Why Your Net worth Can Be Misleading
Your net worth is equal to your assets minus debts and is a useful snapshot of the current state of your finances. One question many people have is whether or not to include their house in their net worth.
Yes, your house should be included in your net worth. To calculate your net worth, you include all of your assets and debts, which include your house. However, since accessing the equity in your home is challenging, it can mislead you into thinking your financial position is stronger than it really is.
In this article, I review why the equity in your home might be tricking you into thinking you are richer than you are and how to calculate your “accessible net worth.”
Why tracking your net worth is a useful exercise
As I’ve already mentioned, your net worth is a snapshot of your current financial situation. It merely allows you to compare your total assets to your total debts. Having a low or even negative net worth does not make you a financial failure.
Think of the recent college graduate who has no assets and a pile of student loan debt. That person will have a negative net worth but has likely increased their ability to start building wealth.
Tracking your net worth over the years and decades can act as a useful measuring stick for how you are doing in your savings and debt repayment goals.
When your net worth can be misleading
The elephant in the room that needs to be addressed when we are talking about calculating our net worth and tracking it over time; the value of your home is inflating your net worth.
If you’re a homeowner, there is a decent chance that your home is the largest asset you own. That means it plays an outsized role in determining your net worth.
Your home equity is what adds to your net worth. Your home equity is simply the difference between the value of your home and your mortgage. If you own a $500,000 house with a $400,000 mortgage, your home equity is $100,000, which increases your net worth by that same amount.
If you live in an area with a hot housing market, the value of your home may be inflating your net worth.
How home equity can become the most significant component of your net worth
Owning can be a great way to increase your net worth in the long run. Here is the general path to how home equity becomes the most significant component of many people’s net worth.
- You use cheap debt (a mortgage) to buy a very expensive asset at a relatively young age.
- On day one of owning a home, your equity is equal to the downpayment you used to buy the house.
- Over the years and even decades, the value of your home slowly increases, and the amount of your mortgage gradually decreases. This begins to increase your home equity and your net worth steadily.
- Given all of the expenses involved in owning a home, you don’t have a lot of extra cash left over to save and invest in other assets. As a result, your home equity becomes the most significant component of your net worth.
Why you don’t want your home equity to be the most significant component of your net worth
The problem with having too much of your net worth tied up in your home is that it can be challenging to access your home equity.
If you own a house worth $1 million and have paid off your mortgage, you are technically a millionaire, even if you don’t have any other assets or savings. If your nearing retirement age and you want to begin living off that $1 million net worth, you will quickly realize how impractical it is to have all of your net worth tied up in an asset that you live in and have an emotional attachment to.
There are only three ways to access the equity in your home and use it to fund your lifestyle.
- Sell your home and rent.
- Sell your home and buy a less expensive home.
- Take out a loan against your home.
All of these options are less than ideal.
Selling your home and renting
The simplest way to access the equity in your home is to sell your house. While this solves the problem of how to access your home equity, it immensely presents a new problem; you need to find somewhere to live.
One option would be to start renting. Selling your home to begin renting is a double edge sword.
- On the one hand, you can access the equity in your home and start spending the money.
- On the other hand, by paying rent, you just added a significant monthly expense. If you’ve had your mortgage paid off for many years, this will likely be a substantial increase in your cost of living.
This all assumes that you are willing to sell your house in the first place. For many, a house is not only their largest asset but the place they raised their children and where they have countless memories.
This is another reason I don’t want the majority of my net worth tied up in my house. Not only is it difficult to access the equity, but the emotional attachment can also prevent people from making “cold, rational decisions” like they would with any other asset.
Another way to potentially access some of the equity in your home is to sell your house and buy a smaller, less expensive home. This option allows you to retain ownership of an asset while accessing some of the cash tied up in your home.
If you sold your four-bedroom house for $500,000 and bought a 2-bedroom condo for $250,000, you could access up to $250,000 of the equity in your home minus transactional and closing costs involved in that transaction (which can be significant.)
Downsizing is far from a slam dunk, and it’s critical that the numbers line up, or it could end up being a disaster. You still need to use a significant amount of your home equity to buy the smaller home, which makes it inaccessible again.
In the example above, selling the home and buying the condo would mean you have $250,000 in cash and $250,000 in equity in the condo (minus closing costs). That means you only have $250,000 in cash to live off.
Condos also have condo-fees, which are typically hundreds of dollars per month.
Like with selling to rent, selling to downsize might be a non-starter if you are unwilling to leave your home.
Using debt to access your home equity
If you’re unwilling to leave your home, the only way to access the equity in your home is to take out a loan against the value of your home, which typically means a mortgage.
Like with renting, taking out a mortgage against a paid-off home significantly increases your monthly cost of living, as you now have a mortgage payment.
If your home is your only significant asset, taking out a mortgage is extremely risky as you are using borrowed money to make the mortgage payment.
Calculating your accessible net worth
If you want to avoid the situation where the bulk of your net worth at retirement age is tied up in your home, you’ll want to track what I call your “accessible net worth,” which is your net worth excluding the value of your primary residence.
Compare your accessible net worth to your official net worth to gain a sense of how much your wealth is derived from your home.
- Start by calculating your net worth.
- Then simply subtract the value of the house (the asset), but leave the mortgage (the debt).
- The result is your accessible net worth.
For example, let’s say your assets and debt were as follows.
- Home: $500,000
- Cash: $10,000
- Retirement accounts $125.000
- Other investments $85,000
Total assets: $720,000
- Mortgage: $250,000
Net worth: $470,000
Here’s how your accessible net worth would look.
- Cash: $10,000
- Retirement accounts $125.000
- Other investments $85,000
Total assets: $220,000
- Mortgage: $250,000
Accessible net worth: negative $30,000
You can use this net worth calculator to compare your traditional and accessible net worth quickly.
Think of your accessible net worth as your level of wealth you could access if you decided never to sell your home.
Accessible net worth highlights our dependency on our primary residence
In the above example, we showed how someone with a nearly quarter-million in net worth could have a negative accessible net worth. You might ask why we would not include the value of the home, but we would include the mortgage. The reason is simple.
- As we have reviewed in detail, it is difficult to access the value of your home and convert it into cash.
- Your mortgage, on the other hand, is a liability that you must pay every month (or risk losing your home.)
As you pay down your mortgage or decide to sell your home, your accessible net worth will increase dramatically.
The point of calculating your accessible net worth
The point I want to drive home with the concept of accessible net worth is the importance of building a diverse base of assets that you can easily access. This is not a commentary on whether or not you should own a home or rent.
To provide yourself with the highest degree of financial flexibility, it’s crucial to have access to money and assets that are independent of your choice of where to live.
If your accessible net worth is dramatically lower than your traditional net worth, that does not imply that you should sell your house. It simply means you might need to focus on contributing more to your retirement accounts.
Take your net worth with a grain of salt
Owning a home is a great way to build wealth over the long run. Over time, as the value of your home increases and the balance on your mortgage increases, your net worth will increase.
However, it’s important to know that accessing the net worth in your home can be very difficult, especially if you have a strong emotional attachment to your home.
For that reason, you don’t want too much of your net worth tied up in your home. The concept of an accessible net worth helps you determine how much wealth you have access to if you chose never to sell your home.
If you own your home, your accessible net worth is likely much lower than your traditional net worth. This is not intended to dissuade anyone from buying a house but to highlight the importance of diversifying your assets and investing in assets apart from your primary residence.
Having a high net worth is not worth much if you can’t use it to fund the lifestyle you want.
If you need a little help with the numbers on how to calculate your accessible net worth take my class on SkillShare where I expand on the topics discussed in this article and provide you a spreadsheet to crunch all the numbers.
To be transparent we do get a referral fee if you sign up for the 14-day free trial.
This article is for informational and entertainment purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.
Originally published at Benlefort.com