Conclusive Proof that your House should be Included in your Net Worth…
…But you’ll have to wait till Monday to find out exactly why!
Nope… Your beloved expensive Porsche is not an asset…
Happy Friday folks! I’ve been beavering away at the next post of my financial independence planning series all week, which as you’ve probably guessed by now is all about calculating your Net Worth. When I talk about Net Worth I am talking about it specifically in terms of a number that when you reach it, you can call up your boss and tell him to stick his job where solar radiation is not observable.
The big sticking point in the world of Personal Finance blogs it would seem it whether to include house equity in the calculation. There are many arguments for and against but I’ve never seen a post back up anything with hard numbers to explain their point of view (if you know of one, please let us know in the comments below!). There seems to be a lot of wishy washy chat but no one has run the numbers.
I set out to right this particular one of the World’s most heinous of wrongs, and it turns out (perhaps unsurprisingly) that there is hard evidence that you should include it. The reason I haven’t made the full post today is that I have to iron out a few last details in my spreadsheets, make them look half presentable for human consumption, and attempt to derive a simple formula from them as we did in the last post about calculating your savings rate (Hint: it’s not as simple as just including the net value of home equity into your Net Worth!).
Another very important point to note is that by including some proxy value for house equity into your Net Worth calculation, you must also consider that a similar proxy value for principle payments must be included as part of your savings, which will affect the calculation we did in the above article. For those of you who struggled through that behemoth of a post and made it to the end, apologies, but I will have to make an (hopefully very small) amendment to it, so you might have to go back and have another read of that as well when Monday comes. 🙂
Anyway, just so you can see where I am going with this, I ran a simulation of numbers for theFIRErat whereby he saved 50% of his income from the exact point he signed up for a 25 year mortgage. These are very convenient numbers because a 50% savings rate means you will retire in exactly 25 years. So, having run the numbers, I noted that when he retires and his mortgage expires, his monthly expenses drop dramatically (no mortgage left to pay). The sensible thing for the rat to do would therefore be to work out how much he needs to cover his non-mortgage expenses and then continue saving until he has that much, plus enough to pay off the rest of his mortgage.
At that point he can quit his job, which is turns out is a whole six and a half years earlier than what we are told if we follow the straight up rule of a 50% savings rate equating to 25 years of bondage to the corporate ‘cuffs.
Clearly this is not an insignificant amount of time!
So there is my conclusive proof 🙂 that we have to include (a proxy value for) house equity in our calculations for Net Worth, but you will have to tune in on Monday to read the full findings, and hopefully a simple derived formula to calculate that proxy value.
In the mean time, I hope you have a scintillating weekend my lovely readers!
Discussion (28) ¬
I’m looking forward to the post on that! Right now we include the value of our home in net worth since we own it and could net about 94% after a sale (100% – the 6% sales commission). At that point, I figure we could just invest the money if we wanted, so we include it. But it’s a very sloppy way of calculating (and we don’t even subtract the 6%), so I’m looking forward to your take!
That would be pretty much my argument to anyone who says do not include it in your figures DB40! If you’ve paid off your house already I’m not so sure my spreadsheets will really apply, although I did have an idea about a slightly different way of calculating your house value vis a vis Net Worth but I’m not sure if it’s worth publishing. I will decide on Sunday night I think!
With regards to the whole years till FI / Savings Rate / Net Worth conundrum (as they are clearly all linked) then I just hope I can derive something simple from my spreadsheets as it’s not immediately obvious what the relationship between the Net Worth, principle payments on the mortgage (and consequently expenses) and years to FI actually is. I will keep plugging away though and if not I will just have to tidy up the spreadsheets and publish them here with some full explanations, so you can all see what by the beard of Zeus I am rambling on about! 🙂
Property owned outright, l include. Anything with a mortgage, l check out an average selling price like on Zillow and reduce by a quarter because they are always over valued. I do deduct another 10% for realtor fees and closing costs (in Texas, it’s pretty much 10%).
KemKem, if you are owning properties outright then you probably don’t need to worry so much about years till you’re FI… 🙂
Obviously once you reach that goal, your Net Worth is pretty much just your Net Worth at that point in my opinion, no funny business needed. It’s just a way to keep score, and I suppose to double check every so often to make sure you will not run out of money at any point in your FI life?
Hah hah! I’m not worried, otherwise l’d be screwed since l quit the working world..I wanna see on Monday though..
Uh oh… I’m under big pressure to deliver now aren’t I 🙂
It’s a tricky one since, if you’re living in it as your main home, then it’s not generating any income for you. So while it is an asset, it’s not an income-generating asset. Also the valuation is variable and it only becomes “real” when you sell.
Maybe the way to value it would be to take CurrentValuation – CostOfMinimalHousingSomewhereElse. So if your current place is worth 200 but you could downsize comfortably and happily to a place that cost 100 then you have 100 as a real asset.
Also, as in my case, it can all too easily grow to be a much too big part of your portfolio…
That is a very good point mister squirrel! I guess people argue over it so much as some may be planning to downsize/move somewhere cheaper whereas some will specifically never want to move, so can never free up that capital.
Percentage of portfolio is also a very important factor for reaching FI, if 100% of your worth is in your house then you ain’t escaping the rat race any time soon huh!
oh you tease not getting this post out for weekend reading 😉
Ha ha, very sorry! I really had planned to have it finished for Thursday but hadn’t even figured everything out by Friday. I’m a bit slow… what can I say 🙂
I can see why in the UK it would be fair to add your property equity less selling fees to ones net worth, but less tangible is relating this illiquid portion of your net worth to your FI plans…. You have to live somewhere.
Exceptions would be ERE type of plans, whereby you massively downshifted and gained income on the difference in old property rental income and rent costs of living in a much cheaper place: this could be a smaller place (ie: you bought more house than you needed originally) or an economic benefit from a change in geography (ie: moving out of a major city to somewhere cheaper).
That said, if you love where you live and have no intention to move, then the added net worth is quite useless to you beyond being a tidy inheritance to your kids.
My thoughts exactly! But don’t forget the chunk of your expenses that a paid off house cancels out. I guess you could always split your expenses into “house” and “other” and Net Worth likewise, which may solve this whole hornets nest of a vipers lair.
Andy,
You are a beast! I haven’t even fully finished your other post on savings rate. I was reading it and thinking how in-depth it is! Now an in-depth post on houses/net worth? I love it!
-Nick
Glad you are digging your way through the other post Nick! This next one may be delayed further as I am still staring blankly at my spreadsheets tonight, but I will keep you “posted” (what a terrible blog pun… apologies, it’s getting late here) 🙂
As someone who is retired and has done that, note that in the UK the pension system (where you can only take the pension from 55, and in your case I’d sketch this in at 60) mitigates against paying of the mortgage until you take the pension lump sum. Otherwise you take an income suckout between retiring and getting your hands on the pension.
You are quite correct that ones outgoings drop. I was still working when I discharged the mortgage so it let me hit pension saving hard to max the tax relief. Retiring FIRERat as his mortgage ends might not be the optimal route. OTOH if Rat is looking to retire very early he may have no choice.
This is true ermine! If you could time it to pay off the mortgage when the lump sum is available, that would be pretty sweet. Otherwise, regarding the most optimal situation, you could of course just pay down the mortgage on the normal schedule to leave that money invested in the market as long as possible, if you think it is going to do better than the interest rate on said mortgage. Although I think there is a lot to be said about being mortgage free and if you have the money laying around to pay it off, then why not do it.
@Ermine – can you expand on what you mean by “Otherwise you take an income suckout between retiring and getting your hands on the pension.” I don’t get what you mean.
I’ll be paying my mortgage off in 5/6 years aged 45/46. Cashflow is going to be lovely from that point onwards 😉
Can’t wait to see the post today, it’s been a great series of posts!
Thanks Jon, Glad you are enjoying it. Erm. As you’ve all probably noticed I am horrendously late with the next post in the series. I’m probably looking at publishing it next week now as I’m away for a long weekend and not looking like I’m going to get it finished by tomorrow. Anyway, it turns out there is no simple formula, but I have something, which I think is quite interesting. It will be great to get everyone elses opinion on it but I need to rewrite the post so it doesn’t come across as a bunch of garbled nonsense, which is the current state it is in! I’ve got a great guest post/interview with Eco Thrifty Living in the meantime to post tomorrow though which makes excellent reading!
Did you ever get this out, I’d be interested to see the logic but can’t find it.
Apologies if it is obvious, and I’ve missed it!
David
This article has been sitting in my draft for about 5 months I think now. I really must go back, polish it off and post it! Please accept my most humblest of apologies, I really do need to get it out there so I can forget about it and move on with my life, as it’s been a constant source of niggling in the back of brain for a while now. Thanks for the friendly poke into action 🙂
That’s great, thanks. I’ll keep an eye open!:-)
David
Uhm.. I’m late to the party, I know I just can’t help arguing against some comments here.
“It’s not an income generating asset” – What about the rent you don’t pay? The capital part of your mortgage repayments is still yours ’til you kick the bucket. The interest is the price you pay for ‘renting’ money from the bank and currently in the UK that would be much less than you would pay in rent for the equivalent property. A saving you make should be treated as income for financial purposes, but we all know that.
Second, if you don’t take it as part of your net worth. You are suggesting that someone who pays for a property outright from his savings account takes an immediate hit (loss) to his net worth to the tune of say £250K! That’s just not right.
Hi Weasel,
Glad to see people are still reading the archives so no worries on the late comment! I still never got round to writing the full follow up post anyway. Hah.
It’s a bit of a double edged sword for me. Say you had a fully paid off house. You could either sell that, invest it and use the income to pay your rent. Or you could keep the house.
For me one of the other are no different really and either way you need to save up that extra money to either cover your rent or pay off your house before you can declare yourself FI. It shouldn’t matter whether getting a mortgage turns out to be cheaper in the UK at this point in time, that may not hold true everywhere nor at some point in the future, that is a different argument although it is one that is very hard to extract from this one as they are so intertwined.
Anyway bottom line is that I agree that you *should* include it in your Net Worth (obviously, otherwise the title of this post wouldn’t be “Conclusive Proof that your House should be Included in your Net Worth…” haha) but in terms of calculating your savings rate and your “freedom fund” (such as blogger Huw at FFB40 and The Finance Zombie calculate) actually I now think that not all of your principal payment would be counted. I think that it is neutral in terms of savings rate calculation because it is not really an expense nor is it savings into your freedom fund.
I don’t think I’ve made myself very clear at all there so it underlines the fact that I really need to break out my spreadsheet and explain fully what the heck I am on about.
Anyway cheers for the comment and in principle I obviously agree with 99% of what you are saying… nice one!
TFS
Isn’t the key here consistency, so yes include the asset but then you also need to impute a rental cost into your expenses when thinking about it in terms of FI.
If your only asset is a £250k house it can’t do more than pay your rent unless you are going to sell it and invest the proceeds (at which point you will actually need to pay rent).
So include, but then add something onto your expenses (and there is a whole different debate about what that should be)
David
David, totally agree with everything you just said. It’s basically 6 of one and half dozen of the other really isn’t it?
Adding in the imputed rent into your figures slowly as you pay down the mortgage is easier said than done though, I still haven’t quite figured out how to do that. If anyone has any pointers please do post them here…!