Here is what I said about the mistake of including your home in your equity:
“You include your house in your assets. I often hear people describe their net worth in a conversation like this: “I have a house of $ 200,000 and investments of $ 800,000, so I have a net worth of $ 1 million. The problem with this description is that your home cannot independently generate income except as part of a reverse mortgage. which has its own twists and turns. Basically, owning a freehold home 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 would need to use the money you generated to create an income stream to pay for your future living conditions, whether it be buying another house, renting a house or a move to an assisted living facility. “
Up arose a hue and a cry. I was called several things that would have made my old platoon sergeant blush. So let me explain my reasoning further and identify where you can include some of the value of your home in your heritage.
First, let’s assess why I have the position I occupy.
Net worth is defined as assets minus liabilities. Usually in your asset list you include cash, retirement funds, investments, etc. It is also customary to include the value of your home, a tactic suggested by many people. Liabilities are what you owe. Usually, you include student loans, mortgages, auto loans, credit cards, personal loans, and other debt as liabilities. Subtract what you owe from what you have and that is your net worth.
So if you bought a house worth $ 200,000 and you have a mortgage of $ 150,000, then you have $ 50,000 in equity. If you didn’t have a mortgage, you would have $ 200,000 in equity.
This is where people run into the mental barrier of not including equity in their net worth. Again, let’s assume you own your home for free and clearly. A lot of people just assume they could sell that house and have $ 200,000 in the bank – a liquid, usable asset. That is true. However, on the other side of the balance sheet, they would now have an incurred liability: housing costs. Having no house to live in, since it is sold, the person will have to find accommodation, either by renting it or by buying a new house. If the person was renting, then ideally the $ 200,000 could be invested in a way where the investment would provide enough money to make the rent payments. If the person were to buy a replacement home, the purchase price would likely come from that $ 200,000. Other than the exception that I will describe below, the person has not seen any increase or decrease in the ability to convert these assets into an income stream that allows them to buy anything other than a home.
There is an exception to this situation if the cost of replacement housing is less than the value of your current home. You will see this happen in two scenarios:
Either way, you won’t pay as much for your next home as you would for the current home. You have added value that you could potentially apply to your investments or current expenses. Remember, however, that real estate is illiquid and only worth what someone is willing to pay for it. The endowment effect can cause you to overvalue your home. Sites like Redfin and Zillow are great for giving you a rough estimate of your home’s value, but you’ll never really know until you have a signed contract.
So how does this work out in real life? A study by Steven Venti and David Wise of the National Bureau of Economic Research showed that among older families, home equity is not used to increase consumption, but rather to respond to life shocks, such as death a spouse or moving. in a retirement house. The study shows that older families who are ‘housing rich and money poor’ tend to downsize when they sell their homes, but, in general, older families do not use the homes as an investment. . Instead, they “buy houses to provide an environment in which to live, even as they age into retirement.”
If you count the value of your home as part of your equity, remember to factor in the reverse reaction when you sell: you’ll have to pay for replacement housing. If you are considering downsizing, I suggest that you only count 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, I wouldn’t count my house in my equity because selling it will generate a real estate liability on the other side of your balance sheet.