Eurekonomics: Cash-value life insurance and home equity

By Jeffrey Reeves MA


Throughout the past decade or so, the fallacy that home equity should be "harvested" by means of mortgage refinancing or home equity loans and converted into equity in some other investment has been foisted upon Americans as a legitimate financial strategy.

The most common presentation of these schemes suggests that home equity should be redirected into what some advisors call "investment grade life insurance." Other schemes suggest turning equity you control into annuities, real estate, gold, mutual funds, or some other investment -- aka speculation -- that you do not control.

The consistent mantra of the promoters of this idea is, "That's what the wealthy do." They want you to believe that following their advice is the path because it's the path that those who were already wealthy followed. Bunk!

Each of these demonstrably unsuccessful and failed schemes relies on the flawed principle that you should convert an asset over which you have control into cash. Having done that, you should then give the cash to the financial advisor/planner that recommended the transaction who will then invest your money into whatever financial product or service he or she is currently promoting, earning commissions from selling, or receiving fees for managing.

The results from this strategy are apparent in the home foreclosures many Americans face today. They also appear in the non-performing, under-performing, and money-losing investments into which the advisors often directed the American consumer's home equity dollars.

Average rate of return

The promotional basis for most of these schemes is the mythical average rate of return. The average rate of return shell game uses illustrations that show a consistent seven to eight percent return over multiple intervals -- usually annual. A typical $1,000 investment example used by this scheme with an average rate of return of 8 percent might look like this:
  • Year 1 - $1,000 x 8 percent = 1,080
  • Year 2 - $1,080 x 8 percent = 1,166
  • Year 3 - $1,166 x 8 percent = 1,260
  • Year 4 - $1,260 x 8 percent = 1,361
  • Average rate of return = 8 percent
  • Actual compounded annual return = 8 percent
However, even though this illustration shows an average rate of return of 8 percent over a four year period, it is unlikely, if not impossible, to earn an actual 8 percent year upon year compounded return. (Just ask one of Bernie Madoff's clients if you don't believe that.) A more honest illustration of an average 8 percent return might look like this:
  • Year 1 - $1,000 x + 40 percent = 1,400
  • Year 2 - $1,400 x + 22 percent = 1,708
  • Year 3 - $1,708 x - 15 percent = 1,450
  • Year 4 - $1,450 x - 15 percent = 1,233
  • Average rate of return = 8 percent
  • Actual compounded annual return = 5.38 percent
Even though the returns in the gaining years far outweigh the negative returns in the losing years, the average rate of return is still 8 percent, while the actual compounded return is about 5.38 percent. It's possible to show a much lower actual compounded return with a little bit of creative arithmetic, but this is enough to make the point: average rate of return is always deceptive, is always hypothetical, and is never guaranteed.

The fact that the returns on the investments recommended by the harvesting proponents are not guaranteed or even predictable compounds the primary deception in these schemes, which is that real estate values always move upward.

Granted, throughout the few years before the real estate bubble burst, the values assigned to real estate moved predictably higher. However, the assigned values were often determined by the amount of money an advisor suggested the owner harvest and invest in the financial product he or she had for sale. Add to that the painfully unethical behavior of the mortgage industry granting loans to enhance the compensation of executives and brokers in that industry and the outcome was predictable.

The wholesale failure of financial Behemoths like Freddie, Fannie, Lehman, and so on is proof positive that the actual values of real property were artificially inflated to accomodate harvesting equity and other schemes designed to move money from the pocketbooks of American families into the coffers of corrupt Behemoths.

Eurekonomics: The return of common sense

Let's turn the equity harvesting scheme on its head.

First, I have known many wealthy people. I have known some who harvested equity from their homes and business properties. I have known not even one that became wealthy by harvesting equity; however, I have known some that became paupers by doing so.

The wealthy people that have commented on or reported about this concept have harvested equity only when they could guarantee that the use to which they put the money converted from equity would return more than the cost of converting the equity. In their decision-making, it was always more important to avoid or minimize risk than to hope for returns. They used harvested equity to get richer without risk, not to get rich in the first place.

Conversely, even considering minimal risk investments, few of the wealthiest people I have encountered over the past four decades of my career would ever consider placing a mortgage on their paid-for personal property, least of all their residences. They worked diligently for decades to pay off their mortgages and protect their personal assets from business failures and legal actions. Why would they ever want to put those assets at risk?

What common sense program would ever warrant taking the chance that the family home would be lost to some investment that promises only that it promises nothing. What about a greater return? Think about it. Is there a rate of return that is worth more than peace of mind?

If you would have a strategy regarding equity harvesting, why not consider harvesting equity from a source that you control and using it to pay off your mortgage and eliminate interest payments to the Behemoths? Why not first build and then harvest the equity from your cash value life insurance policies, use it to reduce and eliminate debt to others, and repay the low or no cost policy loans so you can do it again and again? Why not learn how to be the bank?

This is the inverse approach to risking everything you own to get an impossible maybe. It is a way certain to reduce and eventually eliminate debt to others and guarantee that the equity you build in your home, your other personal property, and the cash values in your life insurance policies remain under your control.

Finally, the most powerful argument for this approach is that it has been tried, tested, and proven over many lifetimes and generations. It works in good times and bad. It allows you to grow rich without risk, and secure wealth without worry.

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