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The cover of Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life, written by Moshe Milevsky

This is an excerpt from Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life, written by Moshe Milevsky. A chapter that ran on Globe Investor last week on insurance salesmen and warranty peddlers can be read here.

An excerpt from Chapter 6: Can You Eat Your House or Will It Ever Pay Dividends?

You recall from our previous discussion that for most people during most of our lives, human capital is the most valuable asset on our personal balance sheets. But have you ever thought about what asset is next in line-what your second-most-valuable asset is? It probably won't surprise you to learn that for homeowners, this spot is occupied by their personal residence. According to the U.S. Survey of Consumer Finances (SCF), their personal residence represented fully 85 per cent of homeowners' financial net worth in 2007. For the general population under the age of 35 (not limited to homeowners), homes represented fully 220 per cent of their net worth (and because this statistic includes all people, not just homeowners, it probably understates the mortgage debt held by under-35 homeowners). For people over 65, homes represented between 34 per cent and 40 per cent of their financial net worth.

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These are big numbers, and they've been getting bigger over time. Over the last two decades, housing has become a much larger portion of the personal balance sheet. In 1989, the average balance sheet (not including human capital) for homeowners had about 70 per cent allocated to housing, which is 15 per cent less than in the year 2007-that shift from 70 per cent to 85 per cent represents a significant increase in the proportion of assets allocated to housing over the last 20 years. In this chapter, you see the impact of changing allocations to housing on the personal balance sheets of Americans and the surprising impact that social capital--not human or financial capital-can make on your financial fortunes.

Floating Debt Obligations and Sinking Values One of the impacts of the shift of financial capital allocations to the personal residence has been that our financial fortunes now increasingly fluctuate in lockstep with the value of housing. As discussed in Chapter 3 ("How Much Debt Is Too Much and How Much Is Too Little?"), the 2007 Survey of Consumer Finances reports that 46 per cent of U.S. households have a mortgage on their principal residence. The average balance, in 2009 dollars, is about $153,000 (U.S.). But according to the website Moody', by mid-2009 a quarter of homeowners with mortgages were estimated to have mortgage loans that exceed the value of their house. In other words, more than 10 million American households have negative real estate equity, or what has become known colloquially as being upside down or underwater on your mortgage loan.

But notwithstanding the significant size and impact of the real estate market, and its rise or fall in any given period, it's important to understand that a house-whether financed with a large, adjustable rate mortgage or a small, fixed rate mortgage-contains aspects of both investment and consumption.

It is difficult to forecast-in mid-2009-if and when these indices and regions will improve, or what these numbers will look like in 2010/2011, but the fact remains that housing can decline in value, and for prolonged periods. It is definitely not a risk-free investment.

This distinction is basic, and it will not come as a surprise to anyone reading this book. And yet, it seems to me that this back-to-basics element of the housing money milestone has gotten downplayed in the discussions of housing over the past few years, which have focused on housing as an investment-whether "good" (when housing values are rising) or "bad" (when values are falling).

Back to the Holistic Balance Sheet Let's go back to basics and think about what happens to your holistic personal balance sheet when you buy a house. Most people finance the purchase of a home with debt, that is, a mortgage. In the good old (prudent) days, new home buyers would put down 20 per cent of the value of the house and finance the remaining cost of the house with a long-term 25- or 30-year fixed rate mortgage. Recently, people typically make a down payment of 2 per cent or 1 per cent or perhaps even zero, and finance the majority of the house with (volatile) floating rate debt that might take up to a century to pay off in full. In fact, according to the most recent U.S. Housing Survey, out of 70.2 million households, 9.4 per cent reported purchasing their home with a zero downpayment; and of those who moved to a different home within the past year, 16.9 per cent reported not having a down payment. These ratios increased considerably within the previous 10 years: in 1997, they were 6.1 per cent and 5.71 per cent, respectively. At first glance, when you buy a house for, say, $500,000, you are increasing the left side of your personal balance sheet (your assets) by $500,000 dollars. If you used $50,000 as a downpayment, which came from your own assets, the increase in assets was only $450,000.

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.

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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.

Sure, if you could buy a house that has a bedroom in New York City, a bathroom in Los Angeles, and a kitchen in Chicago and perhaps a garage in Las Vegas, yes, your home would be diversified. Buying a house as an investment has strong similarities to someone being convinced that stocks are good investment in the "long run," but they decide to buy only one stock for their portfolio. I don't care how reliable that one stock is, or how large are the dividends, that stock portfolio is not diversified. The same goes for housing.

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In addition, when you are young, your human capital and hence your total wealth is sensitive to the evolution of your wages and income over time. These two factors tend to decline in a recession and bad economic times, just like housing. In other words, there is a good chance that if your job wages take a hit, so will your real estate. I will actually touch upon this concept again in Chapter 8 ("Portfolio Construction: What Asset Class Do You Belong To?"), when I discuss the interaction between your future wages versus stocks, bonds, and other investments. For now, it is simply worth pointing out that if your wages are sensitive to economic conditions; it makes little sense to exposure a large fraction of your financial capital to the same factors by allocating a significant portion of your balance sheet assets to a house. In fact, evidence from the U.S.-based Panel Study of Income Dynamics suggests that controlling for levels of wealth, homeowners actually own less stock-based investments, compared to renters, possibly because of this same reason. Stocks are diversified, tradable, and liquid. Houses are not.

Housing over Time: A Human Capital Approach In sum, a strong argument can be made-absent all the psychic factors involved in the decision-that renting is the optimal choice when you are young.

However, when you are older (say 50 or 60) and you have unlocked a large portion of your illiquid and nontradable human capital and converted it into financial capital, you can afford to "freeze" some financial capital and lock into a home purchase. At that stage, not only do you have more wealth in total, but also your balance sheet (and especially your human capital) is likely not as sensitive to the state of the economy and its disruptive impact on wages. So, Mr. Spock buys his first house-after 25 years of renting-at the age of 50. (Says Spock, "Nowhere am I so desperately needed as among a shipload of illogical humans.") Now, you might justifiably worry here that if you (or Mr. Spock) don't buy a house when you're young, you might never be able to afford a house when you're older. I have heard many real estate agents say that it's important to get a foothold into the real estate market, or you will never be able to afford a house.

Well, I trust that the experience of the last few years has taken some of the air out of this argument. If you examine the inflation-adjusted growth in the price of an average house during the last ten years, as measured by the S&P/Case-Shiller Home Price Index, it equaled only 3.5 per cent. And this doesn't adjust for the often enormous cost of maintenance that is never captured in the long-term datasets.

There's one more dimension that impacts the housing decision and that is the increasing mobility of the labor force. This dimension results in a much higher probability that you might need to relocate for a job, career, or employment opportunities. This is yet another factor that increases the incentive to rent for as long as possible. There is nothing more disruptive to a smooth consumption path (and the practice of Long Division) as having an illiquid and unsellable house serve as an anchor to a region in economic distress.

Finally, if by renting a house (or condo or apartment) instead of buying as soon as possible, you are truly concerned you might miss out on the market, the authors of one of the articles I cited earlier suggest that you hedge and protect yourself against this risk by investing some money in a mutual fund that is linked to real estate prices, such as a real estate investment trust, or REIT.6 This way, you can participate in the increased value of housing, without having to mow a single lawn or unclog even one drain.

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If you would like to calculate the impact of rent-versus-buy decision in your own life, I have created a calculator that can help you work through some scenarios, so you can see what decision makes the most sense in your case and what the impacts are with different variables. Go to to do your own analysis.

The Missing Factor: Housing and Social Capital During most of this chapter (and this book), I have focused my efforts on teasing out the impact of human capital considerations as they apply to financial capital decisions, using basic rules of arithmetic. And yet, although I have emphasized these two forms of capital, I have so far overlooked a third form of capital, which completes the trinity: social capital.

Social capital-more so than human capital or financial capital-is not visible to the naked eye, is not easy to measure, and, unlike every other form of capital I've discussed to date, does not belong on the personal balance sheet. Social capital is loosely defined as the collection of networks, cooperation, relationship, norms, mutual aid, faith, and various other forms of "glue" that hold a community together. But what does social capital have to do with housing? There is actually a strong link between home ownership and social capital, which is one of the reasons policy makers in the United States (and, to a lesser extent, in the rest of the world) have encouraged and promoted homeownership.

Please note that I am not veering from my mandate of discussing money milestones and personal finance when I mention the role of social capital. The reality is that social capital also serves a smoothing function. How so? If you live in a community or society with high social capital values, you are much less likely to experience disruptions in your standard of living. Think about the neighborhood or community where you live. If you happen to run out of flour while baking a cake or need to jump-start your vehicle to get to work one morning, how many neighbors within short walking distance would you feel comfortable borrowing the cup of flour or jumper cables from? All of them? Some of them? None of them? And do you know the names of all your immediate neighbors?

These might sound like unimportant and even off-topic questions, but they can have a profound impact on financial matters. Although it doesn't belong on the personal balance sheet, social capital is an asset class you can invest in by creating it. Individuals can do this on a community-specific basis; for example, you can arrange a monthly "neighbors' barbeque" for everyone on the block. Specific communities (and religions and schools) can produce social capital as well. Researchers-mostly sociologists-have developed indices of social capital that they've used to indentify regions of the country that score highly, versus poorly, in this dimension. (Apparently Vermont and Minnesota score highly but Georgia and Tennessee do not.) At this point, you may be asking, what does all this have to do with housing?

Well, according to a recent study by researchers at the Federal Reserve Bank of Chicago and the Office of the Comptroller of the Currency; housing, social capital, and financial well-being are all intertwined. According to the authors, greater homeownership rates increase the social capital of a neighborhood simply because homeowners (versus renters) face larger transaction costs in selling their house and moving away. This reduced mobility incentivizes homeowners to invest in things that increase their property value, which, in turn, also creates more social capital. So social capital is created as a result of home ownership, and property values rise in the process as well. Although you might not think about the investment you are making when you lend that gallon of milk, the logic of investing in social capital is clear.

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Investing in Social Capital This relationship between social capital and financial well-being then manifests itself in a number of interesting ways. For example, the authors in the previously-noted study obtained detailed records of more than 170,000 individual credit card histories over a two-year period to observe individual payment behavior and bankruptcy filing status for each of these 170,000 individuals. The dataset contained enough information so that the individual's age, address, marital status, and homeownership status could be linked to their credit card behavior and in particular could determine whether they filed for bankruptcy protection during the two-year period.

Now, as you might expect, borrowers living in counties and regions with high unemployment and poor economic conditions and those individuals who have lower income and wealth status experienced higher default rates. No surprise there.

However, what is interesting is the following conclusion. I quote from their study: "An individual who continues to live in his state of birth is 9 per cent less likely to default on his credit card and 13 per cent less likely to file for bankruptcy, while an individual who moves 190 miles from his state of birth is 17 per cent more likely to default and 15 per cent more likely to declare bankruptcy." This, of course, is consistent with a social capital story under which the closer you live to your place of birth, the more likely you are to have vested social capital to protect. Along the same lines, it seems that married individuals are 24 per cent less likely to default on credit cards and 32 per cent less likely to file for bankruptcy. Finally, homeowners-and keep in mind that home ownership provides another proxy for social capital-are 17 per cent less likely to default and 25 per cent less likely to declare bankruptcy.

In sum, I suspect that people grossly underestimate their home ownership expenditures. They overestimate the amount by which the house will appreciate over time. They tend to live where they work (obviously), which means that their housing capital (which is a subset of financial capital) is exposed to the same economic risks as their human capital. And yet, the one thing an investment in housing might achieve is that it creates its own investment in social capital. Perhaps this one factor outweighs the many other negatives and makes this particular money milestone worth pursuing.

Summary: The Four Principles in Action •Americans (as well as Canadians) have ADDED significantly to their personal balance sheet allocation to housing over the last few decades. Housing can ADD to your net worth over time. However, even a small decrease in the value of housing can also SUBTRACT value from your personal balance sheet, and the effects of this subtraction can be MULTIPLIED if your household is over-allocated to housing.

•A more rational way to approach your need for shelter is to DIVIDE your spending on a primary residence, if you are a homeowner, into an allocation for shelter (meeting your consumption needs for shelter) and an allocation for investment. Another rational approach that has been advocated by a number of financial economists is to hold off on purchasing a house until you have converted a significant amount of your human capital into financial capital.

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•If the cost of the house, today, exceeds the value of your human capital, in all likelihood you shouldn't be a homeowner, period, regardless of how low the (current) monthly payments are or how low the interest rate is. This is likely another one of the most important concepts within strategic financial planning for individuals.

•The role of housing is also connected to another form of capital: social capital. The effects of investing in social capital can MULTIPLY your investment in your home, increasing your financial well-being-and that of your community-in surprising and unexpected ways. So, it's not only about the money after all.

Reprinted with permission by FT Press, by an imprint of Pearson.

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