A few days ago, I got a question from one of our readers.
“My biggest question, as I’m retired in my 40’s but my husband still works, is how much can I spend on a house. What % of my assets is wise to invest in a house that we hope to live in . . . maybe forever.“
That’s a great question! Obviously, there is no exact answer to this question because every situation is different. In your 20’s, you probably rented or just purchased your first home. At this point, the home equity/net worth ratio is probably quite low. As you get older, you’ll accumulate more home equity and it should grow as you get closer to retirement. Hopefully, your home will be paid off by the time you fully retire. This will help reduce your monthly expense in retirement.
Let’s take a look at why your home equity shouldn’t be a large percentage of your net worth, and then I’ll share my numbers. I’m 40 and semi-retired, so I think our situation is pretty similar.
Home equity – The value of your home minus what you owe on the mortgage.
Net worth – The sum of all your assets minus liabilities.
Why your home equity/net worth ratio should not be too high
There are many reasons why your home shouldn’t be the bulk of your net worth. Let’s see if I can get most of them.
- Liquidity – You don’t want a large part of your money to be locked up in your home. What if you need a large amount of money quickly? You can take some cash out with a home equity loan, but that usually takes at least a month. It can also be difficult to sell your home at the price you’d like if the housing market is not optimal. Even in a seller’s market, it takes at least a month or two to sell.
- Opportunity cost – Historically, stocks have returned 8% annually over the long term. Real estate is much more difficult to quantify. Various sources estimate the return to be anywhere from 1 to 5% annually. If you take the expensive transaction cost into account, then the return would drop quite a bit as well.
- Diversity – You shouldn’t put all your eggs in one basket. Ideally, you should have some stocks, real estate investment, home equity, bonds, and cash.
- McMansion – If your home equity is a large percentage of your net worth, it could be an indication that you are living beyond your means. Or maybe you just spent too much on a house. If your net worth isn’t that high, then you probably shouldn’t get a McMansion.
- Cash flow – An expensive home usually means a bigger monthly bill. Property tax, utilities, and maintenance tend to be higher with a more expensive home.
Did I miss anything? Let me know and I’ll add it here.
Currently, our home equity is only tiny fraction of our net worth – less than 1%. I just checked Zillow and our condo hasn’t recovered from the housing meltdown yet. There were a lot of foreclosures in our complex and that drove the price down quite a bit. The inventory is much less now so I’m hoping the price will recover soon. Right now, our home equity is only a little higher than what we have left on our mortgage. That means we don’t have much home equity at all.
Actually, I think Zillow underestimated the price of our condo by quite a bit at $260,000 (this is what I used to derive the 1% number.) I think we can probably get at least $300,000 for it if we decide to sell. Anyway, 1% isn’t a realistic answer, so let’s look at our next home.
As some of you may know, we are selling our 4 plex and rental home. We plan to do a 1031 exchange into a rental home with the possibility of converting it to a primary residence in the future. We have been house shopping a bit and the price is quite high in the area we like. The inventory is also very low and we haven’t found a place we really like yet. If we don’t find a good property, we’ll just invest elsewhere.
If we find a house in the area we like, then we’d probably stay until our kid graduates from high school. That’s 15 years so it’s a substantial period. Of course, life never turns out like you plan so who knows what’s going to happen. Anyway, I’d be comfortable with putting 20 to 25% of our net worth into a primary residence at this point in our life. This will enable us to get a reasonably sized home in a good school district. We would still need a mortgage, but not a huge one.
I wouldn’t want to put more than 25% of our net worth into a house. It’s just a lot of money to be locked up in one place.
What’s your ratio? – Poll closed
So what’s your home equity/net worth ratio?
If you’re buying a dream home where you plan to live forever, how much would you be willing to put down?
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