What are you worth?

FOOD modified

Rick just read “Personal Finance for Canadians for Dummies,” and actually admits to it. “I found it interesting that it suggests not including your personal residence as an asset when calculating your net worth,” he says, ”unless you plan to live off the money you have tied up in it. It seems to me that is not how most homeowners would see it.”

Now Rick knows why the book is called that. If you don’t think your personal real estate is part of your personal finances, you probably live in a double-wide next door to a ‘76 Monte Carlo on cement blocks.

In fact I ‘ve noticed a number of blog dogs stumbling over this concept of net worth, especially when I talk about my Rule of 90. So let’s take a brief minute now (it’s July, what else do you have to do?) and address this basic action.

First, don’t believe what the pointy heads in Ottawa tell you. Recently StatsCan earned fat headlines saying the median net worth of Canadian families hit $243,800 in the latest period (2012), which is an increase of 45% since 2005. Realtors rejoiced upon hearing the news. Proof, they cried, that people are not overextended! Hosiah!

But that’s a bogus number. First, 30% of the net worth is made up of pension assets, which are not only years away from being received in most cases, but which may never be there since pension plans are under assault. More meaningful is the chasm now opening up between the wealthy and the rest. The richest 20% of Canadian families had a median net worth of $1.4 million, while the bottom 20% clocked in at just $1,100.

Overall, houses equal 30% of our collective worth. But since the bottom fifth rarely own a home, and the top fifth usually have diversified wealth, it’s the middle 60% who have overwhelmingly hitched their futures to residential real estate.

Well, how do you stack up? I’d be interested in knowing.

Net worth is the number that’s left after you subtract all liabilities from your total assets. It’s a key metric not only for talking the bank into lending you $175,000 for a sailboat, but also for charting a path to financial security. And yes, Rick, whatever your house is worth, and what it’s mortgaged for, are key elements in this discovery.

First, list what you own. That includes real assets: The house (use a conservative estimate of current market value, not what you paid for it). The Kia. The Elvis-on-velvet art collection. Then add in financial assets: cash on hand or in the orange guy’s shorts. RRSPs and tax-free savings accounts, per your current statements. Pathetic GICs and dead-end cash in your chequing account.

There is some debate about including the current balance in your company-sponsored pension plan, since most people have a defined-contribution plan and its ultimate value is completely unknown (and taxable). Ditto for your RRSPs, because this money is also pre-tax – in other words, a third or more of your retirement savings is actually owned by the government. Even teachers and civil servants with defined benefit pensions may think twice about adding in future benefits – unless you plan on commuting your pension (highly recommended) and taking over management of it upon retirement. It’s certain there will be an assault on government pensions over the next decade or two, as it already happening with some teachers, for example.

Now, deduct from this total what you owe. The mortgage is a biggie. Then the car loan, an outstanding line of credit or HELOC. Any investment loans. Credit card balances. Student debt. RRSP home buyer pay-back. Money the CRA is up your butt about. Unpaid bills.

The difference is your net worth. If it’s $283,400 then you are (according to a really flawed yardstick) a median person. Above $1.4 million, you’re elite. Below $1,100 and we’ll assume you wandered into this blog looking for a bathroom.

So tell us where you stand. And when your net worth is calculated, figure out how much your real estate equity (current value minus the mortgage) comprises of it. Tell us that, too.

For example, a $700,000 slanty semi in Leslieville with a $575,000 mortgage has equity of $125,000. If the hipsters owning it have $75,000 in other stuff (TFSAs, cash etc.), then of their $200,000 in net worth the house equals 64%. Is that too much? Not if they’re 26 years old. And what are the odds of that?

Well, over to you.

Venus & Mars

MOWER modified

Women hate debt. Men crave stuff. No wonder the divorce rate is half.

Books and sites on debt elimination are catnip to many females, while the testo crowd is drawn to the ‘hot tip’ junior mining stock destined to rise 600% in a week. Women seem happy in little houses with no mortgages. Men like vast spaces, status, and consider massive debt the bank’s problem.

In normal times, she wins. But these days are anything but. Cheap money has spawned elephantine debt, made house prices insane, created a wealth effect as real estate bloats, and convinced everyone this is the new normal. So, what’s the best course of action? Load up on loans to buy stuff you’d otherwise never afford, or take advantage of this historic rate break to pay off indebtedness fast?

Well, depends how much you’ve gambled on your house. For example, if you ignored my Rule of 90 (ninety minus your age determines how much net worth should be in a home), and put all your money into a down payment then took on a fat mortgage, you need to recover.

There are effective ways to do that. Making annual lump sum payments, or adding 10% extra to each monthly cheque, for example. You can chop down on the amortization period every time you renew. You can switch to weekly payments and trash the mortgage years sooner. (Ensure you get the right kind of weekly – installments equal to 25% of the monthly.) Or, invest your new savings for growth, then dump a bigger amount against the principal at the end of the term.

The goal should be not only to pay down the mortgage faster, if a house is your only asset, but to ultimately reduce debt servicing costs so you can diversify. That’s what wealthy people do. They don’t have all of their eggs in one basket, at one address, in one city. With real estate values at historic highs and household debt extreme, the odds of a reversal are great. Besides, a one-asset strategy is just gambling in a world where nutbars shoot down airliners and the climate’s screwed.

Diversification means having financial assets as well as real ones. They should first go into your TFSA, then a non-registered account and some RRSPs (best used for income-splitting). I’ve written at length on what to buy, and in what proportion – including bonds, preferreds, trusts and equity ETFs. For most people: no gold, no individual stocks, no GICs.

And once you do build up a reasonable amount of liquidity, the strategy of busting your mortgage is far less compelling. Sorry, girls. But in a world where real estate debt is cheap, and often tax-deductible, you might actually want more of it.

A survey published a few days ago shows lots of people get this. Done by Investor’s Group (yes, those guys with the 1.99% three-year home loan deal) it asked Canadians with at least $500,000 in investible assets (besides their house) about mortgages. The poll found almost 70% of these high net worth folks could pay off their mortgages with cash if they wanted to, but many chose not to.

Huh? Isn’t it the holy grail of people like Gail Alphabet and almost everyone with estrogen and a Bichon Frisé to get that home loan trashed, above all?

Nope. Not the wealthy ones. And there are two big reasons.

First, investors with financial assets have done extremely well over the last five years. Stock markets are up over 150% and balanced portfolios have been delivering roughly twice the annual returns seen in real estate. Even those with conservative portfolios half in fixed income have seen 10% or better gains, and sailed right through the 2008 fugliness.Why would they cash in all of it, triggering capital gains taxes, just to pay down a mortgage at less than 3%?

Remember the latest inflation number? It’s now about 2.5%. So isn’t a mortgage at anything less than prime pretty much free money?

Secondly, wealthy people know about diversification. They like to own lots of assets, instead of shouldering debt on just one. So if you have a $400,000 mortgage costing you 2.4% (TD’s new two-year rate) and your $400,000 balanced portfolio is making 13% (the YTD 2014 return, annualized on a 60-40), why pay debt off? That would simply consolidate all of your net worth into one asset – a mistake the kids make – and exacerbate risk.

Says an IG guy: “Mortgages provide access to lower-cost funds than many other lending facilities because they are seen by the lender as being fully secured, and have a built-in cushion (equity portion) in the event that the value changes over time.” And he’s right. In our house-horny culture even the bankers have been smitten by the false security of real estate.

Of course, lots of wealthy people also happily incur mortgage debt when the interest can be deducted from taxable income. So, the minute some folks pay off their mortgage they take a new one for up to 65% of the equity, invest the money in financial stuff, and create a fat tax break.

In short, a house and a mortgage are part of an overall financial plan. They are not a plan on their own.

He wins. Ouch.