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