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Column: Is your home an investment or a liability?

Editor’s Note: In “How To Retire With Enough Money: And How To Know What Enough Is,” economist Teresa Ghilarducci lays out the financial advice you need to retire comfortably in a neat 100 pages. In the excerpt below, Ghilardcucci explores how your home fits into that retirement picture.

I often advise that your allocation should be split up between stock and bond funds, but I’m aware that for many Americans, there’s another significant investment in the picture: their home. Whether your home should be considered an investment or merely a place to live is a debate that’s heated up since the subprime-mortgage disaster of the early 2000s. The causes of that debacle are beyond the scope of this piece, but it’s worth noting that America’s fixation on home ownership predates the housing bubble of the 2000s. Since long before that, the real estate and lending lobbies have been telling Americans (and Congress) that home ownership is essential to happiness and prosperity, that a mortgage-interest deduction is some kind of gift and that a mortgage is “legitimate” debt. It’s now virtually an article of faith that “home ownership is the American dream!”

If you think that 300-million-plus people all dream about the same thing, check your math. (Plus, most historians would tell you that inasmuch as there is an “American dream,” it is upward mobility, not home ownership per se). However, there are circumstances in which buying makes sense. Owner-occupied housing is often of better quality than rentals, for example. And in certain markets, at certain times, housing can appreciate so quickly that it outpaces an owner’s mortgage costs. These are situations in which it may make more sense to take out a mortgage than to keep renting. Because although buying with cash is the ideal, it isn’t feasible for most people — a good rule of thumb is that your home’s price should be about two and a half times your annual income, and saving up that amount is a daunting prospect.

However, aging households tend to shrink, as widowhood, divorce and children leaving the nest reduce household size. In later years, you might find yourself with what I call “too much house.” In that case, it’ll probably make sense to liquidate, downsizing to a smaller house or even renting. The pro-home-ownership arguments aren’t as valid when you reach the downsizing stage.

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Here are a few things to consider when deciding if continuing to own a home is right for you. The tax advantage: Is it worth it? Americans worship at the altar of the Almighty Mortgage-Interest Deduction, but it works out only for people who itemize, which most lower- and middle-income people don’t do, because for them the standard deduction is worth more. Another way of saying this is that most lower- and middle-income folks pay less income tax if they take the standard deduction than if they itemize their deductions. Even if having mortgage interest does nudge you into the territory where it makes sense to itemize, bear in mind that the mortgage-interest deduction pays off most for the highest-income taxpayer.

Let’s compare a middle-class person with a federal tax rate of 28 percent and a high earner with a taxable income in excess of $400,000, whose tax rate is about 39 percent. (These rates fluctuate, depending on what Congress does from year to year). The middle-class person would save 28 cents in income tax for each dollar of home mortgage interest, whereas the taxpayer in the highest bracket pays 39 cents less per dollar. But either way, both of them are paying a dollar to the bank to get this deduction.

The bottom line: The math never works in an interest payer’s favor, but the person with the highest income gets the most help from the government to buy a house and pay the bank interest.

And there’s another question for you to consider: Are you really diversified? If nearly all your net worth is tied up in your house, you’re at risk. Your money would be safer in a broad portfolio of stocks and bonds.

And that’s a problem. It’s hard to lose your entire investment in a house (although as we saw in the recent downturn, it does happen), but you’re not shielded against temporary downturns in home values. Nor is a house a liquid asset you can easily tap into in times of need (say, unexpected medical costs). As long as you need to live in your home, its value is mostly an abstraction. Of course, you can borrow against it, but that entails a whole new set of payments alongside your mortgage — with more interest, of course. Great for a lender, not so good for you.

How does rental housing stack up to real estate in your area? The quality of rental housing is good in some places, not so great in others. It may be worth it to buy instead of rent if you’ll get a better home for a comparable monthly expense.

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A final note about this: As I mentioned before, it often makes sense to sell your home if divorce, widowhood or grown-and-flown children have reduced your household size, say, from four people to one. Here’s a good rule of thumb for whether you should sell your house: How much of your income is going toward your mortgage? If you can barely make the monthly payment, you have too much house. Liquidate, cash in on the equity you have and invest that money in an index fund.

To see how housing decisions play out in real life, let’s visit two hypothetical people: Jennifer and Paul.

Jennifer is a 57-year-old real-estate broker earning $125,000 a year. She has $500,000, from a divorce settlement and an inheritance, and she rents her apartment. The money is not in a 401(k) or IRA account. Given that it’s Jennifer’s goal to work through age 67, as well as her comfortable savings, she is on track for retirement on her terms. However, one dilemma that might arise for her is whether she wants to keep renting for the rest of her life or buy a home. (Given that she’s in real estate, we can imagine that Jennifer hears this question from her colleagues a lot.)

My advice is that if Jennifer knows where she wants to settle down permanently, it’s a good idea for her to buy a home, especially since as a broker, she’s likely to be a very competent negotiator. But she shouldn’t be confused by budget experts who advise not spending more than one-quarter to one-third of her monthly income on housing. And neither should you. Here I have figured that Jennifer shouldn’t pay more than $180,000 for a house, which will cost her about $10,000 a year in maintenance and taxes. That $10,000 is about 10 percent of her take home pay, not one-third to one-quarter of her income. People with lower incomes spend a third of their income on housing; people who have more money and more costly things in their lives, like travel and expensive health care, spend a smaller portion of their incomes on housing. Also, that expert budget advice is not for young people who can expect higher incomes as they grow older. Jennifer is no spring chicken. Earnings fall for workers after age 50, especially for college-educated workers (promotions are less frequent and new jobs often pay less than previous jobs). Jennifer’s basic expenses should be on the conservative side, so as she ages she has room to pay for expected and unexpected costs of growing older. The bottom line: She should not buy a more expensive house that will eat up her capital, especially in taxes and maintenance.

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If Jennifer were trying to qualify for a 30-year home mortgage, the bank would say that based on her income of $125,000 per year and average interest rates and taxes, she could buy a home costing as much as $270,000. However, let’s say she doesn’t listen to me (or the bank) and buys a $212,000 home, making a 20 percent down payment ($42,400) and taking out a loan of $169,600 with a 5 percent interest rate. Jennifer would pay more than $150,000 in interest on that home over 30 years! Granted, she’d recoup some of that from the mortgage-interest deduction on her taxes. But remember my rule that there are two sides of the interest rate: earning and paying. Jennifer (like you) is much better off on the earning side. For that reason, she should pay cash for her home. A mortgage at her age isn’t a good bet.

True, people often justify a mortgage because buying gets you better-quality housing than renting, since landlords generally don’t maintain housing quality. But wanting better-quality housing is an argument about consumption, not investment. Consume only what you can pay for. If you want better housing for the money, buy a less expensive house, one with a mortgage that you can pay off in two to seven years. Peg your housing budget to your annual income; that’ll give you your target neighborhood and lifestyle.

There is one argument for taking out a mortgage, though it’s rarely valid in reality. If you buy when the housing market is heating up, so that the value of your property appreciates at a greater rate than your mortgage-interest rate, then it’s a small win. The problem is, no housing market will stay hot over the length of a typical mortgage. And there’s always risk involved in buying housing; a market downturn could happen. Paying off the bank, however, is a sure thing.

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The bottom line: Jennifer should pay cash for the house, keeping the interest she would have paid the bank for herself, and she should hold down yearly housing expenses to less than a quarter of her income. If she lives in a market with such high home prices that buying a $180,000 home for cash isn’t a possibility, it’s better for Jennifer to keep renting.

Now we turn to Paul, a widowed salesman. He’s healthy, frugal and a DIY type, but he’s also amassed no savings. His chief asset, really his only one, is the house he inherited from his wife. So shouldn’t he sell it? He could invest the proceeds, and isn’t that a good thing given his precarious financial state?

Actually, no. Paul needs a place to live, and remember, the house is paid off. That doesn’t mean he lives absolutely free; there are property taxes and insurance to pay. But no rental on the market costs as little as those two monthly expenses, so Paul should stay put. A better idea is for him to take in a renter, turning his house into a source of income and a way to pay for a new furnace and other maintenance costs.

Reverse mortgages: deal or no deal?

The reverse mortgage has become very popular in the last decade or so. Here’s how it works: Provided a homeowner is 62 or older, lives in the home and isn’t carrying a mortgage that exceeds the value of the property, he or she can get a loan against it — as a lump sum, a series of monthly payments, or a line of credit — without repaying it. Instead of the monthly payments that a traditional mortgage requires, the interest accrues, giving the lender an ever-larger stake in the property. The loan comes due when the homeowner dies, or sells the home or, in some cases, defaults on property taxes.

Several things seem to make this kind of loan attractive. First, it allows homeowners to get at their home equity without selling — the appeal to senior citizens, many of whom have spent decades in their homes, is obvious. Second, because the home is collateral, there are no income requirements for this loan. Third, and probably most appealing, is the “no required repayments” clause (though if the homeowner chooses to make payments on the loan, there is no pre-payment penalty).

I’m not sold on reverse mortgages. Neither are the AARP and consumer-protection agencies. These loans tend to have high up-front fees and interest rates. They can be risky for younger retirees, especially if their home is a large part of their net worth. The problem here is that you might spend down the proceeds of the loan and then be left with very little in assets late in life, when costs such as long-term care still loom ahead. A secondary concern is heirs. If it’s important to you to leave a substantial estate behind, this is probably not the right loan for you.

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The bottom line: These mortgages vary in their terms from lender to lender, and every borrower’s situation is different. When in doubt, talk to a fee-only financial planner or look up the excellent articles on reverse mortgages done by AARP.org or bankrate.com. If you proceed down this road, counseling will be required before you sign, so listen and ask questions.

Of course, the most financially advantageous way to tap the equity in your home is the most obvious — sell it. But another factor plays into that decision: your emotional attachment to the home, something that’s hard to put into financial terms. Still, long story short, you’ll pay a price for holding on to a large house as a solitary widow or widower or as a couple with no children living in the home.

All of this circles back to the following advice: Downsize now. If you’re ready to start living on 70 percent of your current income, trading down to a smaller home — renting one, in some cases — can get you a long way toward that goal. Plus, there are two advantages to liquidating your house earlier rather than later. One, you’ll be diversified, thus safer, right away. Two, you won’t put yourself through the stress of a move later in life and will have time to build up a fund of good memories in your new home. As a result, you’ll avoid being emotionally tethered to a property when you’re older and it’s harder to move.

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