'Home equity harvesting' needs wary look

Q: We are trying to plan for retirement and have been approached by an investment advisory team to do something called "home equity harvesting."

Our current mortgage is about $100,000 and our home is worth more than $650,000. They are suggesting we refinance all but 20 percent of our home value and invest in several financial products including an investment-oriented life insurance policy.

We would take out a $520,000 mortgage with a 30-year fixed rate of 6.5 percent. Our federal tax rate is 28 percent and our state tax rate is 8.5 percent, so after the mortgage income tax deduction, the real interest rate we will be paying is 4.29 percent.

This plan seems to make sense because of the 10 percent average historical rate of return on stocks. The insurance policy they recommend has a guaranteed minimum investment return of 3 percent. Any comments would be appreciated.

A: Not all of your interest will be tax-deductible. The IRS distinguishes between acquisition indebtedness and home equity indebtedness to determine whether your mortgage interest is deductible. Debt incurred to acquire, construct or substantially improve your home is tax-deductible.

Indebtedness is reduced as the debt is paid off and cannot be increased by refinancing. Refinancing of an acquisition debt is considered acquisition debt to the extent it does not exceed the principal outstanding on the loan immediately before the refinancing (your $100,000). Debt secured by the home that exceeds the acquisition indebtedness is deemed home equity indebtedness and is limited to the lesser of fair market value of the home minus total acquisition indebtedness on that home ($650,000 - $100,000 = $550,000), or $100,000 ($50,000 Married Filing Single).

Acquisition and home equity debt may be combined in a single loan when claiming interest deductions. Refinanced debt amounts in excess of the prior debt's outstanding balance can be combined in a single loan. In your situation, you could refinance your acquisition indebtedness ($100,000) plus an additional $100,000 as home equity debt and interest paid on that amount would qualify for the mortgage interest deduction.

Some of the more aggressive "equity harvesting" plans call for financing in a deferred interest type of mortgage. Your mortgage payment is based on a very low interest rate, typically1 percent. The real rate of interest accrues separately and is payable within a certain period, usually five years. After the five-year period you either pay off the loan or refinance again.

The assumption with this type of mortgage is that your home will continue to increase in value, which will allow you to refinance the larger amount needed to cover the new loan which includes the accrued interest.

I have seen the results of people "cashing out," "stripping equity" or "equity harvesting" in the late 1990s, so I have a difficult time advising clients to do this. The underlying assumptions are generally too optimistic and the costs involved with the insurance or annuity products almost assure that you will never match the rate of return for the overall market.

If the selected investments do well, putting your home equity to work may increase your net worth. On the other hand, if the investments don't perform as expected, you could be putting your home and plan for retirement at risk.

The following analysis uses the performance of the very low cost Vanguard S&P 500 fund as an investment benchmark, assumes no taxation on your investment and assumes you don't need to use any of your home equity to make your mortgage payment: If you had "harvested your equity" of $520,000 in 1999 and invested in this index fund, your account value would have grown to $676,067 by December 31, 2006. This is an annualized 3.285 percent rate of return.

You would have paid $315,528 in mortgage payments over this same time period if you had financed $520,000 at 6.5 percent. After the eight years, you would still owe $461,109 on your mortgage. At this time, if you decide to pay off your mortgage, your remaining investment account would be $214,957 ($676,067 - $461,109) less any tax owed on the investment gain. If you did not "harvest your equity" and instead invested the $39,432 annual mortgage payments in the Vanguard S&P 500 fund over this same period you would have accumulated approximately $407,000 with nothing owed on your mortgage.

Beginning a monthly investment in a good no-load mutual fund equal to the amount of the proposed new mortgage payment may be a better plan than acquiring more debt on your home.