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

Book Excerpt No. 2

Many homeowners should have rented Add to ...

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.

Moshe Milevsky, Associate Professor of Finance at the Schulich School of Business at York University and executive director of the Individual Finance Insurance Decisions Centre

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.

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'sEconomy.com, 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.

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