Are you living in your bank? A lot of Americans are. It should be no surprise that the equity in our homes far exceeds the money in our savings and retirement accounts. (Thank you, real estate market run-up!)
But that doesn't mean that you should put up a velvet rope along the lawn and back away from your crown investment jewel. Make sure your house is always working for you -- now and in the future. Here are six things to consider.
Weigh mortgage vs. stock market
Should you pay down the mortgage or use the money to add to your portfolio? It's a common question, and one you can answer with two numbers -- your after-tax return on your investment and your after-tax rate on your mortgage. The formula you'd use to put these numbers into practice is: (1 - your tax bracket) x your mortgage rate = after-tax interest rate. So someone in the 25% tax bracket with a 6% interest rate on their mortgage has an after-tax rate of 4.5%.
An investment that earns more than 4.5% after taxes is a winner. We know that the stock market has returned an annualized 9% to investors over the past century. But perhaps you don't have a long time period to weather the market's ups and downs. (Remember, that 9% is an annualized return.) The answer might be to split the difference: Invest some of your cash reserves in the market and direct some toward paying down mortgage principle.
Don't bet the house
Some homeowners -- wowed by the returns of the stock market (or at least the potential payoffs touted by unscrupulous advisors) and tempted by the rising value of their homes -- tap into their home equity to chase higher investment returns. That's too risky for our blood. Take this real-life example provided by the National Association of Securities Dealers. One big-name brokerage convinced a woman to take out a mortgage on her $400,000 home and invest it in tech stocks ... in 2000. You can guess how that went. Even more buttoned-down tech stocks like Microsoft (Nasdaq: MSFT ) , IBM (NYSE: IBM ) , and Oracle (Nasdaq: ORCL ) are down 45%, 21%, and 55%, respectively, since their lofty turn-of-the-century valuations. A lot of the racier fare is now bankrupt.
Don't let the deduction dazzle you
April 15 is like Christmas for new homeowners. Real estate agents, friends, and even the mailman have probably all sung the praises of what they saved on taxes because they got to deduct their mortgage interest. For many, however, the morning they rip open their tax return check is anticlimactic. The deduction you take isn't simply the amount of interest you paid on your mortgage. It's the difference between the standard deduction all taxpayers get (for 2005, it's $5,000 for singles, $7,300 for head-of-household filers, and $10,000 for married couples filing jointly) and the amount you paid in mortgage interest. The real extra value for a married couple who paid $12,000 in mortgage interest last year amounts to just $2,000 ($12,000 minus $10,000).
Still, it's a sure thing
Paying off a loan is a slam dunk. Doing so guarantees that you "save" what you would have spent on interest. Almost all other investments have a potential downside. The one downside to pouring your extra funds into your home is that you tie up your cash in an asset that's not as easy to liquidate, should you need the money in a pinch.
Consider the "comfort" factor
No matter how the numbers play out, for some, the peace of mind of knowing that the house is paid down is worth forgoing a potential bump in investment returns. The bonus to a mortgage-free retirement is that your expenses are lower. (Census data shows that the average American spends 27% of income on shelter and its maintenance.) This allows you to take out less from your retirement accounts and make the money last longer.
If you're nearing or in retirement, there are other ways to make your home provide more than physical shelter. It can serve as a nest egg, too.
Converting your nest into your nest egg
A recent article in The New York Times quoted an economist saying that baby boomers are severely shortchanging their retirement savings. Based on economic data, about half will be unable to maintain their current standard of living in retirement, she said.
By retirement, boomers may discover that what they lack in their portfolios they make up for in their castles. Census data from 2000 showed that in households headed by someone age 65 or older, 79% of the net worth was home equity. And that's before the big real estate boom.
Clearly, many of us are living in our banks. After our retirement party, will we have to put out the "for sale" sign and move to, say, Danville, Ill. (where the median home price is $72,800 -- one of the lowest in the country -- and snow shovels are not optional)? It's a question many retirees are faced with as they find themselves house rich and nest egg poor.
There are other options besides Danville (which I'm sure is a perfectly charming locale), of course. In this month's Rule Your Retirement newsletter, Doug Short details the ins and outs of one popular stay-put strategy: the reverse mortgage.
A reverse mortgage is a way to augment retirement income. Here's basically how it works: The homeowner gets cash from the lender (a lump sum, monthly cash advance, a line of credit, or some combination) and makes no mortgage payments for as long as he or she occupies the home. Fannie Mae (NYSE: FNM ) has aptly named (and trademarked) its reverse-mortgage product -- the "Home Keeper Mortgage."
Don't run out the door after a reverse mortgage just yet. There are age requirements (all homeowners on the deed must be at least 62), equity requirements, loan limits, and pretty steep up-front fees. There are also many protections in place for homeowners who wish to go the reverse-mortgage route.
In the March issue of Rule Your Retirement (which released today at 4 p.m. EST), we detail the ins and outs of reverse mortgages as well as look at portfolio rebalancing and decide the winner in the "I Bonds vs. TIPS" battle. Also featured are two great interviews. We talk about money hang-ups with Eric Tyson, author of Mind Over Money and Personal Finance For Dummies. And Pulitzer Prize-winning humorist Dave Barry reveals why there's a giant eyeball on the dollar, and he dishes on the allure of Suze Orman.
Fannie Mae is aMotley Fool Inside Valuerecommendation.
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Dayana Yochim is aging quite nicely in her cubicle. She owns none of the companies mentioned in this article. Microsoft and Fannie Mae are Motley Fool Inside Value recommendations. This is the Fool'sdisclosure policy. It sponsored this message.