In his recent address to the nation, President George W. Bush cited a decline in home prices as a factor in the financial crisis. But as he pointed out, the problem isn't so much that prices are down almost 20% from their peak in mid-2006, it's that many Americans were betting everything on the housing boom to continue.
For most Americans, the largest chunk of their net worth is tied up in home equity, and some got burned by an overly optimistic outlook on where housing prices were heading. Now, it's time to think more realistically about the role of home equity in an overall investment strategy.
It was easy to get caught up in the housing bubble. On average, home prices in the 10 major U.S. cities tracked by the Case Shiller Home Prices Index more than doubled from 2000 through the peak in July 2006, exceeding the S&P 500's 88% return from its low in 2002 to its highpoint in October of 2007.
Most analysts say you can typically expect a 2% to 4% annual increase in the price of your home. In the 1990s, home prices rose a cumulative 21.5%.
Of course, seesawing prices have made it much more difficult for some homeowners to count on home equity in their investment plan. But as the market cools, home equity is likely to again fill the role of a low-risk investment.
Consider asset allocation. For example, having lots of relatively safe home equity can free you up to own more performance-oriented stocks and stock funds. At the same time, if your home equity stake is small, you should consider boosting your allocation to low-risk investments such as bonds or money markets.
The Age Question
Much like an asset-allocation strategy changes as you near retirement, the importance of building home equity depends on your age and financial goals. Prepaying a mortgage is as much an investment strategy as it is a step toward debt reduction. For younger investors, extra cash may be better off invested in a retirement plan than in paying down relatively affordable debt
As you near retirement, however, it becomes increasingly important to get out from under debt. Paying down a mortgage before retirement can free savings from the burden of a monthly mortgage payment, allowing the use of that money for other expenses.
A Tool for Borrowing
In most cases, you can secure lower rates on loans when you use the equity in your home as collateral. The inherent risk, however, is that defaulting on your loan could put your home in jeopardy. For this reason, be selective when deciding when to tap into a home-equity loan. For example, borrowing money for long-term expenses like home improvements or college tuition makes better financial sense than using home equity for short-term purchases like a vacation.
Of course, many homeowners failed to heed this caution in recent years, when home prices were increasing by 10% or more per year. Consumers were less concerned about borrowing against their home's equity, confident they would earn it back in short order.
Despite the recent freefall, home prices are still almost 80% higher than they were in 2000 -- more than three times the increase than in the 1990s. If you're a homeowner, remind yourself that while you shouldn't count on double-digit annual gains in home values, your home equity is likely to remain a steady workhorse in your portfolio.