Let’s solve one of the great financial debates of all time. Does home equity generate a return on investment?
Jack and Jill both have $100,000 of cash – and both decide to buy identical houses next door to one another – each priced at $100,000. Jack uses his $100,000 to pay cash for his home. Jill invests her money at 6%, and takes out a $100,000 mortgage at 4%.
A year later, the market has been kind – and both houses are worth $110,000. If Jack’s home equity generated a return on investment, how do you explain that Jill earned the same $10,000 with no appreciation? Answer: there is no return on home equity – the return is on the value of the asset whether it is owned free-and-clear like Jack; or completely leveraged, like Jill.
Yes – Jill has a mortgage payment and Jack does not. But remember, Jill put her $100,000 into an investment that grew 6% in value. Jill now has two earning assets valued at $216,000 (her $100,000 house and her $106,000 investment account) while Jack has just $110,000 of earning assets – his house.
What’s more, Jill has eliminated another silent risk that Jack still has. If Jill loses her job, she has $106,000 of cash to see her through. If Jack loses his, he’s got nothing other than a paid-for house. Jack’s lack of cash in a, emergency (illiquidity, in financial speak) drastically offsets the peace-of-mind of a paid-for house.
Bottom line: equity in your home returns nothing – and therefore is no different than burying cash in the back yard, or stuffing it in the mattress.