There's a debate raging whether one should include their primary home when calculating net worth or not. I think it's absolutely fine to include you primary residence as part of your net worth.
For example, in 2020, I put down $1 million to buy a larger home during the global pandemic. To then not include the equity of my primary residence as part of my net worth would be foolish.
I didn't suddenly just lose $1 million! In fact, I used my $1 million to take on leverage to boost wealth. Home prices are up between 15% – 20% in one year in San Francisco since I bought the home.
On the other hand, in my post, “The First Million Might Be The Easiest,” I exclude my primary residence in calculating my net worth figure at 28. I excluded it to be conservative.
The way to calculate your net worth is a personal preference. 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:
- 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.
Remember, the return on rent is always negative 100 percent. After 30 years, you build zero equity renting.
Leveraging Debt To Build Wealth
I think the best mortgage amount is $750,000 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 $750,000 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 1%.
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.
Careful Borrowing Too Much
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.
Net Worth Calculation Flexibility
For example, with the 10-year bond yield rising, you might consider allocating more of your net worth towards bonds and less towards stocks which recently hit all time highs. The 60/40 portfolio looks very attractive now. 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. Also check out my latest Net Worth Targets By Age, Income, And Work Experience post.
Shop Around For A Mortgage
Credible offers some of the lowest refinance rates today because they have a large network of lenders competing for your business. If you're looking to buy a new home, get a HELOC, or refinance your existing mortgage, consider using Credible to get multiple offer comparisons in a matter of minutes.
When banks compete, you win. Mortgage rates are still near all-time lows. Take advantage! Get a no-obligation quote from Credible today. I locked in a 7/1 ARM for 2.125%.
Explore Real Estate Crowdsourcing Opportunities
If you don't have the downpayment to buy a property, don't want to deal with the hassle of managing real estate, or don't want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible.
For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you're looking for strictly investing income returns.
I'd also check out CrowdStreet if you are an accredited investor. CrowdStreet primarily focuses on real estate opportunities in 18-hour cities where valuations are lower and growth rates are higher. Thanks to technology, the spreading out of America is a long-term trend.
I've personally invested $810,000 in real estate crowdfunding to diversify and earn income 100% passively.
Manage Your Finances In One Place
One of the best way to become financially independent and protect yourself 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 your money.
Finally, they recently launched their amazing Retirement Planning Calculator that pulls in your real data and runs a Monte Carlo simulation to give you deep insights into your financial future. Personal Capital is free, and less than one minute to sign up.
Ever since I started using the tools in 2012, I've been able to maximize my own net worth and see it grow tremendously.
Include Primary Home When Calculating Net Worth Or Not is a Financial Samurai original post.