The conventional wisdom used to be: Pay off your mortgage as
soon as you can. Retire with a paid for home. Some personal finance
writers still believe that. I used to believe it too, but not any
No debt is as bad as too much debt. I used to be a zero-debt
advocate, but now I make a distinction between bad debt and better
Better debt is debt you use to buy an appreciating asset. The
mortgage on your primary residence is better debt and I don't
believe in paying it off or paying extra unless you just have so
much money you have nothing better to do with it. Here is why:
If you have too much of your net worth tied up in home equity,
your money isn't working hard enough, you are very sensitive to
falling real estate prices, and you are going to find it very
difficult to tap your home equity if you need it.
Let's start with the the most obvious problem with home equity.
It is that you are tying your money up in an asset that, as a
general rule, doesn't earn enough. You can do a back-of-the-napkin
calculation on your required rate of return using the formula:
(w + i) / (1 - t)
This is your withdrawal rate in retirement (typically use 4 or
5%) plus the rate of inflation (historically 3.5%) divided by one
minus your marginal tax bracket. So an example would look like
5% + 3.5% / 1 - 33% = 8.5% / .66 = 12.88% required rate of
This is the amount your money needs to earn to pay yourself, pay
Uncle Sam, and not lose purchasing power.
The problem with locking a large portion of your net worth up in
non-cash flow producing real estate, like your home, is that most
of the time, that money just doesn't work hard enough. You need
that money and, if you are typical, you need it to produce at a
much higher rate than residential real estate typically does.
Most people have been brought up believing a paid for home is
security. They can't kick you out of a paid for home. That safety
is an illusion. It is something we tell ourselves but it just isn't
Another thing we used to tell ourselves is that at least we
can't lose money in a home like we can in the stock market. Well,
we know that is just not true either!
Another critical problem with home equity is that the more you
need it, the harder it is to get to. What lender, for instance, is
going to give you a home equity loan when you have just lost your
job? What kind of bargaining power do you have in the sale of your
home if a loved one is sick and needs hugely expensive
out-of-pocket medical treatment?
One possible solution is to take out a home equity line of
credit and let it sit there unused in case you ever need it.
However, as we discovered during the mortgage crisis, that is not
the foolproof solution many people thought.
In 2008, lenders across the country froze home equity lines of
credit, even for borrowers with perfect credit scores. Lenders sent
hundreds of thousands of letters to consumers telling them those
home equity lines of credit they paid money to secure, could no
longer be tapped.
Most of us think of diversification in terms of asset classes.
You also have to think in terms of diversifying liquidity. On the
liquidity continuum, cash is obviously most liquid. Businesses and
limited partnerships are probably least liquid. In between you have
a broad range.
Having an emergency fund is key. I believe in at least twelve
months of expense, in cash, on hand. Next comes cash flow.
Interest, dividends, option premium, rent, and royalty payments are
all forms of short term liquidity. After that are items that can be
readily bought and sold in efficient markets. This would include
stocks, bonds, options and futures. From there, liquidity becomes
Some investments have lock-up periods in which you cannot sell
them or you will pay a big penalty to sell them. Others, like real
estate, can be easy to sell at times, but almost impossible to sell
at others. The more complex the asset, likely the less liquid it
It is helpful to consider that most companies don't go bankrupt
because they lose money. A company with investors pouring in cash
can survive for a very long time. Companies only go bankrupt when
they don't have sufficient liquidity to meet their daily
The same is true of individuals. Most individuals who file for
bankruptcy have jobs and assets. It is just that their cash inflows
don't properly match up to their cash outflows. When this happens,
you have a liquidity problem.
Your job, as Family CFO, is to structure your assets so that no
matter what happens, your cash inflows match up to your cash
outflows. In other words, liquidity has to be a primary
As a general rule, I like to think of liquidity as being inverse
to assets. The less resources you have, the more liquid you need to
be. As your assets increase, you can afford to put more and more of
them in less liquid assets.
The same is true for variability of income. The more variable it
is, the more liquidity you need. For example, if you are a
commissioned salesperson, a business owner, or work for a company
with shaky prospects, you need more liquidity than someone who
lives comfortably on a government paycheck.
If you haven't already, sit down and list out your assets. The
free, My Financial Plan web app on SniderAdvisors.com, is an
excellent way to keep track of assets and liabilities.
Stack rank your assets from most liquid to least liquid. Then
ask my favorite question … "What if?"
Ask yourself, "What if I had no income coming in for two months?
Where would the money come from?"
What about six months? A year? Two years? What if you were
permanently disabled? What if you were sued or someone in your
family became ill?
Asking these questions forces you to examine your resources in
terms of liquidity. If you don't like the answers you come up with,
it might be time to restructure your assets or get going on
augmenting your savings.
No statement in this article should be construed as a
recommendation to buy or sell a security or to provide investment
advice unless specifically stated as such. All investments involve
risk including possible loss of principal.