For years Dave Ramsey has claimed that the house you live in is not an asset, but a liability. Of course, on your financial statement showing assets, liabilities, and net worth, your residence goes on the asset side of the ledger. I think Dave thinks of it as a liability because it is expensive to maintain, costly to insure, and you have to pay substantial property taxes to keep it. It is also a thing to which we become enormously emotionally attached. It is, after all, our castle.
In proffering advice, many financial advisors simply ignore the value of the client’s house altogether, either because it does not represent a value that can be invested by them or they simply deem it to be irrelevant to one’s future financial well-being because it is a use-asset rather than an investment asset. This has never seemed right to me since, for many, it represents a very substantial asset.
You might have heard many rule-of-thumb recommendations from your financial advisor. Pay off the mortgage before you retire. Consider refinancing only after x% drop in interest rates. Use home equity as a last resort source of funds. Some however suggest using it first. It is standard advice that a mortgage or home equity loan is always the last debt to be paid off because the interest is tax deductible. Prior to 2008, the most egregious rule-of-thumb assumption by nearly everybody, advisor and client alike, was that house values would always go up at approximately the inflation rate providing a handy hedge against inflation. Dr. Larry Kotlikoff refers to rules-of-thumb as “rules of dumb” because they typically do not consider all the variables. It is easy to think too simplistically as we think about housing. This is especially true of our particular castle.
The questions that we hear from clients while discussing housing seem to have a familiar ring to them. The most common is “should I pay off the mortgage or pay extra on the mortgage?” You may already know that there is an economic answer to the question that involves whether the after tax interest rate on the mortgage is more or less than the after tax rate of return on your portfolio. If the portfolio produces the higher rate, then don’t prepay. This of course assumes that the money that would be used to pay on the mortgage would alternatively be invested in a portfolio producing some assumed rate of return. This ignores the risk component. Prepaying the mortgage produces a risk free rate of return equal to the interest rate on the mortgage. Investment portfolios carry some uncertainty to the return. It also ignores the elation that most people feel when they know that their house is debt-free.
There is a flip side to this that good analysis may help to address. That is knowing just how much that elation is going to cost you in living standard for the rest of your life. Maybe that good feeling would be worth $X, but not worth $Y. Notice here that this statement assumes that there is a cost, rather than a benefit, from prepayment. The time value of money, as well as the assumed inflation rate and tax rates are all important variables to consider in performing these analyses. Sorry, things financial are rarely as simple as they seem.
While conducting interviews for an article in The Journal of Financial Planning, Ed McCarthy determined that most advisors are not currently in favor of prepaying the mortgage. However, in that same article, he quotes Michael Kitces, another advisor, who recently asked a very relevant question in his blog, “Why is it considered risky to buy stocks on margin, but prudent to buy them ‘on mortgage?’” Kitces wonders if the advisory community is contradicting its own advice. I wonder who’s best interest is being served by not prepaying the mortgage.
One dimension of housing that we like to explore with clients is whether they plan to keep their house for the rest of their lives. If so, we then ask, what will become of it then? We find that children are rarely as interested in owning the family residence as their parents might think that they are. Once this question is confronted, access to the equity in the house if needed during retirement becomes more of a reality. If you plan to live in your house for the remainder of life, it might make some sense to develop a strategy to tap into the equity of the house at some point. Reverse mortgages are costly but not out of the question. They can often be accessed less expensively via a family member than through a typical mortgage or insurance company. Private annuities with children who can afford them should also be considered, using the house as the asset transferred in exchange for the annuity.
If clients do not expect to keep their house for their lifetime, we then explore what will be the triggering event that would cause them to move? Too often we hear something like “when I am no longer able to take care of it.” Or, “when I can no longer get up and down the stairs.” The problem with this line of thinking is that both of these usually occur over time with much ebb and flow. The result is that the house deteriorates as one becomes increasingly unable to provide the ongoing maintenance while becoming more reluctant to pay somebody to do it. Another result is often that a sale becomes absolutely necessary at a particular time rather than when it is more optimal. We like to help people think through these things as part of their financial plan.
In proffering advice, many financial advisors simply ignore the value of the client’s house altogether … This has never seemed right to me since, for many, it represents a very substantial asset.
Scott Neal is President of D. Scott Neal, Inc., a fee-only financial planning and investment advisory firm. You may write with questions or comments to scott@dsneal.com or visit www.dsneal.com.