How Discounting the Value of Your Home Could Keep You Out of Financial Trouble

January 3, 2007

In a comment on my post about the Dangers of Owning Your Own Home, Enough Wealth, pointed out that “home equity IS part of your net worth” and what you do with the realized value once its sold is irrelevant”.

From a financial perspective I agree that the equity in your home does make up a portion of your net worth. However, I think that it’s psychologically unhealthy to factor in the appraised value of your home on your asset side of the personal finance ledger for several reasons.

Squandered Gains
I agree that a person could realize the gain from their home by downsizing or renting but many people in the US today don’t have this frame of mind. I think the unfortunate mentality that you always need a bigger, better, fancier house frequently keeps people from turning their home appreciation into cash.

Speculation
Every time I hear someone excitedly talk about how their house has appreciated by 35% in just two years I think back to the tech boom and how so many people were adjusting their retirement plan years ahead based on the booming market. If you make your financial plans based on an “appraised” value of your home and the assumption of similar continued gains you may not save and invest as much as needed, thinking your home appreciation will make up for it.

Liquidity
I think investing in real estate is a great way to grow your wealth, I do it, but I don’t think you should look at your primary residence as an investment you can easily cash out of. Your home is not a liquid asset. In all likelihood you can’t just sell it tomorrow for the appraised value, like you could a stock or a mutual fund. Depending on a variety of factors, you may have to settle for much less than you think your home is worth. Plus you don’t have to pack up your entire life and move to sell a stock.

Discounting Home Value
That being said, your down payment, monthly payments, and home appreciation do build up equity in your home that represent dollars you’ve accumulated over time. It would be nice to reflect that in some way on your personal finance balance sheet. Perhaps a good way to do this is by discounting the equity you’ve built in your home.

The discount would allow for things like the cost of selling, moving costs, adjustments in the housing market, and any other fluctuations. In my opinion, a conservative approach would be best when determining the discount. The larger the discount percentage used the less likely you are to overvalue the asset and make financial decisions based on inflated numbers.

For example, let’s say you have built $50,000 worth of home equity through down payments and monthly principal payments. If you discount that $50,000 by 50%, the $25,000 worth of real estate in your net worth will reflect the financial value you’re building while also setting the realistic expectation you can actually turn your home into that amount of cash.

Supported by The Thrifty Scot
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Ben

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Ben
Ben Edwards, the founder of Money Smart Life, saved up enough to buy a Nintendo back when he was 12 years old. When he used the money to buy shares of Wal-Mart stock instead, he knew he wasn't like the other kids... His addiction to personal finance has paid off for his family and now he's helping you to afford the life that you want. Check him out on the web at Google Plus, Twitter and Facebook.

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Comments

6 Responses to How Discounting the Value of Your Home Could Keep You Out of Financial Trouble

  • karla (threadbndr)

    I do two ‘net worth’ calculations each quarter. One with my house and the accrual accounts (for taxes, insurance, future house upgrades, saving for new car, etc) and one without the accruals, primary residence, personal property and vehicles.

    The first is my ‘classic’ net worth, but the one I acutually use for my personal financial ratios and tracking is the second one. I think the ‘adjusted’ net worth tracks my actual liquid and uncommitted assets much better. That’s the one I pay attention to.

    I know too many people who are ‘house rich and savings poor’. It’s an easy trap to fall into.

  • moneysmartz

    Good point mbhunter. That’s money we owe the bank, a mortgage is probably the biggest liability most people have.

  • mbhunter

    I don’t include my home’s value, but I do include my mortgage as a liability when I calculate my net worth. I have to live somewhere, and it keeps me working a little harder. 😉

  • Ashish Mohta

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