Reincarnating dead capital

“Your house is not an investment” is often recited as sage advice within personal finance circles. The premise is that investments must produce a steady stream of positive cash flow in order to be considered as such. Your home does not qualify as an investment as there is no rental income earned from the property whilst you are living there. Furthermore, the majority of homeowners finance their purchases via mortgages which require monthly funding thereby reducing net monthly cash flow. Arguably, despite benefiting from living in it your house is a liability whilst you still have a mortgage.

Should I own my home outright?

Consider the following question: should you ever aim to own 100% of your property?

To some, the answer appears to be “obviously yes!”, the theory being that if you own your home outright then you don’t need to pay a mortgage and the associated interest payment to a bank. However, the problem is slightly more nuanced.

Were you to have 10% equity in a property there would be a marginal benefit to owning an additional 15% bringing your ownership up to 25%. The reason is that mortgage interest rates tend to be calculated as a function of the amount of equity. As you own more of the property, the loan to value ratio (the percentage of the property funded from debt) declines. As the loan to value ratio declines, the borrower is charged a lower interest rate. This occurs in stages – think of it in terms of steps such that the incremental interest rate saving occurs in loan to value bandings.

The interest rate savings are not continuous. Beyond certain percentages of equity, there incremental interest rate savings drops off. This differs for different lenders but a simple rule of thumb might be that beyond 50% equity in a property, there is little to no interest rate savings. For example, the change in equity from 30% to 50% might reduce your interest rate from 2.5% to 1.5%. However, an increase in ownership from 50% to 60% could still result in the interest rate charged remaining at 1.5%.

The dead capital theory

Let’s think of a really simple example and consider the optimal financial strategy. Let’s say you were going to purchase a £1 million house (I wish!). Fortunately, you have lots of cash at your disposal; £750,000 to be precise. However, you notice that interest rates are held fixed at 1.5% for any ownership greater than 50%. In this scenario, it isn’t optimal to own 75% equity in the property. The reason is twofold:

a)       There is no step change in debt interest cost for every £1 borrowed above £500,000. The rate remains 1.5% regardless of whether you borrow £500,000 or £250,000 as no interest savings are available;

b)      Instead of owning the additional 25% to take your ownership up to 75% you could invest the additional £250,000 in cash elsewhere.

Owning £750,000 of the property wastes the opportunity to invest £250,000. Effectively, £250,000 is dead capital, underutilised and sub-optimal.

Where the additional £250,000 is used to purchase additional equity in the £1 million property, the incremental interest saving is £3,750 in interest per annum (1.5% * £250,000).

Consider utilising this dead capital. Imagine instead that the £250,000 was invested into a £500,000 investment property. Once again, given the 50% loan to value ratio the mortgage interest cost will be 1.5%. However, you are able to rent out the property at a yield of about 4% of the property value. Whilst the borrowing cost will be £3,750 for the new property, the rental income will be £10,000, netting a cool £6,250 per annum.

Comparing the two scenarios, it’s clear that utilising dead capital and increasing cashflow by £6,250 per annum is better than a £3,750 saving per annum.

Converting your home into an investment

Let’s take a pause for a second. During our working lives most of us do not have the luxury of £750,000 in equity. However, as we reach retirement many of us have been paying off mortgages and sitting on appreciating properties for 25 to 30 years. That’s a tonne of dead capital that isn’t being utilised!

Equity release enables you to harness some of that dead capital. It is the means by which you can take out some of the equity that you have built up and turn it into cash to spend however you like. Equity release is recommended for people who have reached retirement and wish to benefit from the equity that they have built up in their own homes. Effectively, this transforms your home into an investment – remember that an investment is an asset that provides positive cashflow. Equity release makes this a possibility.

You could use equity release to pay for a family trip or wedding, for big home improvements, for a new car, to pay for healthcare, and to provide an early inheritance for your children. Alternatively, you could use equity release as outlined above, to release the dead capital and provide another income stream for retirement.

How much equity can I release?

There is no such thing as a free lunch and the same is true for equity release. Equity release is a form of debt that you will need to pay for in the form of interest. Furthermore, the mortgage principal is repaid on death (morbid but fair). However, the cash is earned as a tax free lump sum payment or as regular payments.

The difficulty is in figuring out how much equity you will be able to release. Fortunately, there is a helpful equity release calculator that can quickly give you an idea as to how much you could receive by indicating how much your house is worth. It’s very easy to use – you literally put in your post code…and that’s it!
How much equity could you release and what would you do with it?

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