To Your Wealth Column

Allocating your Biggest Asset:

Your Home

BY MICHAEL P. HAUBRICH, CFP

October 3, 2002

In this column last month I discussed how to prepare for and take advantage of the next bull market. One of the strategies was identified as proper asset allocation. There has been much written about asset allocation (the proportion of a portfolio invested in stocks, bonds and cash). However, asset allocation theories and models that were originally developed for institutions -- large pension funds and endowments, are not relevant for individuals of more modest means. Furthermore, individuals have other considerations, such as taxes, changing personal needs, and death, that pension funds and large tax-exempt accounts do not have. For most of us, our personal real estate makes up the largest single asset we own. Yet rarely is this huge asset viewed as a component of our allocation strategy.

Financial planner and author Bert Whitehead, has addressed these non-institutional investor considerations by developing a model that he calls "functional asset allocation." Under this model, your personal residential real estate is included as an investment class along with stocks, bonds, and cash. While you may not think of your home as being similar to money accumulating in a bank account, or invested in stocks or bonds, your home does provide an inflation hedge while you build up equity as you pay down the principal balance on your mortgage.

As you make your mortgage payments, a portion of every payment goes toward reducing the principal balance of the outstanding loan amount. Uncle Sam offers an income tax incentive for purchasing a home (and actually two homes) by allowing us to deduct the portion of our mortgage payment that represents interest and property taxes. These benefits, combined with low mortgage interest rates, have made home ownership more affordable and attractive than ever.

One more benefit of home ownership comes when you sell. All realized gains up to $250,000 for single tax payers and $500,000 for married are tax-free.

Whitehead recommends that buying the right size home is the best investment middle income earners can make. But how much house is considered the right size? Whitehead suggests up to two or two and one half times your annual income as being appropriate. For example, if you’re earning $80,000 per year, you should buy a home worth $160,000 to $200,000. Plan on living in that home until its value represents 100-115% of your annual income, then consider trading up to a property that once again represents two or two and one half times your income.

If possible, try to put 20 percent down to avoid Private Mortgage Insurance (PMI). This insurance guarantees that the lender will be protected if you default on the payments. It is added to your mortgage payment and can add as much as several percentage points to your loan rate. Whitehead agrees with many pundits of financial planning, that you should do whatever is necessary to come up with the 20 percent down payment to avoid the PMI cost such as requesting a gift or no interest "loan" from parents or relatives. If you are stuck with having to purchase PMI insurance, look at refinancing or removing as soon as you can. You can do this as soon as you have 20 percent equity built up in your home, but you have to be proactive and request that the PMI be removed—it does not happen automatically when 20 percent equity has been achieved.

Our personal real estate represents not only one of the biggest financial investments we will likely make in our lifetimes, it also can represent a significant contribution to our asset allocation and should be viewed as a part of your total investment strategy.

Be sure to visit our web site at www.toyourwealth.com for other strategies to consider when preparing for the next Bull market including information and ordering a copy of Bert Whitehead’s book, "Financial Dysfunction, Why Smart People Do Stupid Things with Money".  For ordering information visit www.BertWhitehead.com.

Michael Haubrich, CFP, is president of Financial Service Group, Inc., a registered investment advisory firm in Racine.