Photo: Flickr / ayearineurope
Recently, I wrote an article outlining a few common retirement mistakes, one of which sparked some serious discussion.Here’s what I said about the mistake of including your house in your net worth:
“You’re including your house in your assets. I often hear people describing their net worth in a conversation like this: ‘I have a $200,000 house, and $800,000 in investments, so I have a net worth of a million dollars.’
The problem with this description is that your house cannot independently generate income except in a reverse mortgage, which has its own twists. Basically, owning a home free and clear eliminates the need for you to have a housing expense—save, of course, for property taxes, insurance, and home maintenance costs.
If you were to sell your house, then you’d need to use the money that you generated to create a stream of income to pay for your subsequent living arrangements, whether that’s buying another house, renting one, or moving into assisted living.”
Up arose a hue and cry. I was called several things which would have made my old platoon sergeant blush. So, let me further explain my reasoning and identify where you can include a portion of the value of your house in your assets.
First, let’s evaluate why I have the position that I do.
Net worth is defined as assets minus liabilities. Usually, in your list of assets, you include cash, retirement funds, investments, etc. The habit is also to include the value of your residence, a tactic many people suggested. Liabilities are what you owe. Usually, you include student loans, a mortgage, car loans, credit cards, personal loans, and other debts in the liabilities side. Subtract what you owe from what you have and that’s your net worth.
So, if you bought a house worth $200,000 and have a $150,000 mortgage, then you have $50,000 in equity. If you had no mortgage, you’d have $200,000 in equity.
This is where people hit the mental hurdle of why to not include the equity in their net worth. Again, let’s assume that you own your home free and clear. Many people simply assume could sell that home and have $200,000 in the bank – a liquid, spendable asset. That is true. However, on the other side of the balance sheet, they’d now have an incurred liability: housing expenses.
With no house to live in, since it was sold, the person would have to find housing, either by renting or by buying a new home. If the person rented, then ideally the $200,000 could be invested in a manner where the investment would provide enough cash to make the rent payments. If the person bought a replacement home, then the purchase price would probably come out of that $200,000. Aside from the exception I’ll describe below, the person has seen no increase or decrease in the ability to convert those assets into an income stream that allows him or her to buy something other than housing.
There is one exception to this situation if the cost of replacement housing is less than the value of your current house. You’ll see this occur in two scenarios:
- Your home’s value has risen significantly in value compared to where you’d move next. Perhaps you are the type of person who could make Ty Pennington blush with your handyman ability. You build pergolas for fun. Through your sweat and ingenuity, you have vastly improved the value of your house for a minimal outlay. Now, your house is worth a lot more than you paid for it.
- You are downsizing. When you bought your house, you had three kids and four dogs, so you needed the room. Now, the kids are out of the house and you’re an empty nester. While playing hide and seek in your house is a blast, you realise that you don’t need as much space.
In either instance, you’re not going to pay as much for your next place as you can get for the current house. You have incremental value that you could potentially apply to your investments or to your day-to-day living expenses. Don’t forget, though, that real estate is illiquid and only worth what someone is willing to pay for it. The endowment effect may make you overvalue your home. Sites like Redfin and Zillow are great for giving you a ballpark estimate of what your house is worth, but you’ll never really know until you have a signed contract.
So, how does this play out in real life? A study by Steven Venti and David Wise from the National Bureau of Economic Research showed that among older families home equity is not utilized for increased consumption, but, rather, is used to react to life shocks, such as either the death of a spouse or a move into a nursing home. The study does show that those older families who are “house rich and cash poor” do tend to downsize when they sell their homes, but, in general, older families don’t use homes as an investment. Instead, they “purchase homes to provide an environment in which to live, even as they age through retirement years.”
If you are going to count your home value in your net worth, remember to account for the opposite reaction when you sell—you’ll have to pay for replacement housing. If you plan to downsize, then I suggest counting only the difference between the price at which you can sell your current home and the cost of a replacement home. However, if you don’t, then I wouldn’t count my home as part of my net worth, as selling it will generate a housing liability on the other side of your balance sheet.
NOW WATCH: Money & Markets videos
Business Insider Emails & Alerts
Site highlights each day to your inbox.