On the right side of the personal balance sheet, you had to finance the purchase of this house with debt, so if you made a 10 per cent down payment and financed the other $450,000, your liabilities have increased by $450,000 in total. The important thing to remember is that the equity on your personal balance sheet has not changed. You have $450,000 more in assets and $450,000 more in liabilities-and you've converted financial capital into a down payment.
Now let's examine what your personal balance sheet will look like in five years, ignoring human capital considerations. If you have been carefully paying down your mortgage debt, perhaps the remaining liabilities have been reduced to $400,000. And, even if housing prices have not increased at all, you have created $50,000 more in equity in your home, for total equity of $100,000. (This is the original downpayment of $50,000 plus the $50,000 in total payments over the last five years.) So far, so good. But now let's imagine that housing prices fell by 20 per cent over that same five-year period. This isn't inconceivable-and is exactly what just happened in many regions of the United States over the last five years, as shown in Table 6.1. In that case, a 20 per cent drop in the value of a $500,000 house leaves you with a balance sheet asset of $400,000. This is exactly what you owe in debt (mortgage) on the house, and you have no equity. The $50,000 you originally invested in the house is gone, and all the payments you have made in the last five years could essentially be considered rent. You are no further ahead now, financially, than you were five years ago. All you did was consume housing.
Let's explore that notion of consuming housing a little further. When you buy a house, you can think of a portion of the money you spent as creating additional and potential financial capital (an investment, in the world of financial capital). However, another fraction can be viewed as a prepayment of your future liabilities, namely your need for shelter. In other words, think of the money you spent on a house as partially going toward a mutual fund (an investment) and partly going toward a large supply of milk, eggs, cheese, and other household staples (things you consume).
The reality is that housing fulfills a need: your need for shelter. This is an implicit liability on your personal balance sheet. By purchasing a house you are pre-paying that liability in advance. Think of it like a pre-paid phone card, but for rent and for the rest of your life. According to this line of thinking, the $450,000 mortgage doesn't quite increase your total liabilities by $450,000 because you have reduced your implicit housing liability. What all this implies is that housing is part consumption (to defuse your implicit shelter liabilities) and part investment, and you should keep both of these dimensions in mind when you consider the housing money milestone.
My Strong Bias: Many Homeowners Should Have Rented So, where does this leave us in terms of practical housing advice? For one, I think that a large proportion of individuals within the population should not own a house, or they should at least push off the purchase as long as possible, and instead rent. Anyone that followed this advice in the U.S. over the last few years, possibly the last few decades, would be much better off today. This is not just me being preachy or dispensing with advice that-with hindsight-proves correct. If you actually go back to one of the first principles I discuss in this book, namely Long Division and the spreading of resources over time, you can arrive at the same conclusion, but the reason is not as simple as you might think. It isn't because housing is a "bad investment" or has performed poorly relative to other asset classes. Instead, it relates to the investment characteristics of your human capital when you are young and as you age.
In a number of recent studies, a variety of mathematical economists have developed a control theory model to derive the optimal or rational approach to housing over the life cycle. (I discussed Dynamic Control Theory in the Introduction.) You can think of their research as exploring how Mr. Spock (from Star Trek), who knows all the odds and can act completely logically, would behave. According to these researchers, most "typical" people under the age of 40 shouldn't own a house but should rent, instead. But again, this isn't recommended for the reasons you might think. Here's the Spock argument against home ownership early in life: When you are young the vast majority of your true wealth is locked up in human capital, which is illiquid, nondiversified, and definitely nontradable. It therefore makes little sense to invest yet another substantial amount of total wealth in yet another illiquid and nondiversifiable item like a house.