Buying a home is a major investment, and not just because it costs a lot of money. Over time, real estate prices tend to rise—especially in high-growth neighborhoods—which means if you take good care of the property, you should see a positive return on your investment, or ROI.
Because of this, and because homes tend to be expensive, many people who buy houses have much of their net worth (the sum total of all their assets, including home equity, other investments, and cash, minus liabilities like debt) tied up in equity in the home.
In some respects, this is a good thing; houses tend to be relatively “safe” investments, and the more your property value grows, the more your net worth will grow with it. However, having too much of your net worth tied up in a home can also be problematic; it exposes you to more risk, and prevents you from pursuing other investments.
So how much of your net worth “should” be allocated to your home? And how should this affect your home buying decision?
“Normal” Net Worth and Home Equity
Let’s start with a brief discussion about what’s “normal” in terms of home equity and net worth. Though what’s typical isn’t always what’s best, it can help you understand how home equity often plays into net worth. For people less than 35 years old, the median net worth is $6,676, but excluding home equity, is $4,151. Home equity here is a minority of overall net worth, but the gap isn’t very big.
As people get older, home equity tends to increase, both overall and in proportion to overall net worth. This is because many home equity gains are passive, a result of regular mortgage payments and steady increases in real estate prices, and homeowners paying off a massive home loan may not have much extra money to invest in other areas.
For Americans 45 to 54, the median net worth is $84,542, but excluding home equity, is just $25,006. That gap grows even bigger over time, with Americans aged 75 and older having a median net worth of $155,714, but excluding home equity, just $20,366.
The Advantages of Home Equity
Homes, and real estate in general, are a great investment. Having your net worth in the form of home equity can be advantageous. For starters, the real estate market, despite its ups and downs, is relatively stable. You don’t have to worry about your house suddenly becoming worthless, and even if it does (due to a natural disaster), you’ll have an insurance policy to back up your savings.
On top of that, you likely purchased your home with a down payment and a mortgage. This gives you financial leverage, giving you the ability to purchase an asset you otherwise wouldn’t be able to afford. Over time, your investment has the potential to grow even faster because of this, especially if you get a good deal. This is also an easy investment for most homeowners to comprehend; just making your mortgage payments every month will increase your equity over time, without requiring you to make an extra concentrated effort to save additional money.
The Advantages of Other Forms of Equity
Home equity does have some limitations, however. For example, it’s not a very liquid investment; selling your home can take weeks to months, if not longer in some markets, which means you won’t have immediate access to your investment. Real estate, while a reliable way to generate a respectable return, is also just one type of investment. Other investments may offer higher yields (along with higher risks) and exposure to other types of markets. Spreading your net worth across multiple sectors and types of investments will reduce your likelihood of seeing your net worth plummet due to a crash in just one area.
There are also advantageous savings and investment programs to consider, many of which have distinct advantages over simply buying a home as an investment. IRAs and employer-sponsored programs like 401(k)s.
Some sources suggest allocating somewhere between 25 and 40 percent of your net worth to real estate, including your home. This allows you to capitalize on the advantages of real estate ownership while giving you plenty of flexibility to pursue other avenues of investment and wealth development. Obviously, this varies with your age, risk tolerance, and other factors. But the average American has too much of their net worth tied up in a home; for Americans over 75, it represents nearly 87 percent of their total net worth.
Buying Your Next Home
So how exactly should this information influence your next home buying decision?
First, it’s a good opportunity to take inventory of your current assets and your investment strategy. Are you happy with the state of your portfolio? How much is your current net worth, and where would you like it to be in 10 years?
Second, it should help you decide how much home you can afford. If you don’t have many other investments, it may not be a good idea to buy the biggest or most valuable house you can possibly afford. Buying a smaller or more reasonable house could give you a chance to save more money monthly and allocate that money to complementary investments.
Finally, it’s a chance to figure out how much of a down payment you should provide. It’s usually a good idea to put 20 percent down, if you can afford it, but depending on how the rest of your net worth is allocated, more may not necessarily be better.
Buying a home is a tough and complex decision, but you don’t have to go it alone. In fact, you shouldn’t go it alone. Working with a buying agent is a solid way to ensure you’re getting the most for your money. Contact Green Residential today to learn more about our process, and how our buying agents can help you find your next dream property.