Why I Don’t Include a Primary Residence in Net Worth for Financial Independence

DISCLAIMER: This post is about your primary residence only, not a property that was purchased with the intent to be rented to create cash flow and had the numbers run accordingly.

ducks & covers

I know I’m about to take shit for this one, but I think – if you read this post to the end – you’ll understand (and maybe even agree!) with my rationale.

Today, we’re going to examine why I don’t include the value of a primary residence as part of a net worth as it pertains to calculating your financial independence number.

As a refresher, the 4% guideline states that you reach financial independence when your invested assets equal 25x your annual expenses – at that point, you can safely withdraw 4% of your assets each year and never run out of money. For example, if I spend $40,000 per year, I’m financially independent when I have $1M invested. I can withdraw $40,000 from my $1M each year, and compounding returns will (on average, over time) always replace the money I take out, guaranteeing that it never runs out (assumes an average 7% real rate of return).

Distinguishing between “net worth” and “net worth as it pertains to financial independence”

When I’m calculating someone’s net worth in general, I’ll include their home – and usually, the result is not what they expected.

That’s because most people include their property’s total estimated value (i.e., they get Zesty with a Zestimate from Zillow) as an asset, and ignore the fact that they owe hundreds of thousands of dollars on said asset.

“Zillow says my house is worth $500,000, so I’m adding that to my net worth! Woohoo!”

When you add your house to your net worth in general, you add two things:

1. Your home’s value

2. Your liability (the amount you still owe on your mortgage)

…the net of which roughly provides your “equity.”

Your equity is the amount of the house that you actually own. That means (down payment) + (any amount you’ve paid toward the principal balance), which will (hopefully) be inflated by appreciation. The bank owns the rest.

The liability is the amount that you still owe the bank. This is the part that nobody ever wants to include in their balance sheet because it’s a big fat reminder that a mortgage is a death pact with the devil (the word “mortgage” literally translates to death obligation, so nobody come for me – come for your Latin teachers).

If the home sells for the Zestimated $500,000, you have to pay the bank back (and pay the seller and buyer agents 6%, assuming you use them), netting the difference.

That’s not to say you shouldn’t own a home – but by definition, debt of any kind technically detracts from your total net worth. “Net,” in this case, means “assets minus liabilities.”

If you have $50,000 in a 401(k) and $100,000 in equity in your home but owe $350,000 on your mortgage, knowing you have a negative $200,000 net worth is sometimes the wake-up call that you need to save or invest more aggressively.

So that’s net worth in general – why don’t I count primary residences in your net worth for financial independence?

Your net worth as it pertains to financial independence

This is the part that I pray will bring you around to my point of view: Your house doesn’t count in your net worth as it pertains to FI (a.k.a., the amount you need to reach work-optional status) for two major reasons:

1. It’s an investment that you have to pay for every month (more on what happens if you own your home outright later) – meaning it’s not creating passive income for you, it’s costing income. In other words, it needs to be factored into the expense side of the equation.

2. You can’t use your home’s value to buy stuff (more on why the counterargument for home equity lines of credit is usually bogus later).

Your FI calculation only gives a shit about two things: How much you have in the market creating 7% returns per year, and how much your life actually costs every year.

Let’s extend our above example:

Let’s say I need $1M to retire in order to draw down $40,000 per year, and my home is worth $450,000 (I have $100,000 in equity and still owe $350,000).

Remember, I have $50,000 invested in the market in a 401(k).

You may look at this and say, “Dope! You’ve got $50,000 invested and a $450,000 house. $500,000 net worth! Halfway there!”

Your net worth – as it pertains to financial independence – is $50,000.

You can take the house out of the equation entirely.

Why?

Because paying down a mortgage (as it pertains to your journey toward financial independence) is functionally the same as paying rent. By that, I mean, it’s an outflow of cash every month. At the end, you’ll own the property – but the property doesn’t impact your ability to reach FI, because in order to use the value of the property for anything else, you’d have to sell the property – and therefore plant yourself firmly back in square one, with a monthly housing expense.

Someone who pays $1,000 for their mortgage each month and someone who pays $1,000 for rent each month are functionally in the same boat as it pertains to the amount they need to reach financial independence.

That is, up until the moment that the homeowner owns the home outright and no longer has to pay $1,000 per month for their mortgage (though they’ll still have taxes and insurance).

All that to say: Your equity in the house doesn’t positively impact your FI status, but the mortgage debt doesn’t negatively impact your FI status, either.

All that matters when you’re striving for financial independence is the amount that you have invested in liquid investment accounts that return an average of 7% per year in passive returns that you can actually use to support your lifestyle.

A home is an asset, but it’s an illiquid one. Your home may be going up in value quickly (especially if you live in Denver, it seems), but you can’t use any of that value until you sell the house. The popular counterargument is that you can take out a loan on your own equity (and pay interest on it): This is something I wouldn’t necessarily advise unless you’re using that loan to buy an asset that creates passive income.

Saying that your home is a liquid asset because it enables you to take out even more debt is not an intellectually honest argument for your primary residence contributing to your financial independence number, because your FI number can support you in perpetuity without you ever earning another dollar: A home equity line of credit just kicks the can down the road, as it’s debt that you have to pay back.

If you get a HELOC, you either have to (a) keep earning income in order to pay back the loan, or (b) your other investments have to subsidize it.

If you can sell your home, why can’t you count the estimated value toward your FI number?

I can already tell you with almost complete certainty that someone who didn’t read this post is going to comment, “But my home is still worth $450,000! I could sell it if I wanted to! It counts.”

Sure, you can sell your house and net the appreciation difference – but that leaves you with one, teensy problem:

You still need a place to live, and you just sold yours.

The chances are, you won’t be able to pocket much of that appreciation outright. Say you manage to net $100,000 on your home’s sale after you pay back the bank and pay the agents – you’ll probably need to use some or all of it for a down payment on the next place you live, if you buy again. And if your home has appreciated by more than $100,000 since you purchased it, it’s not unlikely that the next house you buy will have appreciated by somewhere in that ballpark, too.

Unless you’re willing to rent (not a bad option whatsoever, if you ask me) or substantially downsize, most people just shuffle that same pot of money forward to the next property.

This is why I often say your home is a phantom presence in your net worth: Sure, it’s an asset that’s worth something to you, but it’s not valuable to you in the same way that your money invested in equities is valuable to you – that money is returning an average 7% per year without you doing anything or ever adding any more money.

Ultimately, it boils down to the difference between a liquid asset generating 7% annual returns that can be tapped at any time vs. an illiquid asset that appreciates but must be sold outright to capture value

That’s not to say that you shouldn’t buy a home – after all, if you do it “correctly,” you won’t delay your early retirement very much. It’s just to say that – for most people – the value of your home is that it’s your shelter (and that’s pretty damn valuable!), not a passive income-generating asset.

But what if you own the home outright? That’s a little bit of a different story, but not quite.

Let’s say you fully own the $450,000 house. Say you sell it for $600,000 in 5 years. You pay $36,000 in broker fees (6%) and pocket $564,000, because you’ve already paid the bank back.

Now, the chances that you’re going to put $564,000 down on your next place are slim. You really have two major options, if you want to avoid paying for mortgage insurance:

• Put 20% down on your next place (say you want to buy something else that costs $600,000, as the market around you has appreciated and you don’t want to downsize).

• Buy your next place (almost) outright in cash.

While you could almost buy the next place in cash and not have a mortgage payment, you’d have to borrow a little – and the opportunity cost of your fat chunk of change isn’t worth giving up, in my opinion.

If you put 20% down on your next $600,000 place ($120,000), that leaves you with $420,000 to do something else with.

If you invest that $420,000 in an asset that generates passive income, now that becomes something that contributes toward your FI number.

So simply owning your home outright doesn’t qualify it to count toward your financial independence goal, but it does get you one step closer:

If you sell the house and invest some or all of the proceeds into something that generates passive income (like the stock market), you’re good to go.

Owning your home outright has another impact on your FI number: You don’t have a mortgage payment.

So while you’ll still be on the hook for taxes and insurance (which can easily eclipse $1,000 per month in expensive areas or on expensive properties), not having to pay mortgage principal and interest helps a ton when you’re calculating a FI number – simply because your expenses are lower.

Granted, the second you sell that house and take out a mortgage on another one, you’re right back where you started and the FI number goes up again (for example, if you pay $2,000 per month for your housing, you need $600,000 invested to throw off $2,000/mo. in returns).

That’s why I always tell people to calculate a FI number assuming they’re going to have to pay for housing in some way, even if they have plans to own their home outright – you don’t want to get into a situation where you retire, 10 years pass, then you want to sell your home and realize you can’t afford to buy another one because your invested assets aren’t quite high enough to cover a monthly mortgage payment.

Bottom line: When calculating your FI number, the only things that count are assets that generate passive income you can access.

And hey, if the real estate you own is a rental property that generates cash flow, that counts, too.

Everything else may contribute to your general net worth, but if you can’t use it to pay for your grocery bill, it’s a no-go.