What is the relationship between your income and your Net Worth? Does paying down a mortgage increase your Net Worth … these are the comments made by Diane to a reader who said that they had income that was going into CD’s, but still had a mortgage:
[If] you are paying down your mortgage some – rather than just interest … then your net worth may be going up [?]
I told Diane that it doesn’t work that way Where Diane is right that putting money into CD’s while you hold a mortgage is probably a sub-optimal financial decision, it’s NOT because your Net Worth would change … paying down your mortgage does NOT change your Net Worth – it just reduces both your CASH (on hand) and MORTGAGE balance columns in your NWiQ profile …
… your total of Assets – Liabilities (hence, your Net Worth) remains the same!
Diane took me to task:
I assume [that you would be] applying income to [your] net worth and that is NOT reflected in the assets/debt columns of the networth calculations – it’s future cash for the most part (those who have incomes ;)) — or did I miss how else the income is reflected other than as a header above (along with our education)???
These are very good ‘technical’ questions, that I can explain (for those who are business/finance minded) as follows:
Income/expenses is/are a bit like a business’ P&L (Profit and Loss Statement), and your Net Worth is like a Balance Sheet … the former is a ‘work in progress’ and the latter is a ‘snapshot’ at a specific point in time.
Both cash and loans sit on the Balance Sheet … or, in our case, on our statement of Net Worth. Simply moving amounts around does not change either. Your Balance Sheet only changes if you make or lose money, grow or reduce assets (as long as you are not turning them into cash or some other balance sheet item).
Similarly for your Net Worth: decreasing a positive bank balance (on one side of your Net Worth statement) in order to similarly decrease a negative house balance (a.k.a. a mortgage) on the other side hasn’t changed anything – except where you keep various components of your Net Worth.
On the other hand, earning more profits (reflected in a businesses P&L) is similar to earning a salary or other income for a person (income) provided that you don’t spend it all (expenses) …
… they all help to increase your Net Worth (or improve the value of the business, as reflected in an improved Balance Sheet).
BUT, it doesn’t matter if you ‘store’ that extra income in a bank account (i.e. the CASH column of your NWiQ profile) or in your mortgage (effectively reducing it) … your Net Worth goes up by the amount of income that you saved since you last calculated your Net Worth.
As Scott says:
As long as you are living in your home, it is a liability and costing you money if anything.
That is, unless you are prepared to tap into that home’s equity and use that money to invest.
Yes, it’s what you ’save’ from your income (i.e. after expenses) that goes into improving your Net Worth regardless of whether you use it to build up your bank balace, pay down debt, or – as Scott suggests – buy a new asset.
Just curious: if I had enough money to pay off my mortgage I would be better off buying a rental property with the cash instead? I understand it would not particular be something you would do but given the choice what option is better?
@ RDiN – Not sure why you say “it would not particular be something you would do” as it’s exactly something I would do! 🙂
Although, I would finance BOTH properties, because there are tax advantages to what you suggest (in many jurisdictions), but the key advantage is LEVERAGE:
– Paying off your mortgage REDUCES leverage, but
– Buying a rental (assuming you finance a portion) INCREASES leverage.
If you believe that RE is generally going to increase over a sufficiently long holding period (say 10 to 30 years), why wouldn’t you want the bank to subsidise your capital appreciation.
But, if you really did not want to increase borrowings/leverage then at least paying cash for another property (keeping your current home loan in place), which gives you TWO appreciating assets (we are assuming sensible purchases with 10 – 30 year holding periods) instead of one.
Of course, the second porperty is also bringing in (over time) increasing rents … makes this option a no brainer, doesn’t it?
OK i’m convinced and as a result of much due diligence I am currently in the process of trying to purchase a rental property. Accordingly, what type of mortgage do you feel is more advantageous in holding said property, for example, 30 year fixed, 15 year fixed etc?
@ RDiN – So much of the wealth-building process is common sense … we just sometimes need a “little push” to see what common-sense is:
In this case, the questions are simple:
1. Do you intend to pay off the loan before you are ‘forced’ to by the bank?
2. Is the current fixed (usually a little higher than variable) interest rate higher, lower or similar to the ‘typical’ interest rate that you would expect in 1.?
… it’s the answers that might be interesting 😉
BTW I hope that the ‘convincing’ that you mention is your conscious mind convincing your subconscious … and, not anybody else convincing you!?
Definitely in the context of starting to make sense as opposed to being convinced.
@ RDiN – LOL. OK … If you want to ‘think out loud’ with answers to 1. and 2. let’s see if we can point you in the right direction …
Rental property purchase price is $200,000.
25% down payment.
Finance $150,000 @ 5.375 interest rate, 30 year loan.
House has 3 bedroom, 1.5 baths, which is vacant & needs heating repair.
Also has a studio apt on the same property that currently has a tenant paying $800.00 a month.
Taxes are $4666.00 a year.
I can probably rent the 3 bedroom for about 1300 to 1500 a month.
Whatcha think, too much info?
Forgot to mention that I will have a cash reserve of around $100,000 in a savings account after setting up the house.
@ RDiN – Don’t want to be difficult, but you didn’t answer my two questions 🙂 I’m trying to help you figure if/how long you should fix the rate on your loan for.
In terms of the ‘deal’: let’s assume that your closing costs are paid in cash (you are rolling in the stuff); in which case your $150k loan will cost you $840 p.m. … sounds like the studio alone will pay that, and the rental on the house goes to contingencies (repairs & maintenance, vacancies, etc.) with the remainder going into your profit. Sounds good to you? Sounds too good to be true to me …. I’ll take 10 (unless I’m missing something?)!
I’d go looking for another couple with my $100k, then sit back for a while …