How Not to Convert Equity

Posted on January 10, 2006  Comments (1)

CNNMoney is not exactly intellectual discussion of economic and investing issues but normally it offers fairly good material for the large number of people. Especially those who really don’t want to read Warren Buffett or Brad Setser. Still the following quote in their article, Cashing in on hot real estate is just wrong:

They also have one extremely valuable asset: a house in the now trendy Silverlake neighborhood of Los Angeles that’s worth $1 million, nearly four times what they paid in 1995. The equity, Handel says, is “lovely,” but it’s not doing them much good right now.

San Diego-based certified financial planners Christopher Van Slyke and Terry Green recommend an unconventional plan: taking out a new $500,000 ARM.

Handel and Laport can pay off their existing mortgage before the rate rises and retire their other debts. They can put the remaining $200,000 into stock and bond funds.

To be sure, borrowing against a house to put the proceeds into the market rarely makes sense. But in Handel and Laport’s case it does because so much of their net worth is tied up in their home, and the super-hot L.A. real estate market looks primed for a fall…

They can convert equity that might melt away.

They can what? In no way does increasing their leverage convert equity that might melt away. Any amount of “melting away” will still happen after this increase in leverage – no conversion has happened. They still have a full ownership interest in the real estate. If the value of their house fell $300,000 before or after this supposed “conversion” they would “lose” (on paper) the same amount: $300,000. The investment risk for the house has not changed (for the whole portfolio you could argue it has but that gets complicated and subject to debate).

The way to convert some of your asset to something else is to sell that asset (or a portion of it or hedge it in some way though for a house this is not easy or maybe even really possible). It is likely difficult to sell a partial ownership interest in their house (in which the new owner would share in the increase or decrease in the value of that house) but that is the way you would convert the equity in the house to something else.

In general CNNMoney is fairly simplistic. And much of the time that is fine. Improving on the investing of most Americans is not that complicated. First, actually save some money (especially in an IRA or 401k plan). Just doing that gives a very high likelihood of improvement. Second eliminate needless high interest expenses (credit card debt…). And CNNMoney is often demonstrating the wisdom of using a budget to prioritize properly, again likely to be quite beneficial to many.

I have no doubt CNNMoney does much more good than harm, but saying that taking a loan out on the value of your real estate converts that equity, is just wrong, and is dangerous thinking.

It would be like taking a margin loan on stock (remember all those who had huge portions of their entire portfolio in one stock – remember Enron) and saying that converts your equity. No it does not. You still are taking the full equity risk with the investment. Increasing your leverage by borrowing against that investment does not convert the equity.

Another good source (overall CNNMoney is too) of economic and investment learning is Marketplace (daily radio program with podcasts on NPR). Again it is somewhat simplistic economic and investment information, but nevertheless worthwhile. Marketplace is in the second day of two weeks of broadcasting from China – quite interesting. They offer A brief tour of China’s economic history (unfortunately they use flash and created a not very usable way to display the information).

Marketplace also offers a blog.

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One Response to “How Not to Convert Equity”

  1. Curious Cat Management Improvement Blog » Housing and the Economy
    September 4th, 2006 @ 4:57 pm

    [...] Combining the risks of leverage, adjustable rate mortgages, a high percentage of income devoted to mortgages and the volatile job economy we now must take for granted is not something to take lightly. I previously posted on How Not to Convert Equity (disputing CNN Money’s claim on how to “convert home equity”). If the regulators, mortgage lenders and borrowers together combined to take on more risk than was wise then the bubble could indeed burst. [...]

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