But, What Could Go Wrong?

by Rick Adkins, CFP®

Ten Years Ago I received a call from Arkansas Business’ George Waldron. He had been “pitched” by brokers on the idea of borrowing out the equity in your home and investing it with them “to earn a higher rate of return.” We had gotten to know each other pretty well when our offices were next to each other and he wanted a different view on the scheme. At the time, my concerns related to the behavioral aspects of employing this strategy.

While on vacation recently, I received an email from Kyle Masset who was doing a follow-up to George’s article. In preparing for the interview, I re-read the original article. That was a sobering experience.

In the fall of 2006, no one quoted in the article, including me, had a clue what was about to happen to our economy just two years later. There was almost a naïve assumption that investment returns would stay at double digits; real estate values would go up, up, up; and mortages would remain as they had been, loose and easy! In retrospect, that was a recipe for disaster, not clever planning.

Here were my key points in this year’s interview:
1. We all have a tendency to think transactionally, not holistically and certainly not contemplating diverse scenarios. Few of us believe we will have a heart attack within the next week. We certainly don’t consider what would happen if we had a heart attack in the next week while driving a car at 70 mph down the freeway – or worse having a heart attack twenty feet up on a ladder cleaning our gutters.

It is always a good exercise when making a financial decision to ask, “What could go wrong?” with respect to each key assumption. Then when you analyze the transaction, you’re not just looking at a rosy outcome, you also consider less optimal results.

2. Flawed assumptions can lead to disastrous results. In the period of the initial article, I had been traveling a bit, speaking to financial planning groups. Planners on the east and west coast were personally taking similar approaches with their mortages, due to the high cost of homes in those areas. They were using interest-only, 100% mortgages that would be renewed every five years. That meant requalifying – both you and your house, every five years.

If you were renewing your loan real estate started tanking in 2008 and your home value had dropped 30%, you had to come up with the difference. On a $600,000 home, that’s $180,000! To make matters worse, if your portfolio was invested in the S&P 500, you had lost 37% of your value. That’s like having a heart attack while driving 70 mph and cleaning your gutters!

3. Flawed assumption II. The returns for the S&P 500 for the last ten years did not average double digits – they have been 7.42%. Mortgage rates ten years ago were in the 5 to 6% range. Even if you could have refinanced with declining home values, is it worth one to four percent to go through all the hassle?

Smart financial decisions are seldom made quickly, without realistic modelling and lacking well-considered scenarios (particularly a few “bad” ones). So next time you’re evaluating an important financial decision, remember “But, what could go wrong?”

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