Home Equity & Asset Allocation

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SPX4me
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Joined: Sat Aug 29, 2020 3:53 pm

Home Equity & Asset Allocation

Post by SPX4me »

Hi all, I’m new to the forum, and have enjoyed everything I’ve read thus far. Apologies if my question has been answered dozens of times already, or if I’m posting this in the wrong area. (While I’m new to the forum and haven’t spent much time studying asset allocation, I am not new to the stock market. I’ve been investing for many years, and my career involves following the market on a daily basis.)

My question is how you think about home equity in the context of asset allocation (be it 80/20 or otherwise). I paid off my house last year, and it is now a significant portion of my net worth. After paying it off, I increased the amount of my exposure to the stock market as well. On one hand, I feel I’m aggressive with a significant portion of my liquid assets concentrated in one index (S&P 500). On the other hand, almost half my net worth is in my home, which should reduce the volatility of my aggregate net worth.

My net worth approximately breaks down as:
  • 45% home equity (fully paid off, no mortgage)
  • 45% stock (about half from 401k and half from taxable accounts, essentially all in S&P 500)
  • 10% cash (18 months of expenses)
Part of why I’m asking is that I’m considering reducing my cash holding further. (The thread on whether Emergency Funds are necessary was a good read.) I know that risk tolerance varies by individual, but I'm trying to get a sense of where I am on the spectrum.

Thanks all,
SPX4me
sport
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Re: Home Equity & Asset Allocation

Post by sport »

Welcome to the forum.

I don't consider home equity at all when choosing an AA. While it is certainly part of my net worth, it is not part of my investment portfolio. I am retired and our home has long been paid off. It is not practical to use the house equity for rebalancing, tax loss harvesting, etc. I consider the home a place to live, and the portfolio a thing to have an AA.
NorCal13
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Re: Home Equity & Asset Allocation

Post by NorCal13 »

I'd agree with the prior poster on separating AA and NW as it pertains to your home in general.

One thing that others here have suggested is to reduce your exposure to RE in general in your investment allocation if you feel your NW is disproportionately in your home. So less REIT exposure for example. Not a material difference overall since that allocation should be low anyway but might make you feel a bit better. That and it might stop you from buying that 2nd home :)

Psychologically, as I get closer to 'winning the game' (and ultimately got there), having a nice portion of the NW in my home equity outside of the portfolio allocation helped/helps me along the way to justify taking a bit more risk (+5% say) on the equity side. Why? I figured my home equity is a nice 'emergency mental ripcord' if things got inexplicably dire (you know the .00001% thing). Knowing that we *could* then sell, downsize or move a MCOL place for example gives me more courage (but not bravado).

Many here wont' need such a 'crutch' but I do...YMMV!
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Cyclesafe
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Re: Home Equity & Asset Allocation

Post by Cyclesafe »

Tempting yes. But doing so is a lie to yourself to justify more equity. If you think you can tolerate more volatility just pile it on. Don't hide behind your house (or your social security or SPIA's etc.).

BTW, if the stock market tanks, it might not be the best time to sell your house.
"Plans are useless; planning is indispensable.” (Dwight Eisenhower) | "Man plans, God laughs" (Yiddish proverb)
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SPX4me
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Re: Home Equity & Asset Allocation

Post by SPX4me »

Thanks guys. I'm still struggling a bit with this, but I think I'm getting closer to putting my finger on what's bothering me.

I think a way to summarize it is that I see different scenarios that could significantly alter my risk profile, yet each scenario has a 80/20 split of my non-home assets.

To illustrate, below are 2 asset allocation scenarios.

Scenario 1, which is my current breakdown - % of net worth, and this time also including % of non-home assets
  • Home Equity 45% of NW (n/a % of non-home assets)
  • Stock 45% of NW, (82% of non-home assets)
  • Cash 10% of NW, (18% of non-home assets)
Scenario 2 - this is a scenario I could've entered if I didn't choose to pay off my house last year. I assume I could also do this today if I choose to take on debt against my house
  • Home Equity 20% of NW (n/a % of non-home assets). This is really an asset of 45% and debt of 25%
  • Stock 65% of NW, (82% of non-home assets)
  • Cash 15% of NW, (18% of non-home assets)
So both scenarios have non-home asset allocation of 82/18. But isn't scenario 2 significantly more risky? While it does have more cash, it has 65% of my NW in stock, and debt of 25% of my NW in my mortgage. What am I missing? If you agree with me so far, couldn't I argue that at least some of the money I put into my house was the same as putting it in an illiquid fixed income product with yield equal to my old mortgage? Or maybe you guys are implying that it's less risky to have a leveraged position with a larger cash/emergency fund than a non-leveraged position with less cash?

I'm not really itching to put more into the market, but I want to better understand the implications of my decision to pay off my house. I've read elsewhere that people don't even consider primary residence home equity in their net worth calculation. I get that you need a place to live, and that it's illiquid, but I can't get my head around the idea that my NW declined when I paid off my house, and that it would increase again if I took out a loan.
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camillus
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Re: Home Equity & Asset Allocation

Post by camillus »

This is a tricky question. How do home equity and a mortgage figure into AA? Bogleheads will normally recommend someone with a large mortgage to invest in a 80:20 AA, for example. They will also caution someone from taking a cash out refi on the same paid-for house to make the same investments.

There are a lot of (irrational) assumptions & biases in all of these recommendations.

Ultimately, your AA - or how much risk you take - is a tool that you use to manage your own behavior. The goal of the stock bond split is to avoid behavioral error, that is, selling at a loss due to stress. Rather, rebalancing requires you to buy low and sell high.

So I think the more important question is how much risk you feel you are able to take. My impression is that having a paid-for house reduces stress significantly and allows you to take more risk without losing sleep.
KlangFool
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Re: Home Equity & Asset Allocation

Post by KlangFool »

OP,

1) You have a house of price X. Your exposure to the risk of the house's value going down does not change whether you pay off the mortgage.


2) So, the only difference between paying off the mortgage or not has to do how much money/risk exposure outside the house.


In scenario 1, you have less money/risk outside the house basket. In scenario 2, you have more money/risk outside the house basket.


So, do you think it is more or less risky to be in scenario 1 or 2? You could make an argument for either one and you would not be wrong.


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KlangFool
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Re: Home Equity & Asset Allocation

Post by KlangFool »

OP,


I do not include house/home equity/Emergency Fund into the asset allocation. I cannot rebalance the house/home equity/Emergency Fund. Hence, they cannot be part of my asset allocation.


If your house value goes up by 30%, you are not going to sell the house and invest the extra money into the stock/bond.


KlangFool
capsaicinguy
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Re: Home Equity & Asset Allocation

Post by capsaicinguy »

KlangFool wrote: Sat Aug 29, 2020 8:53 pm OP,


I do not include house/home equity/Emergency Fund into the asset allocation. I cannot rebalance the house/home equity/Emergency Fund. Hence, they cannot be part of my asset allocation.


If your house value goes up by 30%, you are not going to sell the house and invest the extra money into the stock/bond.


KlangFool
This is also generally how I think of a house as well when it comes to my AA. I just try to minimize it's total expense to me while making sure I'm meeting my investment goals. By keeping to a 15 or 20 year fixed mortgage it lets me sleep better at night with a more aggressive AA with investments. Best of both worlds IMO. :sharebeer
tryingtogetahead
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Re: Home Equity & Asset Allocation

Post by tryingtogetahead »

OP, I was in a very similar situation to you recently with a fully paid-off home that represented a large percentage of my NW (23%), except that I also had some rental properties with significant equity in each of them. I think your age and NW are also big factors. How old are you and what is your NW? I recently did cash out refis on my rental properties, got lower interest rates, and invested the cash in stocks. This further diluted my RE exposure.
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tennisplyr
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Re: Home Equity & Asset Allocation

Post by tennisplyr »

I have no mortgage on my home and while I consider it part of my net worth, I don't consider it part of my investable assets or AA.
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mojorisin
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Re: Home Equity & Asset Allocation

Post by mojorisin »

KlangFool wrote: Sat Aug 29, 2020 8:53 pm OP,


I do not include house/home equity/Emergency Fund into the asset allocation. I cannot rebalance the house/home equity/Emergency Fund. Hence, they cannot be part of my asset allocation.


If your house value goes up by 30%, you are not going to sell the house and invest the extra money into the stock/bond.


KlangFool
This is accurate.
I count it in my net worth but not AA.
You cannot "manage" your home as an investment like an ETF.

My point of view: a home is an expense not an investment as it likely costs more to own annually than the return when the opportunity cost of stock returns is added in (there are exceptions in high growth markets of course). Of course you need somewhere to live, and there is personal quality of life value in a nice home with a family. With interest rates low, I've always kept about 40% equity in my home then invested the rest vs. paying down my home aggressively. I'm locked in at 2.35%. I have 5x in investments than the balance of my mortgage so I can pay if off at anytime but I'm still 10 years from retirement. My investment portfolio is running faster than if I owned my home. So my plan is to get to my retirement number for savings then I have the choice to pay down my home later or pay extra for a couple more years.

I have friends who aggressively paid off their homes when they were younger, I invested heavily. This strategy has worked out way better for my bank account than theirs. However this is just my view... YMMV.
alluringreality
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Re: Home Equity & Asset Allocation

Post by alluringreality »

In terms of financial assets, I think of Scenario 1 as stocks and cash without debt, and I think of Scenario 2 as stocks and cash with debt. In the following thread petulant describes Scenario 1 as efficient and Scenario 2 as inefficient, due to the debt. Generally Scenario 2 might be considered the riskier portfolio, due to the additional stock holding. Some people may describe Scenario 2 as having a stock allocation higher than 100%, since the debt is larger than the cash. It's definitely debatable if Scenario 1 and 2 are necessarily equivalent when holding the same asset allocation. Since I am carrying debt that I'm paying off across time and holding a constant allocation, I tend to think of that as actually lowering my stock allocation with time as the debt decreases, sort of similar to the idea of an allocation glidepath.
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bertilak
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Re: Home Equity & Asset Allocation

Post by bertilak »

Investable assets must be liquid assets. Home equity is not very liquid.
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grabiner
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Re: Home Equity & Asset Allocation

Post by grabiner »

A home is not part of your asset allocation, but it affects your asset allocation because it changes your risk tolerance. I prefer to view the home as working more like an annuity; if you own a home, you have a place to live at a cost much less than it market value.

If your portfolio loses 20% but half your retirement standard of living comes from things outside the portfolio (such as a home), your standard of living declines only 10%. Therefore, you can have a more aggressive allocation if you own a home.

A mortgage works the other way. If you have a $1M portfolio and a $500K loan (of any kind), a 20% decline in your portfolio reduces the amount you can spend from $500K to $300K, a 40% decline. Therefore, you should have a less aggressive allocation if you have debt, whether from a mortgage or a student loan. Here, a possible adjustment is to treat the loan as a negative bond.

I did both of these when I bought my home. I changed my asset allocation to 100% net stock, so I would have held all stock if I had paid cash for the home. Instead, I held a bond balance exactly equal to my mortgage balance.
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dharrythomas
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Re: Home Equity & Asset Allocation

Post by dharrythomas »

The house you live in is a lifestyle expense. It is a balance sheet asset that comes with associated ongoing liabilities (taxes, maintenance, utilities, home improvements). It is not an asset that creates an income stream.

Beyond which, residential real estate is a location play. In most area of the country, where there are not extreme restrictions on development, long term returns just about track inflation. I’m talking about the house you are living in, talking is an opportunity to make money as a landlord regardless of property appreciation.

So it belongs in you net worth (less transaction costs, whenever my wife wants to move I subtract $20-25K from my estimated price to account for all the friction), but not your Asset Allocation. You could get more fancy, but that’s about where the computations would come out.
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