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If you’ve been following this blog, you will know that I have a radically different approach to owning your own home than the Dave Ramsey’s of this world who advocate paying off your own home early:
To be fair, Dave and I are actually saying two different things:
1. Dave Ramsey is saying not to carry any personal debt at all – INCLUDING your own home, since it doesn’t generate an income. And, there are certainly many who advocate this approach.
2. I am simply saying that the EQUITY in your own home shouldn’t exceed 20% of your Net Worth.
Now, if your house is worth more than 20% of your Net Worth, and for most people it will, then by definition I am saying that not only is it OK to borrow the rest … you HAVE to borrow the rest!
When you are old and gray, then Dave Ramsey’s approach is fine … but, when you have a plan to retire wealthy, your home – and, your ability to borrow against it – become key.
So, when I told you in a recent post that my house was worth $2 Million … my wife and I actually met BOTH my criteria and Dave Ramey’s as we paid cash and the house fit well within the 20% Rule for us.
As it happens, I can’t stand to see a ‘dead asset’, so we agreed that I could take a substantial line of credit against the house (more than 50% of the current value of the house as a HELOC) and use it to fund some investments … I recommend this approach, even if you fit within the 20% Rule, because you should be maximising the amount that you have invested at any point in time …
… of course, as you get closer to retirement, you may choose to wind back again – as Dave Ramsey suggests – I haven’t, but that’s just me 😉
Now for a ‘small problem’ … a few days ago, we bought a house worth more than twice as much as our current house … at least, it had better be worth more than twice as much, because that’s what we paid.
This means that we have temporarily broken the 20% Rule … d’oh!
It’s not as bad as it sounds, but I wanted to share this story so that I could walk you through our thinking process, because it will be inevitable that you go through a similar process as you gradually step-up your lifestyle (the side-benefit for all of those who read this blog … we hope!):
1. We are taking a very conservative view of our Net Worth: I tend to discount the sale value of any businesses and similar risk-assets that we may have, when calculating our Net Worth, as they can be taken away.
With these ACTIVE assets included, we are well within the 20% Rule, and very close to it even when only counting PASSIVE assets (a MUCH more conservative way to view Investment Net Worth that we will discuss in future Making Money 301 posts).
2. We paid cash for the house (well, we have only put down the deposit, so far, but will pay cash at closing).
Simple: as we did with our current house, we will take out a home equity line of credit and use that for investment purposes.
This means that we have effectively shifted the borrowed portion of the equity in the house from the personal side of our ‘ledger’ (bad) to the investment side of our ledger ‘good’ …
Used this way, borrowing is a positive tool to be used to advance your financial position, which is why I disagree with the Dave Ramsey approach for those who need to step up their lifestyle and have a solid reason for doing so [read: driving desire to achieve some Higher Purpose in their lives] …
… or, if you prefer the Dave Ramsey approach, simply wait before buying the house.
Financial choices abound!
BTW: to be ultra-conservative, we may instead simply use, say, 50% of the equity in this new house (perhaps more, certainly no less) to secure further income-producing real-estate investments (rather than stock purchases) that we intend to hold for a VERY LONG TIME.
As our Net Worth rises, will we pay down that loan (i.e. HELOC)?
We could … as we would again ‘fit into’ the 20% Rule. But, we probably won’t – because the 20% Rule is a minimum standard and there is nothing wrong with investing more, particularly in conservative, long-term buy-and-hold investments.
I see holding such investments, and borrowing a reasonable proportion to fund them, as less risky to my financial future than the typical ‘save and never borrow’ approaches … but, only because my financial future has to be reasonably BIG … certainly more than a simple savings approach could ever achieve.
That’s how we deal with upgrades to our living standards … perhaps, it’s a model that you can follow, too?
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The whole trick to using equity as an investment is that you make more in your investment than the cost to borrow the money.
I’d be interested to know what your borrowing costs are, and over the last couple of years, what you’re investing in that is outpacing the cost of borrowing.
@ Jim – It is not always possible to have returns outweigh borrowing costs in any short-term (say 1 to 5 year) period. That’s why we buy low (sell high, or keep) … lock in long-term when interest rates are low … and wait. Over the last couple of years I have been selling, not buying … now the cycle is beginning again.
Yes, but I’m sure that you realize Dave Ramsey is talking to the majority that buy houses at the national average of $192,000. These people don’t have money to pay for their house with cash and then borrow against it. Therefore, I have to agree with Dave, it is better to pay off your house (at least for most).
Unless your net worth is oven 1 million, I wouldn’t recommend your strategy. Most people have a negative new worth of at least 100k. They don’t have any money to help them out if their investment doesn’t turn out, and they could end up losing their house or going into bankruptcy – which means the rest of us will have to pay for their mistake. I don’t want to pay for other peoples bad investments, and therefore cannot recommend borrowing against your home.
@ Curt – Thanks for your comment! I see two different issues:
1. Making Money 101 – What to do when you have a house with a mortgage and you ‘find’ some extra cash? Suze orman and Dave Ramsey recommend ploughing it into your home loan … I DON’T, here’s why:
2. Making Money 301 – What to do if you have so much money that you can afford to pay cash for a house and STILL fit within the 20% Rule ( http://7million7years.com/2008/04/11/applying-the-20-rule-part-i-your-house/ )? That’s what this article is about … Making Money 301 principles probably don’t apply to people with a Net Worth under $1,000,000.
But, that is VERY different to saying that they should pay down their home mortgage instead of investing elsewhere … they shoudl only do that if they want to STAY with a net Worth under $1 Mill.
I good friend of mine told me some of the same things a few years ago, but now he’s in foreclosure and possibly bankruptcy.
But, to be fair, I’m not putting any extra money into my low interest morgage right now. Their are just too many other good investment opportunities.
@ Curt – I seriously doubt that your friend DID the same things, though …. if he did, he’d be writing this blog 😉 Good on you for doing what YOU think is right!
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