The importance of asset ratios.
Your home is the biggest investment you will make in your life! How many times have you heard this from real estate agents? Of course the people whose job it is to facilitate as many real estate transactions as possible wouldn’t have any other incentives…..
However, for the majority of people, the agents are right. The family home is the most valuable asset most people own and makes up the majority of their net worth.
Why is this a problem? Aside from spending issues during a client’s working lives, the biggest predictor of poor retirement outcomes we see is over capitalizing in your home. Funnily enough, buying a bigger house than you should and spending all your money while you are working are both forms of consumption.
Your principal place of residence is not an investment asset. It is a form of consumption.
Here at Evolution Financial Planning we define an investment asset as an asset that produces an income. Your home doesn’t produce an income and therefore is not an investable asset. Every dollar you sink into your home is a dollar that can’t be invested.
I think that a ratio to work off would be 1:1, that you should have as much in investable assets as your house is worth by the time you retire. Therefore, if you have a $1,000,000.00 house you should have at least $1,000,000.00 in investable assets in retirement. The reason for this is generally, a person’s house is an indicator of their lifestyle and a more expensive lifestyle will require a higher income in retirement to sustain.
However this is a minimal suggestion. I think a ratio of 2:1 would be a more optimal goal, $2,000,000.00 in investible assets to a $1,000,000.00 house.
How might you get there? Let me give you a couple of examples. In each example we will start at age 30 and take out a 30 year mortgage at 6%. We will assume that the stock market does 10% a year and the value of your home appreciates at 3% per annum. The reason I have chose 3% is to represent inflation. As much as we are all told property doubles every 7 to 10 years, the long term data does not support this. This is a simplified example but it shows the power of living within your means.
In the first example our 30 year old purchases a $1,500,000.00 house. The mortgage on this is $9,003.00 per month. Because they have borrowed up to their maximum, they have not been able to invest any excess cash. By the time they are 60 and ready to retire their house will be worth $3,640,894.00 but they will have nothing invested and will be unable to retire.
In the second example, our 30 year old purchases a $1,200,000.00 house. The mortgage on this is $7,205.00 per month which means our 30 year old has $1,798.00 per month to invest. By the time they turn 60 their house will be worth $2,912,715.00 and they will have $3,549,123.00 in investments (assuming they never got a pay rise and increased their contributions. In this example our 30 year old’s investments would be worth 1.2x the value of their home. This would provide for an income of $177,456.00 per year in retirement which would be worth around $74,000.00 in 2023 dollars.
In the third example, our 30 year old purchases a $1,000,000.00 house. The mortgage on this is $6,006.00 per month which allows them to invest $2,997.00 per month. By the time they turn 60 their house will be worth $2,427,262.00 but their investment portfolio will be worth, hold onto your hats, $5,915,863.00. The value of their investment portfolio would be 2.4x the value of their home and would provide an income of $295,793.00 per year or $123,247.00 in 2023 dollars.
This is the power of investing more. Live modestly, purchase the home you need instead of the biggest house you can, invest the difference and you will set yourself up for a comfortable retirement.
