The Myth of Home Equity

Back in the 1980s all the interest you paid was deductible from your income taxes:  car loans, credit cards, mortgages, etc.  In 1986 Congress passed the Tax-reform Act, ending deductibility for all interest except home loans.  What happened next?  The banks began heavily marketing home equity loans.  Buy your car but use your house as collateral and still deduct the interest.  (I always say that when it comes to finances, bankers are a lot smarter than politicians.  See blog for July 1, 2011.)

Formerly, if you took a second mortgage on your house, you were in dire financial straights, but now you were encouraged to be smart, tap your equity and be rewarded with a deduction.  What they didn’t tell you was that the equity from appreciation really wasn’t profit.  As the price of your house rose, so did the price of all the others.  Cash-in your house and you still need a roof over your head, but now they all cost more.  Equity growth through appreciation was just a way of keeping up.  Good equity comes from paying down the balance, which doesn’t happen if you keep borrowing against it.  The "American dream" is to own a house, not to live in a piece of collateral.

What else they didn’t tell you was that a house with no equity is the same as a rental with no landlord.  You are responsible for repairs and maintenance.  You have all the work of a landlord but someone else (your bank) collects the “rent” payments.

Third, they didn’t tell you that for the average person the tax deduction is at best, modest.  About 2/3 of taxpayers take the standard deduction; it does them no good at all.  If you itemize you could always have gotten the standard deduction, so you only really benefit from the amount greater than what you would have gotten anyway.  If your total deductions, including mortgage interest, are greater than $11,600 this year (joint return), your advantage over renting is only the excess, not the entire amount.  You need substantial other deductions to get the full effect, and most of us don’t.

Of course they didn’t tell you that housing prices might fall.  It was unimaginable! – until now.  Then you find yourself underwater.  The irony is that many people who got into this situation treated buying a house as an investment rather than a long-term purchase.  What else do you buy expecting it to increase in price?  Do you think about a new car depreciating as soon as you drive it off the lot?  Do you then park it on the side of the road and walk away because you owe more than it’s worth?  Have you tried to sell your refrigerator or big screen TV lately?  People who wouldn’t dream of risking money in the stock market treated a house as an investment and got burned.

Finally, they don’t tell you that if you don’t eventually pay off your mortgage, you will go on paying for the rest of your life.  It’s not good to be planning your retirement and realize that you have 25 years of mortgage payments to look forward to.  (Financial advisors will tell you never to make an extra house payment, because it's smarter to invest that money - with them, of course - who get the commission.)

This is a critical thinking issue – believing a rosy marketing picture about tax deductions and the American dream, without thinking it all the way through.

It’s also a discipline issue – looking for ways to satisfy today’s itch with tomorrow’s money.


When many behave this way, it results in serious societal consequences.