THE ROAD TO AVALON

In September, my wife Adriana and I made a spontaneous decision to take a one week trip to Newfoundland. We love un-planned, un-scheduled, un-hurried travel with opportunities for chance encounters. Hiking along the ubiquitous wind-swept shoreline trails of the Avalon Peninsula, picking blueberries along the way, striking up conversations with other travelers, and enjoying the hospitality and comfort of B&Bs, suited us perfectly.

Although I wanted to get away from business for a while, I did have thoughts about the sub-prime havoc south of the boarder and recalled earlier periods of upheaval that affected home equity and the mortgage business in Canada.

Bed and Breakfast places are as unique as the people you meet in them. Imagine a person from London who described his work as ‘arbitrage tax negotiator’! This outlandish description was enough to stimulate a lively exchange between his global equity trading vs. my street level view of “lazy home equity”.

At another B&B I met the author of a new real estate book with the intriguing title “The Naked Home Owner”. While the title is rather amusing the metaphor aptly expresses the apprehension of many homeowners over their equity today.

The current mortgage crisis in the States, reminds me of the oil price shocks of the seventies and the eighties market crash. During the oil crisis, interest rates surged to more than 21% and, during the late 80’s, high, short term, interest rates resulted in reduced consumer spending, substantially eroded property values and job losses.

I remember the last real estate cycle very clearly because I bought my house at the peak, in May 1989. Now, after nearly 18 years, its market value is just about back to the 1989 level. At the lowest point I had lost a lot of “lazy equity”. I call it “lazy equity” because I earned no return on the equity tied up in my house. Subsequently, I realized that, had I made only a small down payment, or no down payment at all, the equity could have been invested in other assets that might have appreciated rather than depreciated. Of course, I have enjoyed living in the house and did save money by paying down the mortgage. However, saving money is not the same thing as making money.

While paying off a mortgage does reduce interest costs, at the same time it denies us the opportunity to invest that money elsewhere. By tackling the goal of paying down a mortgage first, before developing a wealth accumulation plan, we may fail to consider the important role a mortgage can play in such a plan.

Alan Greenspan, past president and chairman of the U.S. Federal Reserve, known for his conservative views, apologized publicly the other day for underestimating the potential impact of the un-controlled sub prime market on the housing market and the economy. He had concluded that ‘crashes’ cannot be avoided and that they should be considered as self-correcting mechanisms that restore balance or equilibrium.

How can the hapless homeowner protect equity, the difference between home value and outstanding mortgage financing, when significant “corrections” in real estate values are always possible? The answer is that we must carefully re-evaluate our beliefs and strategies.

Many of our attitudes and beliefs are inherited from our parents and their generation, who thought of their home equity as the ultimate retirement fund or their house as an asset which might also be passed on to the next generation. They taught us to make a big down payment, get a fixed-rate mortgage, and to make extra principal payments whenever we could, to pay down the mortgage debt as quickly as possible.

The problem with this strategy is that it has become outdated. The rules of the game have changed. Unlike our parents, we no longer have the same job for 30 years, depend on a company’s pension plan for a secure retirement, live in the same house for 25 years or keep the same mortgage.

Wealthy people, who have the ability to pay off their mortgages, understand how to make mortgages work for them, and choose not to pay them off. They make minimal down payments, keep their mortgage balance as high as possible, choose adjustable-rate mortgages and, most importantly, integrate their mortgages into their overall financial plan.

The good news is that any homeowner can now implement the strategies that the rich use to increase their net worth. In the last 12 months, dramatic changes in mortgage financing now allow homeowners to combine saving, debt reduction and investing. You can even make your mortgage interest tax deductible! Implementation of these strategies requires that we change our view of a mortgage from a millstone of debt, to an item to be integrated into an overall financial plan.

The traditional strategy has two limitations which, under some conditions, may be restrictive and costly. The equity which is gradually accumulated cannot be accessed without selling the property. It does not contribute to the increasing value of the property nor can it be used elsewhere to generate wealth. Worse still, in circumstances of job loss or other economic disruption, the very time when access to capital might be most necessary, home equity is effectively locked in and unavailable to the owner.

The circumstances of each individual or family are unique and it is not appropriate for everyone to adopt these particular wealth creation strategies. However, if you would like to learn more about them and to discuss whether they might be appropriate for you, please give me a call.