Financial Planning, Home Style

Over the past few years, we’ve seen some of the largest home appreciation figures on record. And if you bought your home during this time, you’re surely appreciative of this phenomenon. But you also need to be aware of how your appreciation might influence your current financing plan.

So this month, we’ll examine a few scenarios that will help ensure you’re not paying mortgage interest that could erode your capital gains; and we’ll show how to use your home to help with broader financial strategy. In our examples, we’ll assume you bought your home three years ago for $550,000.

Scenario 1: $550,000 Purchase, 100% Financing
Let’s say you bought your home in Fall 2002 with no down payment. This would likely make your first mortgage $440,000 and your second mortgage $110,000, because you had to cap your first mortgage at 80% of the purchase price and put the rest into a second mortgage. As you probably learned at the time, when you do 100% financing, rates can be as much as 1% higher on each loan because you’re a greater credit risk to a lender.

Let’s assume further you’ve paid interest-only on both mortgages, which means your loan balances are the same amounts today as when you started. But now your home is worth $730,000 after appreciating 10% per year. This means you can combine your two loans into one single $550,000 loan. Even at current market rates, you could still save about $435 per month.*

The reason is because now you only have one loan for 75% of the value of your home. Rates are much lower for people with this much equity in their homes.

Scenario 2: $550,000 Purchase, 90% Financing
Rates are also lower for people who have even 10% equity. But usually only the first mortgage rate is lower, whereas the second mortgage can be higher. So let’s say you bought your home with 10% down. This would give you a first mortgage of $440,000 and a second mortgage of $55,000. In this case, you may have a great first mortgage rate that you can’t beat with today’s rates.

But with your newly appreciated value of $730,000, your equity has grown from 10% to 32%. If you go to refinance your $55,000 second mortgage with this increased equity position, you can often beat your original rate by as much as 1%. This could save you about $45 per month.**

Equity Can Also Finance: Cars, Home Improvement, New Homes
Of course, this savings might not sound as significant. But there are many other scenarios to consider. Maybe you want to take some cash out to buy a car. Under either scenario above, you could take that cash out as part of the refinancing discussed. And remember that your interest paid on that type of “car loan” is tax deductible because it’s tied to your home. That’s not something the finance department at your local auto dealer will be able to provide. Same thing would apply if you wanted cash out for home improvement, or any other reason.

Another common scenario for people with newly gained equity is for them to put a Home Equity Line of Credit in place. In our examples above, you could put a $100,000 credit line in place, and have it just sit there at a zero balance until you wanted or needed to use it. Many people who are thinking about trading up to a new home do this. The benefit is that you have your cash available to write an offer on a new home without having to sell your current home. This can (and does) make the process of buying a new home much less stressful.

As you evaluate the options that equity-through-appreciation provides, it’s important to remember that any mortgage decision depends on two things: (1) your specific objectives, and (2) your time horizon. As such, the scenarios above might not fit your situation exactly. But the point is that home investing is just like securities investing. There’s a passive approach and an active approach. If you have the right advice on an active strategy, you can usually beat the market and use your home to help with broader financial strategy.

*Original loans of $440,000 at 6.5% and $110,000 at 7.5%. New loan of $550,000 at 5.75%.
**Original loan of $55,000 at 7.5%. New loan of $55,000 at 6.5%. All payments interest-only.