The smart use of debt

Equity repositioning is nothing more than the concept of using debt wisely.  When we use other people’s money to make more money because we are making more money by investing than the borrowed money is costing us, we come out way ahead on very small margins over long periods of time.  I never advocated financial irresponsibility, frivolous spending, or unnecessary risk-taking.  To the contrary, my message was this:  Financial security is defined as having the ability to weather any financial storm or be able to take advantage of any financial opportunity that comes along.  When we tie up all the money in our homes by paying down our mortgages we are (1) forgoing the opportunity to make money on that money because the rate of return of home equity is ZERO; and (2) we are putting that money in an illiquid place that can be difficult to access.

Never has the consequence of a decision to pay off one’s home been more dire than it is now.  Lending is so tight that people can’t borrow against their homes to help meet cash-flow needs due to unemployment or illness. People who don’t have access to cash can’t buy all those things that are on sale right now, like real estate.  People who have put all this money into their homes are not only watching that money “disappear” with declining home values but they’re also kicking themselves for not having the ability to buy the house next door.  For those who did it right—they bought a house, put little down, kept other assets working for them—they are sitting in a much more financially secure place.  Ironically, these are also the folks who are getting their loan modifications approved and even having their second mortgages forgiven.

Am I glad I told clients that cash was king and to sock their money away somewhere other than their homes?  You bet.  So are they.

What to consider

     There was a great article in the New York Times not a month ago about this very topic (“Just Walk Away” by Roger Lowenstein).  If you’d like a copy, send me an email, and I’ll pass it along to you.  The author’s main point was this:  Big companies don’t hold onto bad assets, feel no shame about unloading them, and don’t worry about their credit ratings.  These companies practice “strategic default.”  Case-in-point, I just recently received an email from a company from which I buy products informing me that it was filing for bankruptcy.  It explains, “As numerous companies have demonstrated during this difficult economic cycle, using this type of legal process can be an effective way of achieving a fast and efficient debt restructuring with minimal disruption to the business.”

     So why should individuals act differently?  Why does the Obama administration ask homeowners to continue paying on their debt on homes in which the debt exceeds the value by 2-to-1?  Because it’s good for the banks, which are selling off their mortgage portfolio to the Fed because it’s a good business decision to unload as many bad assets as possible?  I don’t get it.

     If you decide to walk away from a piece of property and your mortgage obligation, you still have to live with yourself.  If walking away from the debt takes off years of your life in guilt and stress, it’s not worth it.  But if unloading the asset in a time in which banks are prepared to deal with it, why not take advantage of opportunity to put yourself in a better place financially?  Yes, your credit will suffer.  Temporarily. Yes, you will have reneged on a promise.  To this point, I thought the article put it brilliantly:  You did promise to pay, but the contract outlined specific penalties for non-payment.  “The borrower is not escaping the consequences; he’s suffering them.”  I also agree with the author that a flood of “strategic defaults” by homeowners might lead to more loan modifications by banks, which is what’s supposed to be happening.  It might “un-stick” the system, which would be good for all of us.  Consider walking away.  Talk to your accountant, your financial planner, your bank.  Get the facts and then decide.