“Is home equity included in net worth when calculating a retirement budget?”
“Is having a mortgage in retirement risky?”
“Was it a good idea for you (Go Curry Cracker) to get a mortgage?”
These questions (and others of a similar genre) are amongst the more popular we have received over the years. (Even more so now that we bought a house.)
Today I want to review mortgages, home equity, and related questions as they pertain to retirement budgeting and spending.
Let’s go.
Mortgages, Home Equity, and Retirement Spending
Is home equity part of net worth?
When I googled, “How to calculate net worth”, one of the first results was very succinct:
Net worth is assets minus liabilities.
And it is. Simple.
Hence, home equity (home value minus mortgage) is part of net worth.
Which is great for accounting purposes. But… does it work for retirement budgeting?
Retirement budgeting
The 4% Rule is often used (or at least discussed) when planning a retirement budget.
Summarized: plan to spend 4% of your starting portfolio value each year, adjusted for inflation.
(For more details: What is Your Retirement Number – The 4% Rule.)
Following this guideline your retirement money should last at least 30 years, even in the worst cases in the historical record (which is why it is the 4% rule and not the 5% rule.)
It is in these troubled times that the trouble of including home equity in net worth becomes clear.
What if you based your retirement budget on total net worth (including home equity) and you happened to retire in 1966 (the worst retirement ever.) Maybe at retirement your stock/bond portfolio was worth $750k and your paid off home was worth $250k (75% / 25%.) Come 1980 or so… and your net worth has dropped to ~$250k.
Where is this $250k? In the house. ALL OF IT. All stocks and bonds have been sold and spent.
Now what? Sell it and downsize? Get a reverse mortgage? Rent out a room or two?
Retirement portfolio decline (chart from cFIREsim)
Any of these could be a reasonable option in this situation. Maybe you have a preference.
I certainly do – that preference is to not be in this situation in the first place by not including home equity in net worth for purposes of calculating a retirement budget.
Said another way – exclude home equity from the portfolio.
But my home has real value! Certainly I don’t just assume it has zero value in retirement?
Right you are. That value is in the form of imputed rent.
You spend less (due to no rent or mortgage.) And you spend that lesser sum from a smaller portfolio (that doesn’t include home equity.)
In the preceding example, this would entail spending $30k/year rather than $40k (4% of a $750k portfolio.) Now at the 1980 point you still have $437k remaining ($250k in the house.) There are still 6 years’ worth of spending in the investment portfolio (out of the original 25.)
Things are less robust if you have a mortgage because of the cash flow necessary to make the monthly payment.
But… YOU have a mortgage!
I do. I even invested it.
There was some interesting discussion about how we think of the mortgage on our recent budget post (Our California Dreamin’ Budget). The following is intended to be clarifying remarks.
Market value of house – mortgage value = home equity, which is not included in our net worth for budgeting purposes. I plan to spend less than 4% of the remainder.
I chose to have a mortgage because it seemed a reasonable hedge – we got to borrow at 2.75% and let relatively high inflation eat that in the early years. I fully expect dividends from investing the mortgage to easily make our mortgage payment in short order. The rest is profit.
In the short term this has cash flow implications. I need to generate the cash to make the monthly payments. This isn’t a large problem as I sized the mortgage such that the payments were comfortably within our ability to pay even though I could have borrowed substantially more (and should have in hindsight.)
A portion of those payments is a real expense. Interest paid is gone forever. The remainder of each payment is principal and I can choose to spend that again in the future (either via home sale or borrowing.) For this reason, the principal amount is NOT part of our budget – it is just a slight shift of asset allocation from stocks/bonds to real estate each month.
Should every retiree have a mortgage?
No. Debt can be a great tool (Sweet, Sweet, Debt), and mortgage debt is one of the best kinds of debt, but that doesn’t mean it is automatically a benefit.
Circumstances matter. Interest rates have more than doubled in the year since we got a mortgage, resulting in a 40% larger monthly payment if we were to refinance at today’s rates. With such high interest rates (5.5% – 6%) the delta to long-term stock market returns (10%-ish) isn’t as interesting.
We are spending less than our portfolio can bear and with plenty of cash flow. Were we close to max budget (4%) or if we had to sell stock regularly to make mortgage payments, I would be less willing to shoulder the additional “risk” of the mortgage. There are plenty of articles out there highlighting the sequence of return risk of carrying a mortgage… imagine having to sell stock that is down 50% to make a mortgage payment, effectively doubling your housing costs.
Is a mortgage risky then?
Debt is leverage, which multiplies returns and losses. Magnifying losses (especially without income) is a bad thing, obviously.
But if you have the cash flow and can ride any short term loss out, having a mortgage is no more risky than early retirement itself. Less risky, even.
Quoting reader brooklynguy:
SWR analysis assumes withdrawal amount rises with inflation. Mortgage loan expense remains fixed (unadjusted for inflation) for the life of the loan. Run the numbers in cfiresim (setting the withdrawal amount as fixed, non-inflation-adjusted) and you will see that a leveraged-investing-via mortgage strategy with a 3% interest rate loan has a better success rate (has been quite “safer”) than the 4% rule.
… to which my reply was, “I should have borrowed more.”
Summary
It is never a good idea to include home equity in net worth for the purposes of calculating a retirement budget. In bad times this could force a home sale or borrowing, both of which are best done by choice rather than necessity. Instead, keep the home equity separate and enjoy the imputed rent of a paid for (or somewhat paid for) house.
Mortgages can be a positive or negative factor in retirement, all depending on the circumstances. Likewise with the choice to invest mortgage proceeds. Since we were able to get a 30-year mortgage at 2.75% fixed, inflation was 9%+, we had plenty of cash flow, and were spending less than our portfolio would bear, a mortgage was a great choice (probably.)
Mortgages can increase sequence of return risk due to regular portfolio withdrawals to make mortgage payments. However, at low mortgage rates a mortgage is actually less risky than early retirement itself.
Because of the nuance and dependencies, there is no one-size-fits-all conclusion for mortgages in retirement.
2.75% is a sweet deal. That’s free money in this high inflation environment.
Leaving the home equity out of the retirement budget is a great idea. It is much safer.
I missed 2.5% by a few weeks. But yeah, free money.
Yikes! Is anybody out there seriously including primary home value in their retirement portfolio? In my own financial spreadsheet there are four different relevant fields:
– Total $ in the market (incl HSA)
– Cash & taxable investments
– Tax-advantaged retirement $
– Net Worth
Only the last includes the value of the house, and we use 2+3 for 4%-rule calculation.
I’ve seen the question many times. I think it is something that people consider when they are trying to wrap their head around how savings is really needed to retire. Since home equity is considered part of net worth for every other purpose it requires some extra noodling in the brain.
My biggest reason for paying off my mortgage prior to retirement was to reduce cash flow requirements. Trying to balance having enough to pay bills, tax gain harvest, Roth conversions and ACA credits is hard enough without having another $20,000+ in mortgage payments to come up with each year.
I am completely with you on this. Keeping income low enough to qualify for good ACA credits can be a challenge with mortgage payments. This is the main reason I did extra gain harvesting before entering the US – we now have a healthy amount of stock at full basis to tap.
GCC—Did you consider a margin loan instead of the (asset depreciation?) mortgage?
A margin loan is NOT fixed and so is as bad as an adjustable rate mortgage.
Especially dangerous with rates rising and stocks falling in value.
Thanks Jan. Most ARM’s I’ve seen have a fixed rate for a set period of time, and then the adjustable period begins after that “teaser rate” term expires. I can’t find specific information about how often a margin loan can rate-adjust, but that makes sense that it would be subject to frequent adjustments from day 1 and possibly cause headaches depending on one’s goals and situation.
I’d think this would tend to make ARM’s generally less bad than using a margin loan for buying a primary residence as opposed to “as bad as an ARM” but situations vary.
ARMs would be generally less bad than a margin loan if rates go up. ARMs usually have a fixed rate period from the start, 1, 3, or 5 years. Sometimes interest only in the early years also.
No, not really. There were some good margin options at the time, in the 1% range… but those are now 3.5% or thereabouts. Compared to the opportunity to lock in rates less than inflation for 30 years, there is just no better option.
Makes sense. Thanks for answering. FS had a good write up on ARM’s recently.
In total agreement with using home equity as part of your net worth calculation, but not part of your retirement or pre-retirement spending calculation. Ever some big bloggers add this form of equity to their NW but not to what they use as the basis for their retirement spending.
Personally we are closer to spending about 2% of assets, but even that is misleading since we have about $100K coming in from dividends and ETFs alone, and our spending is less than that. In fact our single largest expense is federal income taxes since I still do a lot of option trading in a taxable account. Have had some good years and am getting bent over by the Feds due to my hard work, so I guess our spending has exceeded those dividends after all because of their need for me to pay for others student loans, etc. SS makes up the difference which they then tax me on as well, but that is for another time. And I agree with others that in retirement not having a mortgage makes cash flow management a lot easier and pleasant. Best wishes to all.
Thanks for paying taxes on your tremendous financial gains.
I know student loans are the topic du jour – won’t your taxes be the same regardless?
Since TN receives more $ from DC than it pays in taxes, if anybody is paying for others’ student loans it is probably the taxpayers in NY, NJ, MA, CT, and CA (the so-called donor states.) Although really – it will just come out of the future tax revenue of the students themselves (higher lifetime income.)
GCC – regarding your question on whether taxes will be the same regardless of student loans being paid for by the taxpayers, the answer is a big no, they will be higher. The University of PA’s Wharton School of Business estimates that the bill for this boondoggle will be $2K per every American. But since over half the people in the country pay absolutely nothing in federal income taxes, the burden will fall on people who actually pay taxes, the camp I fall into in retirement still.
OK, well let me know when your tax bill increases.
I really doesn’t matter to us. We have been retired for 3 years now and withdraw less than 1% from stash for expenses. Technically we could live on interest from a cd and still be fine although we choose not to.
Diversification is the key, so many more choices and options!
Current real CD yields are negative. I’m missing the connection between mortgages and your comment, sorry.
This was an easy decision for us in terms of net worth/debt in retirement since home loans are only floating / adjustable this side of the world =)
Yes, an amazing outcome for you in terms of debt. What was your main reason for not borrowing more at the time? And isn’t a lot of the property inflation already baked in as prices rose rapidly in low rate environment and will be more subdued/flattish/down now that rates are going up?
I sized the loan based on cash flow. If I doubled the mortgage size (and payments) I probably would have had to sell stock to make the payments. That’s fine if the market is going up…
Are you including dividends in your cash flow? Because aren’t dividends basically a forced stock sale, that can be “undone” by re-investing the dividends.
Some people might otherwise prefer dividend stocks that come at the cost of lower appreciation, only so that they can avoid “selling” stock.
Any dividend paid lowers the value of the stock by the same amount.
>Some people might otherwise prefer dividend stocks that come at the cost of lower appreciation, only so that they can avoid “selling” stock.
Dividends and selling appreciated stock are mathematically equivalent in terms of stock valuation, so this is a losing proposition
Worse though – a dividend is 100% taxable, whereas selling stock is only taxed in part (some of the sale is capital gain, some is tax-free return of capital.)
Qualified dividends is long term capital gains
Home equity belongs in the net worth calculation.
Your retirement portfolio, a.k.a. nest egg number is a different calculation, and unless you have defined plans to downsize or sell your property and become a renter, home equity should be excluded either partially or completely.
I guess I just summarized the post, but I think that distinction is important, and in most cases, a homeowner should use their nest egg number when calculating a safe withdrawal rate, not their net worth.
Cheers!
-PoF
Good points made here. We’re debating whether to have a mortgage or pay cash if/when we move to California. The state income tax is another reason to keep cash flow needs lower.
Stay cool this week.
At 3% it paid to borrow as much as you can.
At 6% not so much.
At 8% pay it off
This article prompted me to think about equity in rental real estate. I have not been including that in my planning — I have just been including the NOI for each property. I suppose I could include the equity in those properties in my calculations but then I’d be applying a SWR to real estate investments and that doesn’t make a whole lot of sense to me. What your post did make me realize though is that equity in the rental real estate should make me more comfortable perhaps nudging my SWR up to 4% because if I end up in a historically unusual situation and that ends up being too high, I’ll still have a couple of valuable rental properties I can sell or borrow against.
I wouldn’t apply a SWR to real estate either, but yes the equity is there should you need it. The important thing is thinking through what that looks like in advance at various interest rates
It may not apply in your case, since your kids are younger, but recently I’ve been playing with a Financial Aid & Expected Family Contribution (EFC) Calculator, and it seems like, in our case, possibly selling our ~$200K house, that we own outright, and moving a few $100Ks from stocks and bonds in our taxable account into a more expensive, say $600Kish house, would lower our EFC by tens of thousands of dollars per year. We’re perfectly happy in the house we have now, but it seems like something worth considering. Just wondering if any thoughts about FAFSA and EFC for college entered, at all, into your calculation to use a mortgage to pull equity out of your home and invest it in the markets, rather than leaving that money, basically hidden from FAFSA, in your home equity, since FAFSA doesn’t count equity in a primary residence?
Yes, “hiding” wealth in a house is a way to tilt the EFC calculations in your favor. However, many colleges also use the CSS profile which does factor in home equity. I haven’t looked at it at all yet, but the EFC is going away and being replaced with the SAI (Student Aid Index) after the Consolidated Appropriations Act of 2021 became law.
‘Investable Wealth’ does not include ‘LifeStyle Investments’ such as homes.
In Aus, the Cost of Living for a home owning couple (~$20,000 / y) is about half the CPI indexed non-contributory (welfare) means tested Age Pension for age 67+. Principal Place of Residence (home) is not included in the Asset Test but all other wealth at fire sale prices is.
The risk of having no income after age 67 is that of government not paying the Age Pension.
Typically, those entering the post retirement dying phase requiring Age Care have a home, a bit of investable wealth and receive the Age Pension. The home and most capital become a Refundable Accommodation Deposit on an Age Care position, government paying for those who can not, and the Age Pension paying for daily expenses.
If the Age Pension is likely to be adequate income in retirement then all but the means test taper start of $A419,000 can be invested in the home to good financial advantage provided home costs are moderate. Otherwise more Investable Wealth than $419,000 is required.
lifestyle investments… I like that phrasing, thank you
Yeah bye bye my home dream now with IR at 6%. It seems like everybody but me got the below 3% IR in the few years but again I couldn’t afford because all of my money was being channeled to FIRE. Damn FIRE that is screwing so many lives lately. The sub-group of FIRE called the Sad-FIRE is growing exponentially and nobody talks about it
I would like to talk about it. Please share more
Yes, you could actually look at a home as a liability in retirement. You still owe taxes every year, (you are really a tenant of the government anyway) maintenance and insurance costs keep going up. Then, if you need to move fast, say into a nursing home, you may have to sell it in a down market.