When people talk about asset allocation, they usually refer to the relative amount of stocks or bonds in their portfolio (like the model portfolios shown here). But I am occasionally asked whether to include personal home equity in asset allocation. If you have a significant amount of home equity, does this mean you are overexposed to the Real Estate sector? Should you change your other investments to compensate?
Conspiracy Theory Argument
Professional portfolio managers are usually paid based on a percentage of assets under management, or when you make trades. Since they don’t usually control your home equity, they can’t charge you for it, which is why some say the industry secretly decided it shouldn’t be included in asset allocations.
I’m not so sure about this one. Most people don’t have professional money managers. And if they do, for example I’m betting that most advisors would include a huge 401(k) in their planning even they didn’t control it.
Pricing and Liquidity Argument
It is very hard to determine the true market value of an individual house. You can’t sell only a portion of it, which means you can’t rebalance relative to other asset classes. Because of these issues, some people say personal home equity shouldn’t be included.
Still, this is also true of investment/rental properties, which I think should be included in asset allocations just as much as owning any company with physical assets.
My Answer: It Depends?
I plan on staying in the same geographical area indefinitely. Once I’ve committed to buying a place, I’m mainly trying to pay off all “future rent” at once. If I never move, then obviously it won’t much to me what happens to housing prices. If housing prices in my area go up, then my house value will go up, and an alternative house I want to buy will go up. The opposite will be true if housing prices go down. Over the long term, prices should pretty much match inflation. So I don’t consider my house as part of my portfolio.
However, if I planned to sell my house upon retirement, and then use the money to move to a significantly cheaper home and use the difference to cover other expenses, then I would care about my house value because I would have to “cash out” at some point. Some people end up relying on a reverse mortgage to pay for things, which would be a similar scenario.
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As someone who does not own a house yet, I do include home equity as part of my asset allocation 🙂 What I mean by this is that I know at some point I will buy a house so I’ve begun buying some real estate funds recently to hedge against future upward movements in real estate prices. When I do eventually buy I’ll sell the funds for a down payment. Basically I’m recognizing that real estate will eventually be a significant chunk of my assets and rather than suddenly shifting a large portion of my assets to real estate (in the form of home equity) I’m doing it piece by piece.
I don’t include mine. I never plan on selling the house I’m in right now even if I do decide to move. It will go from a primary residence to an income property (I hope).
Even if I did plan on selling the house, I wouldn’t consider it as part of my investment portfolio just because it just seems to add confusion (at least for me it does). So for the sake of simplicity, I don’t include it as part of my portfolio but it does on on my balance sheet as an asset with the mortgage going under liabilities.
With all due respect, I think you’re looking at this wrong. If someone owns a $500,000 house, he has exactly the same amount of real estate exposure whether he owns the house outright or has a $490,000 mortgage.
Home equity is simply the opposite of a mortgage: money on which you aren’t paying interest. If you suddenly get an extra $10,000, and try to decide between sticking the money in a CD or putting it towards your mortgage, either way you’ll be increasing your net interest income (interest earned minus interest paid).
If you have a HELOC, paying it off is similar to putting money in a high-yield savings account. You can get the money back, and you’re earning (not paying) interest at a variable rate. If you only have a regular mortgage, paying it off is similar to buying a bond of unknown maturity (as you get the money back whenever you sell, do a cash-out refi, etc.).
So, to the extent you have home equity, you should definitely consider it when making your allocation. As your home equity goes up, it may make sense to decrease your fixed income investments to compensate.
I think an asset should be something you are not currently using to live life from. If your house (equity) or your car is an asset then why not your clothes, the un-eaten food in your pantry? You could liquidate your house, car, or the un-eaten food in your pantry but then you would have no place to live, no car to drive nor food to eat. I would consider a rental property an asset because you could always sell it and still have a place to live. Even if you took the example of selling your house when you retire to smaller house and get the profit difference. The smaller house will cost more then it did if you would of bought it in the first place. If you live under your means why would you buy a smaller house in retirement? Besides the convenience of some community club (no grass to mow) or all your children and grandchildren live too far to visit often so the room is not needed. Your house would only be an asset to the beneficiary other than the family that is not living in the same house.
I use home equity when calculating my net worth, but not when doing asset allocations…
That said, I’m hoping to move and turn my current home into a rental. At that point, the equity I have built up in that house will probably be included in my overall asset allocation. (As I could have sold the house instead of renting it and put the proceeds into my overall asset allocation mix.)
I think the primary home should not be considered on asset allocation. But if you have an investment property, then you could probably count the equity on that as part of your investment portfolio and asset allocation.
All great thoughts!
Sometimes I consider my primary home to be part of my asset allocation. My goal is 1/3 real estate, 1/3 bond-like stuff (mostly my government pension), 1/3 stock-like stuff (mostly stock mutual funds in Roth retirement vehicles). This makes me feel more diversified than thinking of my funds as being half bond-like and half stock-like.
But it does make things a little wacky because although my house cost only 1/2 the median price in my area when I bought it, it’s still half my assets. So, sometimes I just consider myself lucky. Sometimes I tell myself that means I need to save more in the other two asset classes. Of course I’m always saving as much as I reasonably can, so this could inspire me to choose more retirement funds over pre-paying the mortgage. Occasionally I calculate what my equity would be if my house had gone up only 3% per year–that would have brought me closer to 1/3.
Mostly I just think of my house more like an annuity and insurance policy than like a regular asset. It’s like an annuity in that if I actually live in it until the mortgage is paid off, my housing costs will decline substantially. And it’s like an insurance policy in that if my property taxes get too high for me to afford, that means my house is worth a lot of money and I can sell it and move somewhere cheaper. Of course, like with annuities and insurance policies, I’m in trouble if the “company” goes under, so if toxic waste or something is discovered on or or added to my property, then I will have made a bad bet.
Bryan–that is an awesome plan. Jim has a great point about real estate exposure, too.
In conclusion, I agree that the answer is that it depends. Specifically, if thinking of it as an asset inspires you to make wiser choices, then do that; otherwise, don’t.
I don’t count the equity in my home as an asset, and I also don’t include the mortgage as a liability. I look at the mortgage payment as rent. Same goes for my car, the car itself is not an asset, and the loan on the car is not a liability. It’s just a transportation expense. At least that’s how I see it.
Why would you assume house prices will match inflation? The real estate bubble has popped.
Remember you always have to have a roof over your head. Charles J Farrell of Northstar Investment Advisors says that you should not count a home unless as part of your wealth equation at all unless you intend to sell the home and live someplace substantially cheaper. Then only the portion of your home that is redeemed for cash can be part of your wealth equation. A home is locked or dead equity. The only way to redeem that dead equity is to borrow against it or to sell the home. In any case you still need a place to live which is why home equity should not be part of a wealth equation.
One way to to redeem dead equity is to stop paying principal and interest once your equity is 100%.
If you can’t rebalance it, then you don’t count it as part of your portfolio. That’s my rule.
Home equity as an asset? Not hardly. Having just recently completed my 17th year of living in my house, I’ve formed a number of opinions of the concept of homeownership as an “investment” and home equity as an asset. First of all, I may be only an armchair economist, but it seems to me that the definition of an investment is fairly straightforward — an instrument that you place principal into, possibly adding to it over time, and then at some in the future can walk away with that principal and ideally a profit (less any transactions costs and taxes). To date the “principal” I have placed into my home — to my way of thinking — includes my mortgage payments (both P&I), the costs of repairs and rennovations, annual property tax, the cost of homeowners insurance, and on and on. If I were to sell today, I could probably get a price maybe 50% more than my puchase price. However this would not come even close to covering the total costs of owning the home over 17 years. It’s amusing to me — but also sad — that most homeowners look at the increase in value of their homes and then shut their brains down, happily believing that that made a profit but never considering how much this “profit” has cost them.
So a word about equity. While owning a home it’s an “asset” you can only access via a debt instrument — a line of credit, second mortgage, or refinancing. And eventually it has to be paid back, unlike selling a stock or mutual fund. If you sell your home, equity — for most people I would argue — is a best a refund, and just a partial refund, of everything you’ve sunk into the money pit over time.
It’s interesting to me that the concept of “imputed rent” has emerged recently in light of the housing meltdown. As I understand it, the idea is you have to live somewhere anyway, and that is part of the value of owning a home. Hypothetically this “rent” should be backed out of the calcualtion when considering the return on your “investment.” It all sounds to me like an invention of the real estate industry to make us think things are not as bad as they are.
I’m pleased to see that there is a growing line of thought in the financial press that homeownership should begin to be viewed as consumption, not investment. That’s at least a movement toward honesty in considering the whole notion of home equity as an asset.
I think Jim hit the right point above.
It’s a terrible idea to include your “equity” as an asset, but it may be perfectly reasonable to include an estimate of the value of your house as an asset and the balance owed on your mortgage as a liability.
One advantage of doing this is that it may show that your overall asset allocation is really skewed. (As in Jim’s example, you might then realize that you have several hundred times your net worth invested in real estate.)
Rather than go by estimated sale price, though, you might consider other calculations of the value of your house. In particular, if you live in it, a house is worth what it lets you avoid paying in rent (adjusted for whatever extra you have to pay in taxes, insurance, maintenance, utilities, etc.). A present-value calculator can turn that monthly amount into a capital sum. Include that as an asset and your mortgage as a liability and you’ll have a much clearer indication of your true financial position than if you just ignore your house as an asset and treat your mortgage as if it were an expense.
A minor correction on a comment you made:
> I’m betting that most advisors would include a huge 401(k) in
> their planning even they didn’t control it
I have had three different professional money managers and none of them ever bothered with any asset they didn’t fully control. The worst of all was Ameriprise (who I dropped for much much more serious reasons). In fact, one of them said that they will look at my retirement savings only when I leave my job and roll over my current 401K.
I have also spoken to many other financial advisors in social settings, etc. about this issue. Pretty much everyone claims they will definitely help you with non-controlled assets, etc.
The only pattern that emerged was that if I was *not* their customer they claimed they would help me with it, and if I was their customer they wouldn’t care.
Here is a scenario. If you owe $100K on your home and interest rates on fixed investments are dismal (1-2%) and you use fixed investment money to pay down a 5% mortgage you have effectively “invested” that money at 5%.
At the same time you have altered your portfolio allocation considerably. Would you then reallocate a portion of your equity portfolio to maintain a desired ratio (i.e. 60/40)?
You also have the option of pulling that money back out of your home (via a fixed mortgage or HELOC) when interest returns to an attractive level.
IMO, the money you moved from a tradition fixed investment (CD, MMFs) to your home equity is as much fixed investment as any other. I would not rebalance my equity portfolio in such a scenario, unless I was looking to reduce my risk exposure.
Furthermore, it makes no difference whether you live in that house (you must pay to live somewhere) or pay to maintain it. Those expenses will not be affected either way.
Also, your property value (and net worth) will fluctuate on the basis of housing valuations regardless of whether you own your home outright or have a sizable mortgage, so that is entirely irrelevant to this scenario.
Depends. If you live in California or New York where home prices are exorbitant and you have managed to pay off your home then this question is more relevent. With other cheaper areas this is less relevent.
Another thing to consider is if you do include home equity then you have to add “rent” to your expenses. Essentially stocks, etc historically return 8-9%. Homes have historically returned 2-3% in terms of capital appreciation. But homes have also returned a “use value”. Another angle is you have to pay tax every year.
To simplify things better to just exclude your primary home from the equation.