Home Equity, Inflation and Preserving Your Wealth
Understanding a leveraged position
It’s no secret that a home can cost more than the average person has in accrued cash, therefore it’s common practice to obtain a loan to purchase a house. There is nothing inherently wrong with this, and it gets many people into homes they cannot outright afford, but it is important to realize that it is a luxury of faith in the future. Someone crunching numbers behind a desk has determined that the buyer is a suitable risk. In the industry, partially buying an asset is known as a leveraged position.
As you can clearly see by this chart from this chart from the Federal Reserve Bank of St. Louis, a leveraged position on a house has become a very popular idea.
Understanding the risks of a leveraged position
For all the benefits of a leveraged asset system provides, it is still not without it’s risks. The simple truth is that when you leverage an asset, in this case your cash, that you put it at risk.
In the housing market this takes the unpleasant form of losing your home and possibly all of your equity. Many people went through this unfortunate reality during the 2008 housing crash. Nearly 10 million homeowners lost their homes due to foreclosure sales in the U.S. between 2006 and 2014, and in all likelihood many millions of people will again during the next downward cycle. Please refer to this link if you would like to know more about the 2008 Housing Crisis.
It’s not my aim, nor am I qualified to give a detailed explanation of the markets, their influencing factors, what caused the crash and how to predict the probability of another economic catastrophe, but what I can do with certainty is provide a simple outline for a practical way to manage the risks associated with a leveraged position.
Drowning in debt
When it comes to leveraged positions and real estate. What puts the owner in danger of losing their investments is a set of circumstances known as being “Under Water”. Technically speaking, “Underwater is the term for a financial contract, or asset that is worth less than its notional value.” Plainly speaking, it’s when you owe more than the house is worth.
For example, if someone purchased a median priced California home for $706,900 and the value dropped to $500,000, then the owner would still be obligated to repay the entirety of the loan regardless of the current ‘market value’.
If the owners should be unable to make the payments, they will be forced to default on their asset, leaving the lender the right to keep, or sell the property to regain their investment. This can leave the home owner in a very precarious position.
In some cases the entirety of their equity can be wiped out by the difference between the loan amount and current market rates.
Amortization, and the first ten years
An additional factor is that most home loans are amortized. The important thing to know about amortization is that you pay more towards interest in the beginning than at the end. This chart shows that even at a three percent loan that one actually pays more in interest in the first ten years than equity is built.
During the first ten years on a 700,000 dollar loan a loanee would build $167,861.52 in equity. So despite the feeling of being 1/3rd the way done with a thirty year loan, the owner wold in fact would have only 24% of the loan paid off.
If the house in this example had it’s value drop by $167,861.53, then the owner would technically be underwater, and if forced to sell, they would lose the entirety of their equity, a scenario that repeated 10 million times from 2006 to 2014.
The sad truth is that if a homeowner is unable to pay even a single dollar on their loan, they are at risk of being forced to sell their home for whatever the market may be paying at that time. Therefore controlling your home’s equity is a key to successful home ownership during financial uncertainty, because it allows the owners a method of mitigating risk. Bluntly, keeping a portion of your homes equity as cash or other assets gives the owners a hedge against leveraging, and gives the homeowner the ability to invest their equity.
The best hedge against leveraged risk is to have a portion of your equity as an asset that is not subject to leverage.
Banks control your savings
Bottom line is when you build equity in your home you are letting the loan originator; which is usually a bank, control that equity. You are co-investing on a project, but the overlooked catch is that the banks are legally allowed to use the equity you build for other investments. The amount of money they are required to keep on hand is called a reserve requirement. The money that is not deemed a reserve requirement can be used by the banks for other investments. The crux is that until the owner sells, they exercise little to no control over the use of their hard earned equity. I like to think of this as ‘forced savings through equity’.
Utilize Your Untapped Home Equity
There are three main ways of tapping your home’s equity, but regardless of the method the end goal is the same, offsetting the risk of going underwater, and being subject to the whims of the market and bankers.
Whether you like it or not, when you buy a house you are also making a commitment to being involved in the markets, and are thereby are at least somewhat subject to them.
Using one of the three methods of tapping equity, but preferably a Home Equity Line of Credit (HELOC), not only gives the owner a way to protect equity when faced with a foreclosure, but in addition gives the homeowner an opportunity to make improvements, or most importantly hedge your bets.
Inflation, the FED and Your Equity
In addition to the risks of a leveraged position, amortization, and untapped equity, there is another consideration when making a 30 year investment, and that is inflation. Investopedia refers to inflation as, “Inflation is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power”. The below graphic illustrates that since the creation of the Federal Reserve that the American dollar has lost well over 90% of it’s purchasing power due to inflation. If you thought there was any signs of slowing or reversing this trend, consider tat according to moguldom.com the M2 money supply created this year was around 20% of all dollars that were created in the history of the United States.
$100 in 1913 would only be worth about $3.87 today.
Your house’s value is also subject to inflation
The above is true, especially if it’s equity is stored in dollars, which is the case for the majority of homeowners. Most homeowners just pay the mortgage until they own it, and unless equity is needed for unforeseen circumstances, it just sits in the banks vault and devalues via inflation or mismanagement. People often think real estate has a steady increase in value but fail to account for inflation. Your homes value may increase, but the relative purchasing power of that value is greatly, if not entirely negated by inflation.
Officially the inflation rate of the U.S.D is 1.4%, but according to www.tradingeconomics.com, “Inflation Rate in the United States averaged 3.24% from 1914 until 2020”. If one multiplies even the lower official number of 1.4% by the 30 year life of a loan, then you’ll find that your equity has lost 42% of it’s value by the time you’ve paid off the loan. If calculated for average inflation of 3.24% this would be a staggering 97.2% of it’s value. This doesn’t include taxes and maintenance. If we take the average US home price at around 300,000 USD, we can then calculate with 1.4% inflation that the average American homeowner is losing around $4,200 a year, or $11.50 a day.
Some unofficial sources place inflation at 7%, which is much higher than the advertised, and with the increased stimulus for the foreseeable future there is strong evidence for continued inflation. Inflation causes higher prices and over the last 100 years this has definitively been the case. According to this website, the Bureau of Labor Statistics consumer price index, today’s prices in 2020 are 2,529.09% higher than average prices since 1913.
Is there something better to do than lose 42% or more of your homes value to inflation? Yes, and the answer is hedging your bets.
John Exter’s Pyramid and leveraged assets
John Exter was an American Economist, and a member of the Board of Governors of the United States Federal Reserve System.
In Exter’s vision of the monetary markets he placed various assets in a pyramid according to their riskiness, or how much leveraging was involved for a given asset.
In times of growth wealth flows upwards in the pyramid towards riskier but more rewarding assets, and in times of recession wealth flows downwards towards real physical assets.
It is important to note there is no ideal place to be on the pyramid, and any portfolio should be diversified to fit the current markets. The way this relates to home-ownership is that home loans have very high leveraging when compared to historical norms, or even other assets. With interest rates approaching at, or below zero percent, extreme housing prices and small down-payment requirements all add up to most homes being leveraged at many times more than historical rates.
Under normal economic conditions there will be an ebb and flow of money up and down the pyramid to suit the changing market demands. This can take the form of companies going bankrupt, downsizing, or expanding, but when the Federal Reserve steps in and injects currency into the current crumbling strata of the pyramid, then it prevents a natural contraction from happening.
This keeps the markets from deleveraging and creates an increasing amount of risk when the markets do return to ‘normal’. Every time a sector of the pyramid experiences a crash, but are bailed out and return to their previous modus operandi, they are inevitably placed in riskier and increased leveraged positions.
Each bail out, or stimulus package, can be thought of as a support for an increasingly top heavy pyramid that must eventually topple over, or at least partially invert.
Your hedge against inflation is also a hedge against leveraged risk.
When protecting yourself against a leveraged position, such as your home, the best way to do so is investing in a non leveraged position that isn’t subject to inflation. It would be pointless to take out 25% of your house’s equity to lose it in Vegas or the stock market. So then the question is: What assets have zero leveraging or inflation? There are many things one can do with equity such as start a business, pay for college, or make home improvements. These are all great but are notably still subject to the same market conditions.
Real assets like physical precious metals have almost zero potential for leveraging. While they do have their own market conditions and there is evidence of price suppression, ultimately the physical purchasing is still not leveraged. Who would sell you a physical ton of gold or silver for pennies on the dollar down, or on a monthly payment system? The answer is no one. If you find someone please let me know.
Having a portion of your home’s equity in precious metals is not only a hedge against leveraging but also a hedge against inflation.
If an economic downturn happens, using 25% of your home’s equity to keep you afloat during that time is an invaluable tool, but if that equity is placed into an asset that increases in value during a recession then you’ve positioned your self very well.
It’s pretty obvious from the chart below that massive inflation has driven down the purchasing power of the dollar. This has forced the consumer to take highly leveraged positions in order to be able to purchase a home. The disadvantage is that it makes people vulnerable to the whims of the market if they are not positioned properly.
Storing a portion of your house’s value in Gold over the last 100 years would of been vastly superior to leaving it’s value in dollars.
How to not lose your home during the next housing crash.
I don’t predict that anything will happen on the scale of Venezuela in the US, but I think it’s a perfect case study as to how to prepare the homeowner for dealing with highly leveraged assets and high inflation. The below chart shows the relative value of silver in Venezuela. The chart shows a massive increase in the price of silver, but the reality is that silver didn’t increase in price, but rather the Venezuelan Bolívar was devalued through inflation. According to The Central Bank of Venezuela, “Since 2016, the overall inflation rate has increased to 53,798,500%.” Learn more about hyperinflation and Venezuela here.
The unfortunate reality is everyone who had a house watched it become worth next to nothing, but if that owner had used the equity for literally almost anything else or then they would of been better off.
This chart show the insane increase in silver price in Venezuela.
In best case scenario an owner would of placed their equity not in Bolivars, but rather in physical non leveraged assets that are not subject to inflation.
While the conditions that caused this hyperinflation may never come to the U.S., it doesn’t mean that inflation isn’t happening here, and all around the world. It’s simply a built in function of Fiat Money. Investopedia states under disadvantages of Fiat currency that ‘There are more opportunities for the creation of bubbles with fiat money due to its unlimited supply.’
On this website you can track the various national US debt numbers. Before modern fiat currency system every dollar was backed by an amount of redeemable gold or silver. This system was known as the Gold Standard. In 1913 there were 2.64 dollars in circulation to every ounce of silver, and today by comparison, there are 4,284 dollars per ounce of silver. Which is about 1601 times greater.
I’m not advocating for one financial system over another but rather to suggest that if highly leveraged assets become less desirable then one should expect a large flow of money towers physical non leveraged assets, which would obviously drive up the price.
Holding a portion of your home’s equity in a non-leveraged asset does three things:
It hedges your bets against a leveraged position.
It protects your equity from inflation.
Provides a non leveraged tangible investment.
It is incredibly hard to predict the future, and any investment is a gamble. Buying a home is a huge part of life and ultimately is a risk worth taking. Understanding the associated risk and how to mitigate them is the key to building and preserving wealth. A non-leveraged asset, such as precious metals, gives the owner a direct way to control the equity in their home. When a home’s equity is left in dollars, then it’s value is subject to the number of dollars that are in circulation. Removing your home’s equity at least partially from the economic conditions surrounding Fiat currency gives the owner direct control over there investments and helps to minimize the risks associated with a leveraged position.
For any questions or comments please contact Aaron Rose by email Aaronashrosen@gmail.com, or by phone. (415) 716- 8877.
Produced by Partridge|Rosen (Lic: 02041059, 02104183)
https://www.facebook.com/partridgerosen/
Luxe Places International Realty (Office Lic.: 01522223)
737 4th Street, Santa Rosa, CA 95404