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How to make 7 million in 7 years …

Applying the 20% Rule – Part I ( Your House)

Since my early post How Much To Spend On A House is still one of the most visited posts on this site, I thought that I should write a little follow-up piece that gives some examples on how to apply this important ‘rule’.

First a recap:

You should have no more than 20% of your Net Worth ‘invested’ in your house at any one time; you should also have no more than 5% of your Net Worth invested in other non-income-producing possessions (e.g. car/s, furniture, ‘stuff’). Why?

This ‘forces’ you to keep the bulk of your Net Worth in investments i.e. real assets (stuff that puts money into your pocket … not stuff that drains your finances)!

Warning: most people think of their house as an asset, but by this definition, it most definitely is not … let this be a warning to all those ‘house rich … asset poor’ people out there who think they can retire just from their house.

For those mathematically minded, as a formula, this can easily be represented as:

20% (max.) for your house + 5% (max.) for all the other stuff that you own = 75% (min.) of your Net Worth always in Investments! Simple, huh?

Also, for those who have been tracking my posts, the difference between your Notional Net Worth and your Investment Net Worth will be the Current Market Value of Your House + the Current Market Value of Your Possessions; if you’ve been following my advice this should be no more than 25% of your Notional Net Worth.

Now, you may have noticed something interesting:

The Current Market Value of Your House will usually go up over time (current market conditions aside!)

The Current Market Value of Your Possessions will usually go down over time (collectibles aside!).

Houses generally appreciate … possessions generally depreciate.

This sets up some interesting situations that we should discuss … by no means an exhaustive list:

1. Aspiring Home Owner – The chances are that you have debt (particularly if you were recently a student), little income, some possessions, virtually no savings or investments. You will probably never be able to buy a house at all – or, if you can it may never be bigger than a cardboard box - if you follow the 20% Rule …

… My advice is to buy the house anyway IF you can afford a decent down payment (ideally 20+%) and can afford the monthly payments (lock in the interest rates for the max. period that your bank will allow, ideally 30+ years).

A lot of financial mumbo-jumbo has been written in the press, books, and blogosphere about this … ignore what you may have read: for most people, it’s the only way you will ever get financially free.

2. Already A Home Owner – Revalue your home (be conservative … don’t wear ‘rose-colored glasses’ … check what other houses around you have actually sold for … don’t rely on any realtor’s advice – they may ‘talk’ up the price to convince you to sell – we don’t want to do that, yet!). Do this every 3 – 5 years (yearly is better).

If the conservative value of your house puts the equity in your home (Your Equity = What the Home is Conservatively Worth – Today’s Payout Figure On Your Home Loan) at greater than 20% of your Current Net Worth (you will need to redo this calculation at the same time as you revalue your house), then it is time to extract that ’excess equity’.

What to do with this excess equity? Invest it of course! For example, you could buy a long-term, buy-and-hold, income-producing (get the picture!) rental property … or you could buy stocks … or you could take some risk and buy / start a business … or it’s up to you!

But, if you locked in your home mortgage at a cheap interest rate, you probably don’t want to refinance it, so be sure to ask a professional about suitable options for you (second mortgage; use your home’s equity to ‘guarantee’ the loan on another, etc.) … just be sure that you can afford the loans on both your house and your investment/s … make sure you have a cash [AJC: better yet, a Line of Credit] buffer against emergencies (loss of job, loss of tenant, etc.).

 3. Right-Sizing Home Owner – Again, revalue your home … but, of course you can down-grade (let’s say that you are retiring or the kids have moved out) – but just because you have freed up some equity and can easily fit into the 20% Rule doesn’t mean that you can slack off on your Investments.

ADD the freed up amount of equity to your Investment Plan … it will help you retire earlier and/or better!

Remember, your Investments should be a minimum of 75% of your Net Worth … you can and should invest more wherever and whenever possible! 

Again, if your original house is rent-able, and you have locked in a cheap interest rate (like I told you), you may want to keep it as an investment … consider doing so!

Now, buying houses isn’t always about making the right investment choice; there will be times in your life when you have to consider changing houses whether it fits within the 20% Rule or not (one obvious example was our First Home Purchase) …

… most likely, this will be at major life changes (marriage, divorce, babies). So be it!

Remember our Prime Directive: Our Money is there to support Our Life … Our Life isn’t there to support our Money (that would be just plain sick)!

Just make sure to revalue every year at first, then every 3 – 5 years min. and try not to get off-track, but if you do, simply realize if you are off-track financially and that you just have to get on-track at the first opportunity …

AJC.

PS You may want to bookmark this post (using the convenient links below) and review at every major ‘house change’ decision!

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28 Responses to “ Applying the 20% Rule – Part I ( Your House) ”

  1. Robert DiNero says:

    Just a couple of questions: 30 is better than 15?; Should you ever prepay on your primary of rental?; and does it matter what you invest your 75% of net worth in, e.g., CD’s and the like since I am very risk adverse.

  2. AJC says:

    @ RDiN – Thanks for your comment; from memory, you are in the ‘Retirement Zone’ i.e. either preparing for or already in retirement? If so, things change … and, YOU need to seek personal/professional advice! However I will flesh out some ideas in an upcoming post.

    In the meantime, inflation with KILL your CD’s, so get a copy of Worry-Free Investing by Zvi Bodie and/or The Grangaard Strategy [aptly named] by Paul Grangaard for two good – but, very different – approaches to low risk retirement investing.

  3. Robert DiNero says:

    Negative, not in retirement…probably sounds like it from my conserative approach.

  4. AJC says:

    @ RDiN – lol. Sry … in the back of my mind I thought that you once asked a question, saying that you were circa 10 years from retirement … if so, strategy is a little more conservative. If you are 10+ years then you need to read this post because you are JUST like me (I am actually a fearful/conservative investor, believe it or not) … but, you have to go against the grain or everything you fear WILL come true:

    http://7million7years.com/2008/02/19/the-scared-millionaire/

  5. Gryffindor says:

    Great rule of thumb — have started to adopt it in my personal planning.

    Be careful about advocating lines of credit as a substitute for cash — they can fail you just when you need it the most.

    For example, Bank of America just sent me a note cutting down my 500k HELOC down to 375k.

    So important on the investment side to have a reasonable amount of liquidity just in case (even if its not cash)

    Cheers

  6. AJC says:

    @ Gryffindor – I presume that’s not because your 3 month ‘emergency fund’ needs to be $500k?! :)

    Seriously, some rich people keep up to a 2 year expenses cash supply … they also keep transferrable bond certificates, gold bars and so on in their safety deposit boxes – because they can.

    But, let’s not confuse that with the benefit of keeping liquidity in your investment funds targeted at opportunities or against temporary loss of income (e.g. for a real-estate investment).

    If you expect to stay in your job, don’t be afraid to invest the ‘emergency fund’ money; just be sure that it is in something that you CAN access reasonably quickly IF there is an emergency. To me, a home equity LOC can fit that bill nicely …

    … avoiding moving forward because you’re afraid of moving backwards would be a bigger long-term risk.

  7. Jason Dragon says:

    GREAT entry again. It is SO true, yet it seems that so many people, even very popular bloggers just don’t get it. There is a blog I read about a guy who is trying to get a 2 million dollar net worth. It is here… http://www.2millionblog.com/2008/04/paying_down_our_mortgage_is_very_addictive.html
    And he is so excited how he got a raise at his job (But he had to go to china to get it) and how he is sending an extra 10k to his mortgage company each month and how that reduces his interest by $50 each time he does that.

    When I read that I just shake my head. I think to myself he could have found a house as an investment and used the 10k to put down on THAT house and either kept it for passive income or flipped it for quick cash. He could have invested in 100 other things that paid more than the 6.4% he saved. With this sort of logic I don’t know if he will reach his goal anytime soon.

    What do you think.

    Jason Dragon
    http://blog.capitalactive.com/

  8. [...] Making Money 301 « Applying the 20% Rule – Part I ( Your House) [...]

  9. AJC says:

    @ – Jason. Thanks, you have summarized my view quite nicely … but, why don’t we go straight to the “horse’s mouth” and ask $2Mill ?!

    Stay tuned …

  10. Love the 20% rule application in regards to a mortgage and the 5% rule in non-assets. We have discovered that the more we simplify in our life from down-sizing to a smaller place with smaller payments, investing more and purchasing less it feels like a mental enema:-)

    Love your blog!

  11. AJC says:

    @ 1 Button – I think I see the problem …

    … see that little plastic tube with the funnel on the end? It belongs in the OTHER end ;)

    BTW: Sounds like you are well on your way, financially … good luck and thanks for reading/commenting!

  12. [...] There is another blog, by a successful guy who gets this, I highly suggest you read his blog. It is called 7Million7Years.  He recently wrote a blog about home equity, and that you should not put all your net worth into it.  Read it here http://7million7years.com/2008/04/11/applying-the-20-rule-part-i-your-house/ [...]

  13. 2million says:

    Jason — thanks for the comment, you may be right, but please reread the post and it references – unless I am misunderstanding this post I think I am exactly doing that — all I did was “park” my money in my mortgage because it offered the highest rate of return (compared to the alt online savings account) till we purchased our next property sometime hopefully in the 6 months.

    AJC- I love this rule of thumb — its great. Can you post more about your experiences using this rule of thumb and how well it worked for you?

  14. AJC says:

    @ 2million – I agree with your comment re Jason; having read your posts and looked at your Net Worth it seems you are on the right path – the one actually recommended by Jason … in fact, I presume that you are currently ‘cashed up’ for the same reason as I am: the buying opportunities are nigh [but, not quite upon us]?!

    Yes, I will post … in fact, I just BROKE the 20% Rule; so I have a post coming up on that [and, what I intend to do about it]!

  15. nobleea says:

    what if your house value drops by 25%? should one sell investments to drop the mortgage value in order to stay at the 20% of net worth rule?

  16. [...] can argue whether this is true – after all the 20% Rule encourages you to use your home equity to invest – but, would you have the intestinal fortitude to [...]

  17. [...] own home (again, strictly financially speaking, he is probably correct), but I have proposed the 20% Rule that says that you should have no more than 20% of your Net Worth invested in your own home at any [...]

  18. [...] have dealt with the concept of how much ‘house’ you can afford while you are still working, but what about when you ‘retire’ (young … very [...]

  19. Anonymous says:

    [...] as a % of your ‘usual’ after-tax income 4. How does your current setup fit within the 20% Rule and the 25% Income Rule? 5. What – if anything – do you plan to do about it, if you currently [...]

  20. [...] How does your current setup fit within the 20% Rule and the 25% Income [...]

  21. [...] Now let’s look at the details for the 20% rule: [...]

  22. [...] in your first home, in my opinion, you have “entered the race” and that’s when my 20% Equity Rule and 5% ‘other junk’ Rule kick in to help you ‘win’ the race to your Number [...]

  23. liz says:

    As a first time homebuyer, why would you lock a 20% downpayment (probably a good portion of your savings) in a home? Why not put the minimum down and get a non-30yr-fixed mortgage since you’ll most likely want to upgrade in less than 10 years?

  24. DMV says:

    I agree with Liz. I’m not ure about you, but here in Coastal California that 20% number is a VERY large sum of money. Get creative with your mortgage . . . OPM, that is the true way to financial freedom.

  25. Adrian says:

    @ DMV – The 20% is not necessarily your down-payment: it’s the maximum % of your entire Net Worth that you should have tied up in your own home at any point in time. You do this ‘test’ EVERY YEAR.

    BTW: the concept of using OPM to get rich doesn NOT apply to your own home, but to investments that produce INCOME as well as (you hope!) future capital appreciation.

  26. [...] laid out in the Cash Cascade, but keep your mortgage (lock in to current low rates) subject to the 20% Rule and the 25% Income Rule and seriously think about keeping your other cheap debt [...]

  27. [...] happily keep 95% of my net worth in real-estate (incl. no more than 20% in my own home; remember The 20% Rule?) … and, I am NOT talking about REITs here, I’m talking buy/hold income-producing [...]

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