Equity stripping: Think twice

You may soon hear about something called "equity stripping." Although it sounds exotic, it's more risky than risqué.

Broadly speaking, equity stripping is a strategy used to protect your assets from being claimed in a lawsuit. In currently popular references, though, it refers to a strategy for making money from real estate.

Here's how it works: You borrow most or all of the equity in your house and use the cash to invest in stocks, mutual funds, additional real estate, annuities, or life insurance. You'll come out ahead if the return on your new investment(s) exceeds the interest on your loan. Then, as your house rises in value, you borrow again on the higher equity and use that cash to buy even more investments. You have several assets now, instead of one. You're getting richer and richer! Repeat!

Another option for raising investment capital is an interest-only (IO) mortgage. For a certain fixed period-usually five to seven years-all you pay is interest, which leaves you more cash to invest. However, after that time period ends, the payments increase (sometimes sharply) to pay off the principal over the rest of the loan's term (or you have to make one lump sum payment, or you refinance). Don't sign on unless you're certain that you'll be able to meet the new obligation.

On a slightly different tack, you could consider a pledged-asset loan. These are typically made through a brokerage house, although some mortgage brokers offer them as well. If you have a large securities account, you can pledge the securities as collateral for a loan based on the value of your home. If the value of your securities drops, though, you'll have to put up more collateral or the brokerage will sell some of your securities to make up the difference. In this scenario, your home isn't at risk as long as you continue to pay the mortgage, but you could lose your portfolio.

For some folks, this strategy has worked Here's an example of what fans of "stripping" say is good about it. In an era of low-interest mortgages, it was possible last year to get a one-year, tax-deductible ARM at 4.6 percent. In 2004, stocks grew an average of 10.9 percent. Therefore, somebody following this strategy might have been 6.3 percent ahead, pre-tax and not accounting for closing costs. In some areas of the country, investors in real estate may have seen gains of 15 percent. Those folks would have been 10.4 percent ahead (again, pre-tax and without closing costs).

If you live in an area where real estate values are rising but haven't gone through the roof, you might be able to play this out for a while. The same, of course, applies to any investment that you're sure will produce a minimum return higher than the loan rate. Financial planner David K. Sebastian, CFP, of The Physicians Wealth Management Group in Parsippany, NJ, notes, "It's nice to have the money to be able to diversify your assets, but not to the point where you no longer have any equity in your home. That's imprudent."

What will you do if something goes wrong? Frankly, the disadvantages of equity stripping far outweigh the advantages. For one, interest rates are rising, which will most certainly affect ARMs. "People see that they can borrow money on an ARM for a very low rate for the first six months and they think there's some advantage to be had," says Craig Evans Carnick, CFP, of Carnick & Co. in Colorado Springs. "But the truth is, interest rates are going up. It's kind of like putting the value of your house on the roulette table."

Some folks "strip" at the suggestion of brokers, planners, or some other type of salesperson. That alone should serve as a red flag. "These deals are all promulgated by people who stand to benefit by selling the client something with their freshly stripped equity money," warns Carnick. "We see people being urged to strip out equity to purchase variable life insurance, variable annuities, or some other speculative investment. It scares the daylights out of me."

So before you're tempted, think carefully. And if the inherent risk isn't enough to dissuade you, Sebastian points out, "People get into these deals because they only think about perfect situations, not the worst-case scenario. If you're forced into a bankruptcy situation, the courts will treat you far more harshly than they did in the past. The law has changed to benefit the creditors, so it's going to be harder to discharge debts if you run into a serious problem."