have been paying some amount on their mortgage, but Gosh, in the first year, all mortgages are Mostly interest anyway, so we’re just kind of taking the round to keep the numbers the same for the sake of this example. And for everyone out there is raising their hands like But wait, but wait, wait. Yes, you’re right. Email us info at sound, SF GW calm and we will email back the goldstar happily want to recognize you for your mental math achievement.

Paul 9:21

And And incidentally, if if you are one of those people who’s struggling with this decision right now, and you just want to jump on the phone with someone like Corey for 15 minutes, then reach out to us. We’ll make sure that we can look at it as it relates to your situation since you invested the time listening to this episode. But the key is one person had 200,000 locked up in investment that’s the person that put the lower downpayment on and the person on the left side of the screen, put 800,000 down into this quote unquote investment the home and both of them got $100,000 of return. So What people do too often is they look at the 800,000 of equity and the hundred thousand dollars of return and they say, Oh, see easy math, that’s 12 and a half percent. And of course, you didn’t think I could do it that fast in my head.

Cory 10:13

So now actually, I know that you can do that in your head a lot faster.

Paul 10:18

And then that but then on the flip side, you’d say, well, the person with 200,000 of equity got a 50% rate of return. Both of those are totally incorrect. How I would have you begin to think about it, this is a little bit of a, it could twist your mind a little bit. If you’ve been one of those people, that’s as much equity in your real estate as possible. But the additional equity you have in the real estate actually produces no return. I’ll just say that again. The extra equity you have in your home at best may alleviate you having to pay some debt service but in To real outcomes, all the additional equity when given the choice point of putting down 20%, or in this case putting down 80% you literally got no return on the extra $600,000 of equity that the person had, who put down 800,000. Now Meanwhile, the person who has the $600,000 on the side, not only did they get the same hundred thousand dollar appreciation on the home, but they also made money on the 600,000 wherever it was deployed, maybe it was an academically allocated globally diversified portfolio or it could have been a savings account earning 2% but needless to say, their home went up in value and so to their money that was outside of the home.

Cory 11:44

Now in the reason what shows up for me like it’s hard to be but but it’s worth more I have more in there 50% versus 12 and a half, but just like in the in the stock market, like you’re not actually realizing the gain until you’re really Realizing the game, meaning till you sell that investment at the end of the day, because it’s all just a few Gazi about what it’s actually worth until someone writes you a check for it. And so that’s the key is that you haven’t produced any rate of return yet.

Paul 12:14

Yep, exactly. Right. Well, now, speaking of rate of return, this could also go the other way. You know, we’re still in the midst of varying lockdown orders and reopening phases across the country with COVID-19. And we’ve not seen it impact the real estate market anywhere near like it was impacted in 2008. But let’s just imagine for a moment that our home goes down in value. And how does that impact our two families? Well, one, the person that put $100,000 down because the home dropped in value to 700,000. It is the home owner only that absorbs 100% of the loss because for lack of a better way of saying it as you can see in the visual, the equity in your home sits on On top of the debt, meaning, the more equity we have, the safer we have made the bank. Say that again.

Cory 13:11

And this is where it gets

Paul 13:13

real good. That the more equity you have in your home, the safer you’ve made your home for the bank. Okay, I’m gonna come back to that in a moment. But I just want you guys to sit on that for a moment. The person that I

Cory 13:27

asked ask a question that but just a question to sit with is, who’s the higher rolling customer of the bank? The person who has 800,000 left on their mortgage or the person who has 200,000 left on their mortgage? Yeah, who’s the VIP?

Paul 13:47

Yes, yep. Now to the one on the right. We had a home that was worth a million. We’re 200,000 of equity. And just like the other person, the equity 200,000 was white. Now we have a home that’s worth 700. But we owe 800 on it. But on the shelf outside the home, we still have $600,000 of investments. Now I’m of course occurring like we’re not putting growth on either of those. This is to make the concept simple and easily communicable over a podcast individual situation, we can have that conversation with you. But now let’s think about this. Both homes, big downturn, and let’s say it affected your income in a way that you were not effectively able to pay your mortgage. Now, for many of you listening and because the average income of our listener, you may be sitting listening, saying, well, there’s no chance that’s happening to me. I Well, at least I think a lot of people would have said that six months ago. I think even the businesses that have not been significantly impacted by COVID-19. For all of us. It’s given us a bit of that wake up call of the robustness we need to build our businesses with because some of you just dodged a bullet on COVID 19 your maybe an industry you are going to expand into would have been worse impacted, things like that. And some of you, you know, to metaphorically at least that bullet hit yet and you’re doing your best to recover now, all that to say, if that happens, your ability to pay the debt is now hindered. Here’s the question. Who does the bank foreclose on first? Now, probably without this all this other conversation, it would seem reasonable to say, well, the bank needs to foreclose on the bigger loan first, because that’s more money that they need to be able to collect. But here’s the problem. Banks are not in the business of owning real estate. They’re in the business of accepting deposits and lending money. So the person with all the equity, who has a hard time paying the mortgage goes into what has been told to Corey and I, by the people who work in this special asset division of these banks. Call it the green pile. Now, I only know this because I had some executives and special asset divisions of banks who are clients. And they call it the green pile. Why do they call the green pile because they can facilitate foreclosure, they can move through and have that home on the auction block as quickly as possible in the county courthouse steps. And all they have to do is give our first woman $1 more than what she owed. They’re either required to do that they could sell it for less than what it’s owed. But rest assured the bank wants to get at least what they’re owed on the home. And they just

Cory 16:36

pile green does not mean good for the customer.

Paul 16:39

And that’s exactly right. Yes, yeah, the green pile is green for the bank. We can foreclose and there’s equity in the home. On the right hand side of the screen. We have the person now owes $100,000 more than what the asset that the bank lent on. as collateral. Remember, banks don’t lend on your home. they lend against your The future ability to earn an income. So, now they say now we need to call in our collateral because the original thing we lent against your income has been impacted. You can’t make your payments. Oh, wait a second. This home, we owe $100,000 more. Then the home is worth. And so the homeowner calls in situation one with all the equity says, Hey, can you give me a little extra room? We put a ton of extra money down. We’ve made all our payments on time. Could we have some extra wiggle room? to which they would say yes, you bet all the way up to the end of the foreclosure procedure we’ll give you right and the person who had has no equity now owes $100,000 more on their home. Cause the bank says hey, I’m real sorry. I can make some partial payments. Or I won’t can’t make any payments for two months but I hope to be back to work soon then I’m going to be able to make payments in the bank will work with them. People in some of the hardest hits parts of the country during the mortgage crisis went without making mortgage payments sometimes for over a year or more negotiating with the bank and never being evicted from their home. All because they owed more than what the home was currently worth. Now, we’re not in the habit of wanting to have people be over their head and debt on the home that they own. That is not a strategy to embrace. Right? When the worst things happen, like real estate values dropping, do you want to be the one that is more secure? Or the one that’s more exposed? Because there’s one little thing we haven’t addressed about the second woman? She’s does $600,000 sitting on the sidelines and may never need to go negotiate with the bank. You know, we did some quick math, and you could actually make your mortgage payment for like 14 years, even with no interest on the 600,000 Like, that’s a lot of runway and wiggle room to find a job again to stabilize your income again, to sell the house and move if that’s genius to do that literally nearly every single way. The person with the more leveraged home is the one that’s actually safer.

Cory 19:16

Now, and that’s really important, because it might not be a black swan event that affecting the market. It might be a black swan event affecting you. And what

Paul 19:26

I mean, right, right before we do that, Corey, let’s go to commercial. And we’ll come right it’s a good idea for that. I was just trying to create the cliffhanger. That’s that’s Yeah, in that case, Cory, take us commercial.

Cory 19:40

Stick with us. And we’ll we’ll solve the mystery of the second Black Swan. Let me come back.

Paul 19:46

Paul Adams here at sound Financial Group. Are you curious what you can accomplish with our help? You’re here enjoying the show. Our philosophy is helping you increase your effectiveness with money. And now we have a way to help you take another step. On your financial journey, we have designed a financial inquiry call for you and the thousands of other listeners of your business your wealth. This is a complimentary 15 minute conversation, where one of our team members will ask you some key questions. understand your concerns, and if appropriate schedule a time for further conversation with an advisor. If you look at the episode description, you’ll see a link to schedule a call at a time that’s least invasive for you. And even if now’s not the right time for us to work together, we’ll point you toward resources to help you in your financial journey. We always look forward to connecting with our listeners, and we look forward to talking with you soon.

Cory 20:44

All right, welcome back to your business, your wealth and our discussion of return rate of return on home equity. So we were talking about these black swan events, but what if it’s not one that affects the value of your home? What if it’s one that affects the value of your income earning potential, a disability, a layoff, some kind of economic downturn, the cost your your job, your home didn’t go down in value, you still have all that equity. But who would you rather be in that position? Because to Paul’s point before, even if you’re the person with 800,000 of equity in your home, he made all those extra payments. If the bank, if you go to the bank with no job and no income potential and say, Hey, can I have some a break on my payment? Because I made all those I made so much more of a down payment in advance. I’m basically paid ahead, or I’ve made all my payments on time. Can I have some some extra wiggle room? And I say no. And if you say Okay, can I have a home equity line, then to access some of that equity, which then you’ll put back into paying your mortgage? They’ll say no, and you’ll find out really quickly, that even a home equity line of credit, the bank is not lending. With your home as the backing it’s your future income as the backing for that loan.

Paul 22:00

And I think that is so key chord that the call the home is collateral for the loan that’s being made against your future income your personal car is really terrible financial collateral what a lot of people don’t realize same with the home it’s actually a social agreement that they’re they’re holding you to because like okay bank had my car, but it’s the embarrassment of the tow truck coming It’s the embarrassment of the foreclosure notice that really society makes this work.

Cory 22:33

Because the banks not making money when they take back your home, or take back your car. There invest breaking even. And Paul, I think it’s worth talking about how banks make money to finish up this, this conversation because that will really connect these dots about what’s going on behind the scenes

Paul 22:51

indeed. So let’s what I want to do, we don’t need to be looking at the screen right now. We can just talk Korean I with all of you One of the things that happened years ago, I got a chance to interview one of the top heads of credit unions nationwide. And not off the record, but just a little bit of side conversation after he and I were talking and he said, Man, we really try to do everything we can to help our members be more financially responsible to credit union build future financial lives, etc. He said, but as a credit union or as a bank, we have this kind of fundamental incentive that works against people’s financial security. And I said, What’s that? He said, as banks and this was one of the most elusive yet totally obvious things he says, as a bank. We only make money if we lend. Hmm. Which, of course, hit me like a ton of bricks, that all the deposits and interest they pay on the deposits are an expense item for a bank. They’re not the asset the asset or is the money that they lent So we’re going to talk a little bit about how banks make money, and how the differential and interest rate works, and then how that applies to you. So you can look a little bit differently at how a bank talks about lending you money. And it’s even going to change how you listen to the next couple of episodes, where we talk about real estate and using lending inside of real estate. So with that, let’s kind of jump on this little example. Here’s a simple example of money to bank. The outflow that they pay on, say 100,000 of deposits is point 5% interest that they’re paying.

Cory 24:33

That’s my savings account. Yep.

Paul 24:35

Right. And then they’re going to lend that out in a mortgage. And let’s just say they get a 30 year fixed mortgage that they’ve lent out to somebody they get three and a half percent. Now, here’s the quick math that we all do. And in fact, early on being taught by big box financial retail when I started in this career, over 20 years ago, I know I don’t look that old, but I feel older every day. The the underneath the dirt underneath here, the grays on the inside, you got to keep it in the core that we looked that sale, it’s just 3% difference 3% rate of return. Now banks don’t open locations all over the world have secure websites, thousands and thousands of employees on 3% rate of return. But this is the way we’re traditionally taught to look at it. But that’s not how to look at it. In fact, when we have to pay out the interest, if we’re a bank, at half a percent that’s $500 in cost, that’s the investment. Then they get back 30 $500. So very quickly, you start to discover Wait a second, if I put $500 somewhere, and I get back 3500 that is not a 3% rate of return. It’s 600% rate of return. Now once again, for a math geniuses listening this is the danger we get into these asset class creation. Yes, we’re not talking about fractional reserve banking and going any deeper into that at this time, and

Cory 26:07

should only make it a higher rate of return, if that’s right.

Paul 26:12

But the other thing we’re not counting is of course, the bank has overhead expenses, fixed costs, variable costs with employees, ATM fees, all that. But the thing is that I’m pointing out, and Cory is pointing out is that it’s not a 3% difference. It’s a 600% difference, because we have to look at the dollar value of those growing, we talked about that all the way back in the illusions of investing people think, Oh, it’s just a 2% rate of return difference? No, it’s a gradation of the smaller rate of return we’re trying to improve. Now let’s think about how we look at it for our own personal balance sheet. We talked just a minute ago in the episode about why we may want to keep control of our money. Now in this case, what we’re going to do is assume that we as a homeowner to control our capital and not put it all down to downpayment are gonna pay Three and a half percent cost of money using our example of that family an extra 600,000. But we’re only going to analyze $100,000 of it just like we did the bank. And we look at the fact that we pay three and a half percent. And then we hope to get 6% in our investments. That’s the example here. That’s a two and a half percent rate of return. And people look at that all the time and say it’s not worth it. It’s just not worth it. I’d rather just put the money down on my house. And once again, though, it’s not two and a half percent. What is it? Well, we’re sending out 30 $500 a year in interest to that extra money that we didn’t put down on the house. And then if over time, we’re getting 6% coming back to us. The difference between those two is 20 $500. That is a 70 plus percent rate of return on the money we had to pay to keep Debt serves to keep control over money and allow it stay invested on our balance sheet.

Cory 28:04

So if you’re, if you’re only getting half a percent in a savings account, you’re used to getting 6789. And a market based investment account that the spread doesn’t even have to be that big to be a compelling alternative between the two.

Paul 28:20

Exactly right core that I mean, you could see that you could narrow this down, you could do the math yourself, right? narrow your return down to four or five, it’s still not a one and a half percent rate of return. Because it’s money that we weren’t going to control anyway, money that provided no return. If we locked it up in home equity. All it did was alleviate our cost of interest. And just like a bank, your return can be well in excess of this simple math, differential and difference between what you’re paying for money and what you’re getting is return on money. So for all of you out there, it’s so easy to take simple things like real estate and say well, I’ll just has to do with the mortgage person’s opinion is what my father in law’s opinion is what my brother says mechanic, my spouse and I what feels right, is that it can make so much sense if we did the math for you on this, of somebody putting down their 200,000 versus 100,000 apart we didn’t even get to is it’s hundreds of thousands, if not millions of dollars for some families in additional cost in just the way they choose to finance their home. And it’s not because the mortgage professionals don’t know what they’re doing. It’s not because your CPA doesn’t know what it’s because there’s none of those advisors who are seeing all the moving parts on your already existing chess board up until now. And these little moments of efficiency get found by having a coach even the best golfer in the world cannot see their own golf swing. That’s what we want to be able to do is come alongside you in these podcasts give you a little bit different look at something you’re dealing with your money on. And then if appropriate resonates with you reach out to us, we’d be more than happy to help you come alongside you and help you make some of these decisions to get your financial life as close to optimal as possible. get you closer to definite financial independence to fund your work optional lifestyle now, we always encourage you share this episode with somebody do go on it makes a difference. Do a review of this podcast on iTunes. Take the time, send us that review take a screenshot of it we’ll send you a copy of your business your wealth, we have our that upcoming book is going to release soon. We’re going to keep you all up to date. In the meanwhile, we’re waiting for that one you can request sound financial advice, or cape not required. But anybody who does a review of our podcasts now sends us that screenshot will not only get a copy of sound financial advice or cape not required. But you’re also going to go on the list and we’re going to send you a free copy of your business your wealth as soon as it’s out. So from myself from Cory from the entire team here at sound bites nancial group, we hope

Unknown Speaker 31:01

that this has been a contribution to you being able to design and build a good life.

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