Role of Home Ownership
We’ve seen many framed “Home Sweet Home” signs hanging on walls of homeowners’ houses. But we’ve never seen one hanging on the walls of renters’ houses.
Homeowners’ houses, like those of renters, provide shelter, but homeowners are different from renters and so are their houses. Homeowners’ houses are investments like stocks and bonds. They serve as savings piggybanks, like IRAs and 401(k)s, and can be bequeathed to children and others.
Home Ownership Offers Three Kinds of Benefits
Houses, like all products and services, provide three kinds of benefits—utilitarian, expressive and emotional. Utilitarian benefits answer the question, “What does something do for me and my finances?” All houses provide the same utilitarian benefits as shelters, but homeowners derive additional utilitarian benefits from their houses as investments if their home values go up or utilitarian costs if their home values go down.
Expressive benefits convey our values, tastes and social status. They answer the question, “What does something say about me to others and myself?” Homeowners derive expressive benefits in high status, having the means to buy a house or at least put a down payment on one. And they derive expressive benefits from the freedom to modify their houses to express their tastes.
Emotional benefits answer the question, “How does something make me feel?” Homeowners enjoy the emotional benefits of pride of ownership and peace of mind from knowing that no landlord can evict them.
Helping Clients Understand the Three Types of Benefits Derived from Investments
Clients typically ask their financial advisors many housing questions such as:
- Should I buy a house or rent one?
- Should I pay off my mortgage or keep it?
- Should I sell my house and buy a smaller one?
- Should I get a reverse mortgage?
As Financial advisers, we look to enhance the well-being of our clients by considering each of the three kinds of benefits and costs and guiding clients to do the same. This is important to remember as some advisers may be prone to considering only utilitarian benefits and costs and guiding clients to do the same. Buy a house or rent one? Run the numbers. Pay off the mortgage or keep it? Run the numbers. Get a reverse mortgage? Run the numbers.
A daughter wrote to MarketWatch’s Moneyist: “My parents want to use $300,000 in retirement savings to pay off $160,000 left on their home. Is that a good idea?” One adviser said: “Step back and create a budget spreadsheet so you can get a handle of overall cash flow for your parents.” Another adviser said: “I would be hesitant to suggest they use over half of their liquidity to pay down the mortgage. I would ask whether they have considered selling their current home and purchasing a home that would allow them to pay for the replacement home. A reverse mortgage is another alternative to tap equity in their home.”
Yet, the parents might well be right in their preference to pay off their mortgage. The expressive and emotional benefits they could derive from being mortgage-free might exceed their utilitarian costs of diminished liquidity. When our clients have faced the same choices over the years, we consider all three types of benefits and costs and work closely with them to make the best decision.
Houses have a special place in our portfolios and in our life cycles of saving and spending. Standard life-cycle theory says our sole reason for saving during our working years is spending during our years in retirement. Behavioral life-cycle theory says our reasons for saving and spending during our working and retirement years consist of wants for the full range of utilitarian, expressive and emotional benefits of saving and spending.
Spending Source Pyramids and Spending Use Pyramids
Behavioral life-cycle theory includes “spending source” and “spending use” pyramids. The bottom layer of the spending source pyramid contains “income,” including wages, dividends and interest, Social Security benefits and payments from pension plans. The middle layer contains “dips into regular capital,” including proceeds from the sale of stocks, bonds and other investments, whether in retirement accounts such as IRAs and 401(k) accounts, or outside them. The top layer contains “dips into bequest capital,” including proceeds from the sale of investments intended as bequests, especially houses.
The bottom layer of the spending use pyramid includes what we must have or provide, such as food, shelter and support of minor children. The middle layer is what we like to have, such as vacations and new cars. Above these layers is a layer of bequests. For all but the richest families, the largest part of a bequest is a house.
Behavioral life-cycle theory predicts that investors are reluctant to dip into regular capital and especially reluctant to dip into bequest capital, mostly houses. Housing equity makes up a large proportion of the wealth of older Americans, yet, on average, people don’t sell their houses to support their non-housing consumption as they age. Moreover, homeowners are reluctant to embrace reverse mortgages that pay them while they continue to live in their houses. Only 2% of eligible homeowners choose reverse mortgage contracts.
As Advisers, we seek to enhance the well-being of our clients by helping them understand the benefits and drawbacks of their spending source and spending use pyramids. Avoiding dips into regular capital, such as stocks and bonds in deferred-contribution retirement accounts and outside them, is a wise and effective habit that reduces spending and increases savings during our working years.
But that habit becomes a drawback in retirement when dips into regular capital are necessary for a comfortable, yet prudent, standard of living. Even dips into bequest capital, such as by reverse mortgage on a current house or replacing it with a smaller house, might be necessary.
Source: Avantis Investors; American Century Investment Services,Inc.; Quentin Fottrell, “My parents want to use $300,000 in retirement savings to pay off $160,000 left on their home. Is that a good idea?” The Moneyist/MarketWatch, April 3, 2021. Steven F. Venti and David A. Wise, “Aging and Housing Equity: Another Look,” in Perspectives on the Economics of Aging, ed. David A. Wise (Chicago: University of Chicago Press, 2004), 127-180. Thomas Davidoff, “Reverse Mortgage Demographics and Collateral Performance,” February 25, 2014. Available at SSRN. M & A Consulting Group, LLC, doing business as CAM Investor Solutions is an SEC registered investment adviser. As a fee-only firm, we do not receive commissions nor sell any insurance products. We provide financial planning and investment information that we believe to be useful and accurate. However, there cannot be any guarantees. This blog has been provided solely for informational purposes and does not represent investment advice or provide an opinion regarding fairness of any transaction. It does not constitute an offer, solicitation or a recommendation to buy or sell any particular security or instrument or to adopt any investment strategy. Any stated performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. Diversification does not eliminate the risk of market loss. Charts and graphs provided herein are for illustrative purposes only. There are many different interpretations of investment statistics and many different ideas about how to best use them. Nothing in this presentation should be interpreted to state or imply that past results are an indication of future performance. Tax planning and investment illustrations are provided for educational purposes and should not be considered tax advice or recommendations. Investors should seek additional advice from their financial advisor or tax professional.
What housing decisions can we help you with?