There are many ‘tricks’ in the world of finance. These tricks will put $500k to $2 million extra in your pocket over time. One is how to use home equity to build wealth.
There are generic articles that discuss things like paying off high rate debt. However, there is one financial planning strategy that is often overlooked.
The strategy involves using a home equity line of credit (HELOC) to reduce your emergency fund. In short, you can use this knowledge to build an additional $50k – $200k in wealth.
A warning before we get started. This strategy takes financial discipline and an understanding of HELOCS. I highly recommend reading more about HELOCs so you understand how they work as well as their disadvantages.
Background To Using Home Equity To Build Wealth
In order to take advantage of this strategy, you have to understand two items. Your home being a dead assets and the probability of an emergency.
A Dead Asset
Your home isn’t really a dead asset because the value goes up and down.
In reality, home equity is a dead asset. Home equity goes up in two situations. Either you pay off debt or the value of your house goes up.
This is important to understand so I’ll explain further.
You can’t make money in housing if you don’t own a house. However, once you own a house, it doesn’t matter how much equity you have. You get 100% of the upside. In fact, the lower your equity is the greater your return.
For example, if I have 20k in equity and my home value goes up 20k then I have a 100% return.
If I have 100k in equity and my home value goes up 20k then I have a 20% return.
Probability Of An Emergency
I also have experience in financial planning. Therefore, I familiar with the typical advice given to consumers.
The typical advice for an emergency fund is to save six months of expenses in checking and savings accounts. This is a great strategy in regards to reducing risk.
However, there are those that disagree with it because checking and savings accounts pay so little in interest. Plus you will most likely not need the money for an emergency.
In a former life, I used to work for a bank. Therefore, I had access to many internal and industry research reports.
One of the reports analyzed the probability of individuals needing more than 33% of their emergency fund for an actual emergency.
In other words, if you have a 6 month emergency fund, this report analyzed the probability that you’d have an expense greater than 2 months.
Let put that into numbers…
If you have monthly expenses of $5,000 then a six month emergency fund would be $30,000. This report analyzed the probability that you would need more than two months (or more than $10k) for an emergency.
The probability that was given in the report was less than two percent. That means in my example above, the person would have 20k in savings and had less than a 2% probability of ever needing it!
That is the definition of a dead asset!
Combining This Knowledge To Your Benefit
Combining the knowledge above gives you the ability to use home equity to build wealth in one of two ways.
I’ll use an example to illustrate and I’ll also be conservative.
The probability you will need more than two months of an emergency fund is small. However, to be conservative you decide to keep three months in checking and saving. Going back to my example above, this means you’d keep 15k in checking and savings.
The other 15k you can now invest in something like the stock market. You can also be more conservative and put into a 5 year CD. That will pay you a lot more than having it in a checking/savings account.
The probability of you having a large expense, such as a medical expense, and the stock market going down at that exact time is extremely low.
Therefore, depending on the rate of return on your investment you can generate an extra $50k to $200k over a 30 year period.
That is one conservative way to use home equity to build wealth.
This is an advanced strategy and I only recommend this if you know money very well.
The first step is exactly the same as strategy #1 above. However, in addition to investing the extra money, you also draw on the line of credit and invest that also.
This is only possible if the rate of return on your investment overtime is greater than the interest rate on the line of credit.
There is always risk in financial strategies. This strategy has minimum risk if you do it right and you understand investments. If you need help, be sure to become a FitBUX Member and ask your FitBUX Coach.
By Joseph Reinke, CFA