PP vs. Home equity (as percentage net worth), what's the right balance?

[Mike59]

My stats:
(accumulator in mid-30's):

Home equity: 34% net worth  (10 year mortgage locked in at 3.5%, 20 year amortization)
PP: 51% net worth
the rest is in cash/emergency fund and cars (paid off 5+ years old, and running them till the wheels fall off)

I feel like bringing up the home equity with extra payments, but am torn the more I read. The contrarian in me says not to add more to the house as houses are liabilities and no home is a forever home so why bother. The other part of me fears I've averaged in high into bonds/equities in my PP and that one of those bubbles will pop badly anyway so stay safe with a 4% or so gain with the early mortgage payments.

How are your numbers, and what do you feel the right balance should be (and why)?

[dragoncar]

Most people include emergency fund in cash portion of pp - sounds like you are high on cash now.

Home equity I would say limit to 20% if possible.  But the real answer is get the smallest/cheapest place you can tolerate

[ochotona]

How about a college fund for kids? Or future kids if you don't have any yet?

As for me, mid 50s, home paid off, cars paid off, kids' colleges paid off. Home equity about 13% of total net family wealth. Half of liquid investments in PP, other "conventional" asset allocations; that may change in the future.

Been in the same house 22+ years. House-swapping and spouse-swapping are both expensive activities.

My stats:
(accumulator in mid-30's):

Home equity: 34% net worth  (10 year mortgage locked in at 3.5%, 20 year amortization)
PP: 51% net worth
the rest is in cash/emergency fund and cars (paid off 5+ years old, and running them till the wheels fall off)

I feel like bringing up the home equity with extra payments, but am torn the more I read. The contrarian in me says not to add more to the house as houses are liabilities and no home is a forever home so why bother. The other part of me fears I've averaged in high into bonds/equities in my PP and that one of those bubbles will pop badly anyway so stay safe with a 4% or so gain with the early mortgage payments.

How are your numbers, and what do you feel the right balance should be (and why)?

[MachineGhost]

How are your numbers, and what do you feel the right balance should be (and why)?

I include land/estate and other real tangible investments in the "Gold" portion of the PP because it is a confidence/high inflation hedge.  Ideally, it shouldn't take up more than half or one-third of the allocation to avoid rebalancing difficulties.

[KevinW]

IMO personal home equity is not an investment so should not be mixed in with investing decisions. So my answer is "irrelevant." Buy a house if that makes sense to you, or don't, but that's a separate issue from how you invest.

I am working on a millionaire-next-door sort of early retirement. In that scenario, I think it's prudent to reach 100% equity in a modest home at about the same time as the portfolio is 100% funded.

[Tyler]

Home equity I would say limit to 20% if possible.  But the real answer is get the smallest/cheapest place you can tolerate

+1 on both points.

@OP: You have a good interest rate, so you have the luxury of considering different alternatives.  From a diversification perspective (but NOT an investment perspective), thinking of your assets as equally divided between stocks/bonds/gold/cash/HE is pretty sound.  Allowing your home equity to exceed that by too much concentrates a lot of your net worth in one non-productive basket and starves your investment potential.  That said, I'm also not in the "keep refinancing into a thirty year mortgage" leverage camp either.  Once your home value is less than 20% of your net worth (or you've retired, or both) I'd go ahead and pay off the mortgage.  KevinW's recommendation to time mortgage payoff to retirement is very good advice, IMHO.  A balanced approach is generally a healthy one in most things in life.

[barrett]

From a diversification perspective (but NOT an investment perspective), thinking of your assets as equally divided between stocks/bonds/gold/cash/HE is pretty sound.  Allowing your home equity to exceed that by too much concentrates a lot of your net worth in one non-productive basket and starves your investment potential.

Really well said. I am always with Tyler on this topic. Just wish I had understood this all before I got myself in a position of too much home equity relative to other assets. But that will get worked out eventually.

I am working on a millionaire-next-door sort of early retirement.

I'd be really interested to hear what that entails! I have read the book and found the stories of folks earning a modest income and accumulating a very comfortable nest egg to be very compelling.

[sophie]

Home equity: 34% net worth  (10 year mortgage locked in at 3.5%, 20 year amortization)
PP: 51% net worth

This is what jumped out at me...I'd say you have bigger things to worry about, friend.  If I were you I'd think about refinancing to, say a 15 year amortized mortgage, unless you were planning to pay it off when the balloon payment comes due.  When is that?

<Incidentally...I'm quite enjoying the shift in the forum's focus to personal finance.  Keep the posts coming!> 

[KevinW]

I'd be really interested to hear what that entails! I have read the book and found the stories of folks earning a modest income and accumulating a very comfortable nest egg to be very compelling.

I am essentially following the Early Retirement Extreme plan ( http://earlyretirementextreme.com/ ). Except that we have an expensive home by ERE standards (2 bedroom condo in California) and I indulge in an expensive hobby. So we're more like Early Retirement Moderate, or maybe Mr Money Mustache ( http://www.mrmoneymustache.com/ ).

The Cliffs Notes version is that my wife and I have professional jobs but we live like my grandparents circa 1950s instead of how our peers live circa 2015. We live in a 1200 sq ft home; share one modest car; commute by bicycle or public transit; cook food from scratch; pay for everything in cash (except for an easily manageable mortgage); do DIY maintenance; try to fix things before replacing them; enjoy free or cheap entertainment; invest in simple and durable clothing, furniture, and appliances so they last a long time; use things until they're totally worn out; and resist wasting money on junk.

Like I said, my grandparents lived this way and had happy lives. It doesn't feel like deprivation once you get used to it. Actually we're better off due to the Internet and general progress.

As a result, we save something like 50% of our take home pay (I don't track it closely). If you do out the arithmetic, at that rate you become FI in only a few years. Then you can retire completely; or downshift to a lower-paying, lower-stress job and let your portfolio grow on its own; or simply keep working in which case your net worth really snowballs.

[Pointedstick]

Sounds like we're kindred spirits, KevinW. I'm doing almost exactly the same thing.

[MachineGhost]

Except you two are very boring people.

[KevinW]

May I inquire what 'expensive hobby' you indulge in?

Fast cars. Thankfully I'm more interested in tinkering with projects, which is a lot cheaper than constantly upgrading to the latest Porsche or something. But no matter how you cut it, cars are expensive things.

Except you two are very boring people.

Well there is a lot of non-boring stuff that falls under "free or cheap entertainment." 

[Mike59]

Home equity: 34% net worth  (10 year mortgage locked in at 3.5%, 20 year amortization)
PP: 51% net worth

This is what jumped out at me...I'd say you have bigger things to worry about, friend.  If I were you I'd think about refinancing to, say a 15 year amortized mortgage, unless you were planning to pay it off when the balloon payment comes due.  When is that?

<Incidentally...I'm quite enjoying the shift in the forum's focus to personal finance.  Keep the posts coming!>

Thanks for the input and your advice.

The intent with the longer amortization is that I like the flexibility to do what I want with the monthly income. Considering my savings rate is about 50% per year (at least for now) the house is a small expense in the grand scheme, my posing these questions are more about allocation and balance than anything. 

Unfortunately it's too late to change the term without penalties as it's fixed. I'm in Canada so I think this functions differently than in other places, I've not heard of a "balloon payment"  but I did negotiate generous prepayment options (can add lump sums as much as 20% of mortgage amount per year in extra payments) .

[sophie]

I don't know much about mortgages in Canada, but...why not just get a mortgage with a longer term, or do Canadian mortgages typically have prepayment penalties?

A balloon mortgage has a balance due at the end of the loan term - in your case more than half the principle will be due at the end of the 10 years, if you haven't prepaid it.  If you can't pay the principle you must refinance, regardless of the prevailing interest rates, mortgage environment etc.  If you can't get another mortgage or pay the balance you may lose your house.  These were just one of the types of "creative" consumer mortgages that got us into so much trouble in 2008. 

It sounds like you'll have enough savings to handle it though.

[Libertarian666]

I don't count my home equity as part of my portfolio. After all, I can't spend it (or eat it).

[glennds]

I don't count my home equity as part of my portfolio. After all, I can't spend it (or eat it).

I realize your comment was tongue-in-cheek. Certainly if you sold your home and monetized your equity, you could spend it.

Maybe it's a question of semantics, but I get the impression that some people define their "portfolio" as their investments in marketable securities, but to me a portfolio consists of all assets and all liabilities, a personal balance sheet if you will. As to the original question, what's the right balance for home equity vs PP as a % of a personal balance sheet, it's a highly personal  and time contextual answer. For some people, its not a purely financial question because the particular home may bring about satisfaction and quality of life that could very well be considered a form of return or dividend. And for others there may be no such satisfaction value. The administrator of this forum, CraigR wrote a very interesting post about owning a personal residence vs. renting it and he laid out a very rational argument that when the analysis is purely financial, there is a hollow economy to owning. I can't lay my hands on the link to it right now but with a little searching I'm sure it can be found.  It's worth a read.

[Pointedstick]

The most insightful point I've ever heard made about the role of real estate is that we all have a natural short in housing--we need it to survive. So one's primary residence doesn't actually take you long on real estate; it just covers your short. Because if you monetized your house to take advantage of a booming real estate market, you would be out a house, and would need to then to buy or rent another place to live from the very same market you just sold into.

If you want to go long on real estate, you need to buy property exclusively for investment purposes and not live in it, or buy real estate indirectly via REITs or something.

[MachineGhost]

A lot of investors don't even understand how abnormal the subprime real estate bubble was.  Real estate bubbles are truly rare.  It is not a common occurence and it is unlikely to ever happen again.  In fact, it never has occured in this country until the subprime bubble.  So it's truly over.  I also agree with PS.  You can't count on paper equity of what you live in in the same way of being a real asset compared to gold, collectibles, etc. that are not something you absolutely need for living and can't really liquidate.

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[Libertarian666]

The most insightful point I've ever heard made about the role of real estate is that we all have a natural short in housing--we need it to survive. So one's primary residence doesn't actually take you long on real estate; it just covers your short. Because if you monetized your house to take advantage of a booming real estate market, you would be out a house, and would need to then to buy or rent another place to live from the very same market you just sold into.

If you want to go long on real estate, you need to buy property exclusively for investment purposes and not live in it, or buy real estate indirectly via REITs or something.

Sounds right to me. Also, I don't count my "home equity" in my net worth because I don't know how much of it I can monetize it (via a mortgage) and what it will cost to do so.

[dragoncar]

The most insightful point I've ever heard made about the role of real estate is that we all have a natural short in housing--we need it to survive. So one's primary residence doesn't actually take you long on real estate; it just covers your short. Because if you monetized your house to take advantage of a booming real estate market, you would be out a house, and would need to then to buy or rent another place to live from the very same market you just sold into.

If you want to go long on real estate, you need to buy property exclusively for investment purposes and not live in it, or buy real estate indirectly via REITs or something.

But you are only "short" the minimum housing you "need to survive."  So my house in the Bay Area is definitely long housing, given that I only really need a shack in the desert to cover my short.

[Pointedstick]

But you are only "short" the minimum housing you "need to survive."  So my house in the Bay Area is definitely long housing, given that I only really need a shack in the desert to cover my short.

Not really, unless you're prepared to sublet your place or you live in one unit of a multifamily complex that you own.

In order to go long real estate that you own, you need to turn it into a productive, moneymaking asset. Your single-family house isn't a productive moneymaking asset until and unless you sell it or rent it out. In order to do so without moving yourself out (which makes you short housing again), you need some way to divide it into separate "investment" and "personal dwelling" parts. If you can't do that, then you can't be long housing in your own house.

[Kriegsspiel]

This is the formula I posted at ERE to figure out if renting or buying was the more logical choice.

(Monthly Rent + Renter's Insurance)x300 < (Cost of house1) +(Taxes + Upkeep2 + Insurance)x300

It's better to rent.


As far as what the right "balance" is with regards to the rest of your investment portfolio, I don't think it's worth worrying about. It will just change based on where you live, and how much you're worth. Either way, you need a place to live.

1 Total cost, with purchase price, any fees/inspections/etc.
2 I assumed 2% of the purchase price per year.

[dragoncar]

But you are only "short" the minimum housing you "need to survive."  So my house in the Bay Area is definitely long housing, given that I only really need a shack in the desert to cover my short.

Not really, unless you're prepared to sublet your place or you live in one unit of a multifamily complex that you own.

In order to go long real estate that you own, you need to turn it into a productive, moneymaking asset. Your single-family house isn't a productive moneymaking asset until and unless you sell it or rent it out. In order to do so without moving yourself out (which makes you short housing again), you need some way to divide it into separate "investment" and "personal dwelling" parts. If you can't do that, then you can't be long housing in your own house.

I don't need to sublet to be long, I just need to cover my needs.  If I am long bay area housing because I only need a shack in the desert, but consume all my "gains" because I live beyond my need, that doesn't mean I'm not long housing. Similarly, you can say I'm "short" $1000/year in groceries, and that my $50k in stocks give a dividend "covers my short in food that I need to survive."  But if I eat out everyday, I'd need $250k in stocks to cover my eating habits.  That doesn't mean the $250k covers my short, it means I'm $200k long in stocks and I'm consuming all gains by living beyond my needs.

[MachineGhost]

https://www.khanacademy.org/downloads/buyrent.xls

[Mark Leavy]

In order to go long real estate that you own, you need to turn it into a productive, moneymaking asset.

I think this is quite insightful.

On my big ass spreadsheet of Assets and Liabilities, I have a section dedicated to the return on investment from my assets.  Since this is what I live on, only assets that are legitimately likely to support living expenses on a 10 year rolling average fall into this category.

Obviously, you can fudge the boundaries based on your own age and life expectations, but I think it is reasonable to qualify an investment as something that you can reasonably expect to produce market returns over inflation -  over time.