There’s a debate raging whether one should include their primary residence or not as part of their net worth calculations. In my post, “The First Million Might Be The Easiest,” I exclude my primary residence in calculating my net worth figure at 28 because it is the conservative and most accepted way of calculating net worth.
The way to calculate your net worth is a personal preference where so long as you are netting out your liabilities from your assets you’re on the right path. Calculating the proper net worth is all about creating different scenarios that match your risk tolerance and financial goals as we’ve discussed in “How To Better Manage Your 401(k) For Retirement Success.”
It does seem strange to exclude what is likely our most valuable asset from our balance sheet. This post will argue why it’s absolutely fine to include our primary residence when figuring out how much we are worth.
A RENTER’S PERSPECTIVE TO NET WORTH CALCULATION
To understand the fallacy of not including your primary home in a net worth calculation, we must first look at the perspective of the renter.
When a renter calculates his or her net worth s/he adds up assets such as:
* Retirement Plans
* Company equity share
* Pet Bunny
* Other Valuable Assets
And subtracts liabilities such as:
* Credit Card Debt
* Student Loans
* Car Loans
* Personal Loans
* Gambling Debt
* Alimony Payments
* Secret Lover’s Credit Card
* Outstanding Tax Liabilities
We do not include perpetual rent as a liability. If we wanted to do so we would simply “capitalize the expense of rent” by taking the annual rent and dividing it by current rental yield rates e.g. $24,000 a year in rent / 4% = $600,000. In other words, if someone was renting a $2,000 a month one bedroom forever, his or her liability would equate to roughly $600,000 at today’s rates. Sounds extreme, but we all know that the return on rent is alway -100% so there is truth to such calculation.
If we were to conduct this net worth exercise for renters, then we would be severely punishing the 20-34 year olds who are mostly renters given the average age for a first-time homebuyer in the US is around 35 years old. Can you imagine if the average 20-34 year old’s net worth was -$300,000, assuming there are $300,000 in assets to deflect the $600,000 liability? The US would be in full blown economic crisis mode with politicians and young protesters going crazy!
A HOMEOWNER’S PERSPECTIVE TO NET WORTH CALCULATION
Now that we see the fallacy in capitalizing a renter’s rental expense in the form of a liability, we should be consistent with our thinking and not include the capitalized mortgage interest expense in a homeowner’s net worth calculations either. The only remaining variable between a renter and a homeowner is the homeowner’s home equity which is simply calculated by taking the estimated value of your home minus your mortgage. You can take a look at your home’s rough estimate online. I check at least once a week for fun as their algorithm updates 3X a week.
It makes no sense to one day have $100,000 in cash as part of your net worth, and then take a $100,000 net worth hit because you put down 20% for a $500,000 home. This is simply accounting, which everyone needs to understand especially those who are afraid of debt. I think the best mortgage amount is $1 million dollars on about $250,000 in income because of the tax benefits. Any larger mortgage or income amount and the benefits start getting phased out.
Some would balk at such a high debt figure, but that’s because they either don’t make a healthy amount of income, don’t understand tax law, or do not have alternative investments worth $1 million dollars or more that are earning higher than the mortgage interest amount. I’ve been doing my own taxes for over 10 years and meet such criteria. I strongly believe in such a ratio with the current tax regime and 10-year yield at roughly 2.8%.
Home equity can be extracted through a Home Equity Line Of Credit (HELOC), where interest on $100,000 can be deducted from your income if you use the HELOC “not to acquire, to construct, or substantially improve a qualified home” according to the IRS. The language is purposefully vague by the IRS so the average person can view such language as a green light to pay for a new car, college tuition, a 100″ LED TV, a vacation property, or new gold plated undies.
A bank’s goal is to get you to borrow as much as possible in order to earn an interest rate spread. The HELOC amount is largely determined by a Loan-To-Value ratio that goes no higher than 80%. In other words, let’s say you have a $1 million dollar home with a $500,000 mortgage. Your LTV is 50%. You may be able to get a HELOC worth $300,000 to bring your LTV to 80% because it’s $500,000 primary mortgage + $300,000 HELOC = $800,000 / $1 million. Banks pushed such HELOCs like crazy during the bubble and got burnt because many homeowners also went nuts and ended up not being able to pay back their debt.
If it was impossible to extract one’s home equity, then it would be more prudent to keep one’s home equity off the net worth calculation since it is not liquid. Better to be conservative and crystallize the value of your home after a sale then bake in lofty home equity figures which might not be therefore for draw down or investment purposes.
YOU’VE GOT TO LIVE SOMEWHERE ARGUMENT
The “you’ve got to live somewhere” argument is the main sticking point for why we should not include our primary residence in our net worth calculations. Yet, given we do not penalize a renter by adding the capitalized rent liability, why should we take away the home equity of a homeowner? This would be inconsistent math.
Homeowners have on average a 40X greater net worth than renters for several reasons. One reason is the inclusion of home equity as part of such studies, whereas much of the common man does not. If you take out home equity and were able to “buy” a renter or a homeowner like a stock, you would obviously buy the homeowner all else being equal because you realize there is real value in home equity even though it is off balance sheet.
I will always bet on the long term wealth creation of a homeowner than a renter with the same amount of non-housing assets due to inflation. If you are always going to be a price taker, then you will always be paying more money over time. You’ve got to get on the right side of the equation by owning assets in an inflationary environment.
THE SOLUTION TO CALCULATING THE PROPER NET WORTH
Figuring out how to calculate your net worth is a personal choice. Maybe you’re feeling a little depressed one day because you found out your friend from high school joined Facebook in 2005 and is now a multi-millionaire at the age of 30. Go ahead and inflate the value of your 1952 Topps baseball collection which includes Mickey Mantle’s $80,000 rookie card if it’s in near mint condition. Add back your primary home equity as well.
Or maybe you’re feeling like your managed stock portfolio is up an unsustainably absurd amount over the past several years, but you don’t want to sell because timing the market is a long-term losing proposition. Go ahead and remove your primary home equity in your net worth calculation to give yourself a buffer in case of a decline in stocks. It takes 30 seconds to come up with your home equity and add or subtract from your net worth dashboard on Personal Capital or in a spreadsheet.
The Chinese having a saying that if the direction is correct, sooner or later you will get there. The main purpose of tracking your net worth is to make sure you are focused and figure out ways in which you can optimize the various portions of your net worth. For example, with the 10-year bond yield rising from 1.6% to 2.8% in six months, you might consider allocating more of your net worth towards bonds and less towards stocks which recently hit all time highs. You might also consider offloading some of your real estate as well given higher rates means a decline in demand at the margin.
The single family residence in San Francisco I purchased in 2004/2005 cost more than my main rental apartment. If I want to feel richer, I will do mental accounting and pretend my apartment is my primary and my primary house is my rental. Instead, I just omit my existing primary residence from my net worth calculation to keep things conservative while keeping a second set of net worth calculations to include my primary home’s equity.
The more conservative you are with your net worth calculations, the higher the likelihood you’ll end up with more than you expected. No matter how poor or how rich you are everything is about expectations. If you can continuously underpromise and overdeliver, you are going to be one happy camper! Here is my recommended net worth allocation mix by age.
WEALTH BUILDING RECOMMENDATIONS
* Track Your Finances In One Place: One of the best ways to help build your net worth is to get a handle on your finances by signing up with Personal Capital. They are a free online platform which aggregates all your financial accounts in one place so you can see where you can optimize. Before Personal Capital, I had to log into eight different systems to track 25+ difference accounts (brokerage, multiple banks, 401K, etc) to manage my finances. Now, I can just log into Personal Capital to see how my stock accounts are doing and how my net worth is progressing. I can also see how much I’m spending every month. The best tool is their Portfolio Fee Analyzer which runs your investment portfolio through its software to see what you are paying. I found out I was paying $1,700 a year in portfolio fees I had no idea I was paying! There is no better financial tool online that has helped me more to achieve financial freedom. It only takes a minute to sign up.
* Check Your Credit Score: Take a moment to check your free TransUnion credit score through GoFreeCredit.com, a company I trust. 30% of credit reports have errors, which could put a serious hamper on your refinancing or new loan borrowing abilities. I had a $8 late payment I didn’t even know I owed crush my score by 100 points come up during my last refinance! The average credit score for rejected mortgage borrowers has risen to 729 due to more stringent lending requirements. Landlords will often ask for a renter’s credit score as part of his/her analysis.
* Shop Around For A Mortgage: LendingTree Mortgage offers some of the lowest refinance rates today because they have a huge network of lenders to pull from. If you’re looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using LendingTree to get multiple offer comparisons in a matter of minutes. Interest rates are back down to ALL-TIME lows in 2015 due to tremendous volatility and uncertainty in the markets. When banks compete, you win.
Photo: House on cliff in Santorini, FS.