The Conventional Failure of Wisdom with Regard to Home Investments

The general public believes that their home is an asset.   "Assets" are within the realm of investing, finance, accounting and business administration.  That said, a primary residence is almost never, let me repeat that, almost NEVER an asset.  Surprised?  In disbelief?  Think I'm an idiot?  Keep reading!

In business, there are assets and there are liabilities.  Assets are things of value that, for lack of a better way of saying it, create income.  This is important to understand.  I like to think in the mindset of a business owner, as the vast majority of wealth in our Country is created and held by business owners.  For a business owner, an asset is something used to generate income.  Liabilities represent debt.  Most often, that debt requires a periodic outflow of funds called expenses.  So, there in a nutshell is the relationship between Assets and Liabilities, and Income and Expenses.

Now, back to the primary residence - Even when the home is without a mortgage (liability/debt), it is still not "owned."  Let me say it this way; in professional parlance, a home is known as Real Estate.  Real Estate does not mean an estate that is real.  The term "real estate" comes from a Spanish derivative meaning "royal estate."  This is to say that the property was "owned" by the royalty.  Today, it is our government who really owns the real estate.  Even if you don't have a mortgage, just try getting away with not paying the taxes on it.  The taxes are the government's charge to us for using its land and whatever is on it and they will make it plainly clear who really owns the real estate if the taxes go unpaid.  So, even without a mortgage, the primary real estate is never owned, and is therefore not a real asset.

However, real estate can become an asset if it creates income that offsets the expense.  The simplest example of this is rental real estate.  Rental real estate generates income through rents.  If the rents exceed the expenses, then the net result is income, tied to an asset.  By the way, if the rents do not exceed the expenses, then you've still got a liability on your hands. 

The same can hold true for a primary residence.  Let's assume a residence is purchased 100% for cash.  First, we know that this still does not make it an asset.  However, cash is an asset.  If the home investor holds onto the cash and purchases the property by taking a mortgage (liability) instead, then there is something of an offset.  But since mortgages require an interest expense, the net would most likely be an expense, which comes back to a liability.  To turn this situation into an asset/income scenario, the cash that is held must be invested in a real asset that generates income in some form or another.  For most people, this income would be in the form of interest or yield, otherwise known as Return on Investment.

So, the simple solution is to invest cash that would have otherwise been placed into a liability (the home) and instead put it where it will generate an income greater than the expense associated with the mortgage.  This is actually easier than one might think.  I often use the S & P 500 as an example for ease of understanding.  Historically, over the past 85 years or so, the S & P has generated an average annual return of a bit over 10%.  A mortgage, by comparison, will carry a charge of, let's just say 7%.  For someone in a combined (state and federal) marginal tax bracket of 33%, the real interest charge associated with the mortgage is 4.7%.  This means that the money invested in the S & P would, historically, net a ROI of 5.3%.  In this scenario, the home real estate is now part of an asset-generating plan that goes further to create incremental wealth.  

Let me close by giving an example.  Suppose a home is purchased for $200,000.  Using the information above, the client could invest the money, take a mortgage, and through the differences between interest expense and income, create incremental wealth of over $151,000 in 15 years. 

The investor would end up with over $835,000 in investments, pay off the debt and still have over $635,000 left.  This does not even include the benefits of the interest tax write-off which, if invested, would have boosted the overall wealth to over $1MM ($800,000 after paying off the mortgage).  Conversely, with no mortgage, the money not spent monthly on mortgage expense, if invested, would have generated only $484,000 in income. 

The home investment, while not an asset, can be a vital part of a wealth-creation plan if funds are reallocated prudently into a real asset.  If not utilized effectively, a home could not only be a liability, but the ineffective infusion of cash into it could be gravely detrimental to future wealth enhancement.

Greg Polashock is a Real Estate Home Mortgage Loan Consultant and Certified Mortgage Planning Specialist with Cherry Creek Mortgage and resides in Castle Rock, Colorado.  He can be reached via email at Greg@GregIsFinancingSolutions.com, by phone at 303-887-0672 or on the web at http://www.gregisfinancingsolutions.com/.