The following, originally published in 2015, is among the most widely read and discussed posts here at RetirementSavvy. I am re-publishing the piece today because I recently read an article at CNBC that makes many of the same points with respect to homeownership. Interesting.
The article, titled Homeownership Doesn’t Build Wealth, Study Finds, leads by noting owning a home may help you save money, but it won’t help you make money. Households are better off taking control of their finances than relying on fluctuating home values.
It concludes by noting real estate can still be a good investment, but not necessarily living in the home you own. Being a landlord or investing in real estate-related stocks and commodities can be more lucrative than keeping all your capital in the nest.
First, the basic definition. ‘Net worth’ is the amount by which assets exceed liabilities. While the term has value and meaning for businesses, it is largely a useless metric for individual families. Why? Because two ‘assets’ that people love to include in their calculation of net worth are their homes (I’m referring to primary residences and not rental or investment properties) and automobiles. And for too many people the value they assign to their home and automobile(s) form a significant amount of their net worth.
Focusing on Net Worth
As an example, you might hear a couple say their net worth is $265,000.00. No doubt that number is quite impressive. However, if you break it down, you might discover that they are assuming they have $120,000.00 in equity in their home because of some improvements they have made to the home or because of what comparable homes in the neighborhood have sold for in the recent past or what Zillow estimates their home is worth.
Perhaps they have just made the last payment on their cars, zip over to Kelley Blue Book, plug in the relevant information (e.g. year, mileage, condition, etc.) and are apprised that one is worth $17,400.00 and the second is worth $12,000.00. Between the home and cars they calculate a value of $149,400.00. Combine that amount with the $115,600.00 they have in savings and investment accounts and they arrive at that $265,000.00.
Valuing Your Home
There are at least three things that should raise a red flag and give someone pause when looking at those numbers. First, no one, I repeat that no one, knows what their house is worth until they actually sell it. What people believe their house is worth is often a lot higher than what someone else is willing to pay. Second, even if they do sell it at or near the price they believe it is worth, they still have to live somewhere. Assuming they don’t make the sell and buy a tent with the profits, banking/investing the rest, it’s safe to assume they will be using at least some of the profits to use as a down payment and will be taking on another mortgage for some period of time. Third, similar story with the cars. Even if they are able to sell their cars for what KBB says they are worth, I believe it’s safe to assume that most aren’t going to downsize to a bike and bank/invest the rest … they are going to go out and buy another car or two.
Your primary residence is a home, not the stellar asset you might want to believe. If you are interested in investing in real estate, consider purchasing a rental property or Real Estate Investment Trusts (REITs). With respect to retirement, and specifically generating retirement income, it is much more useful to focus on passive and portfolio income, not your home.
Net Worth by Age and Income
At the end of the day, the numbers most people assign to the value of their homes and cars are really irrelevant, particularly with respect to retirement planning. As an example, I am quite certain that the wife and I have about $50,000 in equity in our home and I would peg the combined value of our cars – both paid for – at ~$30,000. We are at 10 – 11 years away from retirement. Even if we were planning on downsizing to a smaller home in retirement and going from two to one car, what good does it do to assign a value to our home and car(s) right now? None.
Marketable Assets or Financial Wealth
So if not net worth as commonly defined, what should be the focus? What is a more relevant metric, particularly with respect to retirement planning? I believe ‘Marketable Assets’ or ‘Financial Wealth’ is the answer. For purposes of studying the wealth distribution, economists define wealth in terms of marketable assets, such as real estate, stocks, and bonds, leaving aside consumer durables like cars and household items because they are not as readily converted into cash and are more valuable to their owners for use purposes than they are for resale. Once the value of all marketable assets is determined, then all debts, such as home mortgages and credit card debts, are subtracted, which yields a person’s net worth. In addition, economists use the concept of financial wealth — also referred to in this document as “non-home wealth” — which is defined as net worth minus net equity in owner-occupied housing.
While the marketable assets or financial wealth number will be lower than net worth, as traditionally measured, and not sound quite as impressive – $265,000.00 certainly sounds more impressive than $115,600.00 – the $115,600.00 is significantly more relevant.
Do yourself a favor and stop focusing on net worth; but if you have to, use either of the modified definitions. Spend your time and energy minimizing your expenses and developing multiple streams of passive and portfolio income; those are the numbers that are relevant for retirement planning.