Good Rules of Thumb to Follow and Common Mistakes to Avoid.
We have all heard the line that your home is often the largest single asset for many Americans. That might be true, but it shouldn’t be for anyone hoping to be comfortably retired one day unless they have a very large pension. While it is true that your home and other personal properties are an asset, they belong in a different column on your net worth statement.
Ideally, most of your assets are investments that produce cash flow and increase in value at a higher rate than inflation.
Personal property (houses, cars, boats, planes, jewelry, etc.) does not generally contribute to your monthly income, nor does it consistently increase in value faster than the rate of inflation after including their expenses (property tax, insurance, maintenance, etc.). In fact, personal property consumes significant cash flow simply to own and maintain properly. This is often one of the mistakes that professional athletes and lottery winners make, by acquiring real property that they later lose due to upkeep costs.
The rule of thumb at our firm is that personal property, including your residence and any vacation homes, should not represent more than 25% of your net worth unless you expect to work for at least ten more years. It is not uncommon for someone to face a retirement crisis by having too much of their net worth in personal property, which then reduces their cash flow available for other living expenses.
Another common mistake that we see relates to mortgages, but in both directions. Some people dislike debt, so they devote too much effort to paying down low-cost mortgages.
The historical rate of inflation is between 3% and 4%, and more than half of the outstanding mortgage loans in the country have a rate below 4%, according to the FHFA National Mortgage Database.
We would rarely recommend someone pay off a mortgage when the interest rate is at or below the normal inflation rate. We view low-rate mortgages through a finance lens based on the total length of the mortgage and expected return on other assets. If someone expects to earn less than their mortgage rate, then the math changes.
In other situations, people are too comfortable with the idea of simply making the payment based on a mortgage qualification calculator and the idea that houses always grow in value. Remember our earlier discussion about personal homes requiring cash to maintain, versus other assets that generate cash flow. The 100-year return on personal real estate is about 1% above the inflation rate, so it probably isn’t wise to overextend yourself to buy a home above your budget on hopes that it will appreciate enough to justify the risk. That line of thinking is what got people in trouble twenty years ago.
A comfortable mortgage should be closer to 10% of your income as opposed to the 30% that some lenders will allow. Given that most mortgage interest on a primary residence is tax-deductible, this is good debt for almost everyone but stay conservative on how much you borrow.
In closing, I would like to highlight our advice or general rules of thumb on real estate. If it isn’t genuinely an investment property designed to produce cash flow or compound in value, then it should be a small part of your net worth. Personal property will take cash flow away from other investments or living expenses. If you have one of those very low mortgage rates from a few years ago, don’t be in a hurry to pay it down. Your financial plan might look better if you make the normal payment and use the savings to max out your 40lk or invest in some other way.
If you are making a new purchase today, be disciplined about your budget and what level of mortgage payment you want to be making for the foreseeable future. Unless you expect to earn very little in return on your other investments, we like the idea of using a mortgage if you are in the market for a new home. Your house is a very important part of your financial plan, but it should be viewed very differently than your investments.