Home Equity is not for Risky Investments

Home equity may be a poor source of investment cash if the market crashes

Massive increases in home values during the last few years have left most homeowners with more equity in their homes than they have ever had before. The equity is the difference in the value of the home and the amount still owed on it; it’s the portion of the house that the borrower actually owns. As home prices increase, so does the amount of equity in the property. In certain parts of the country, such as Washington, DC, home prices have nearly tripled in recent years, and homeowners are aggressively making use of their newfound “wealth”, using their equity for all manner of risky investments. The most common of these uses is buying more real estate. Anyone considering using their home equity to fund more real estate purchases should consider the drawbacks of doing so. It could cost you your home or even drive you into bankruptcy.

Over the years, the most common use for a home equity loan was to remodel or add on to a home. Lenders view these as low-risk loans; the house itself provides collateral and the resulting work increases the value of that collateral. Borrowers rarely default on such loans, and the banks merely sell the property to regain their lost investment. The home equity lending market has changed in recent years, however, and more and more homeowners are risking their property to borrow more money to buy more real estate.

Many people who are suddenly flush with equity are treating this as a windfall of cash. It’s not cash; you can only realize cash from your equity if you actually sell the home. Otherwise, the value of the equity can rise and fall with the rest of the housing market. Nevertheless, buyers are borrowing against this equity and using the funds as down payments on more property, which they typically rent out. There are well publicized cases of individuals who have parlayed a few hundred thousand dollars worth of equity in their primary residence into several million dollars worth of rental property. There are several problems with this. These buyers typically finance the new purchases with interest-only loans in order to keep the payments low. By doing so, they aren’t actually paying anything on the principal of the loan. In order to even do that, they have to make sure that the property is rented and stays rented.

Worse, the large number of investors who are playing this real estate game are driving up home prices even further. True, it gives them more equity to work with on each of their properties, but there is a limit to how much home prices can appreciate in a given market. Those people who need to purchase homes to actually live in have jobs and salaries that pay them only so much. There is a limit to how much salaried workers can afford to pay for a home. Once that limit is reached, home prices cannot increase any more. Compounding the problem is that any given market can only support so many rental properties. Some people want to rent, but most want to buy. If there are too many houses for rent, then prices must come down. And if prices come down, the real estate investors are in a lot of trouble, as they are substantially leveraged with little cash with which to work. A collapse in the market could leave many investors with six, eight, ten or even twenty homes for which they cannot pay, and many real estate experts say that the housing market is peaking.

It’s nice to have equity in a home, but that equity isn’t for playing risky investment games. It’s a security blanket that should be used wisely not exploited in order to try to get rich.