Thursday, November 19, 2015

Mobility and lifetime house equity.

This post utilizes a housing equity calculator to estimate the impact of a move from one house to another on lifetime house equity.   The blog is important for a number of reasons.

First, house equity is increasing as a share of total wealth for new retirees.   This is not a good trend.   Current retirees are more reliant on house equity than past retirees because defined pension plans are scarce and for many people 401(k) balances at retirement are low.

Second, people who move and take out a new mortgage may end up having to continue paying on their mortgage in retirement.  Many financial advisors believe that it is appropriate for people to keep a mortgage in retirement as long as they have a large 401(k) plan.   My recent essay on this topic suggests otherwise.



Third, the loss of equity associated with moving to a new home and obtaining a new mortgage may encourage some people to stay put even if this decision entails turning down a promotion or a better job in a distant city.

People need to be aware of how their decisions impact the amount of house equity they will acquire during their entire lifetime.   One important decision involves mortgage choice.  People who choose a 15-year mortgage will acquire more equity than people who choose a 30-year mortgage.   A second decision, the one discussed here, involves the decision to move.   A person who moves from house to house prior to paying down their mortgage is likely to acquire only a small amount of housing equity.

This post is based on question twelve in my workbook “Solving Financial Problems in Excel” 



Question Twelve:  This problem examines the potential cost of moving on ultimate house equity accumulated over a period of time.

In this problem all houses are purchased with 15-year FRMs at an interest rate of 5.0%.  Also, all houses appreciate in value at a rate of 1.0% per year.    These assumptions can of course be altered in a spreadsheet.

At the beginning of a 15-year period two people purchase a $300,000 house.   One person stays in the same house for all 15 years.   The other person buys a new house identical in value to the one he is currently living in after 7 years.

The sales commission on the first house is 6.0%.   In addition, closing costs on the new house are equal to 4.0% of the house price.

The second person lives in his second house for eight more years.

How much equity do the two people have after 15 years?




Answer:    The house equity calculation for the first homebuyer involves only one home.   The two-home house equity calculator used in the previous problem needs to be modified to include the 4.0% closing costs on the purchase of the second home for the second home buyer.  

The results presented in the table below demonstrate the high cost of moving when all financing is done with 15-year mortgages.   The person who stays in the same house for 15 years has equity of $348,291.    The person who moves to an identical house after 7 years has house equity of $215,036.    The difference in house equity is $133,255.  

Note most of the difference in equity is due to the reduction in the payoff of the mortgage.  Only around 25% of the loss in house equity is due to the sales commission on the first house and the closing costs on the second house.  Nearly ¾ of the loss in house equity is due to a reduction in the pay off the mortgage.  (Mortgages pay off more rapidly near the end of their life.   Since Person B sells his first house he does not enter the rapid payoff period for his mortgage during the 15-year period.)




The Potential Loss of House Equity From Moving
Person A Lives in One Home for 15 Years
Person B Lives in One Home for 7 Years and One Home for 8 Years
Assumption
Price of First House
$300,000
$300,000
Assumption
Mortgage LTV First House
0.90
0.90
Assumption
Mortgage $ First House
$270,000
$270,000
Assumption
Mortgage Term Years First House
15
15
Assumption
Mortgage Interest Rate
0.05
0.05
Calculation
Mortgage Payment First House
-$2,135
-$2,135.14
Assumption
Holding Period First Home
15
7
Calculation
Mortgage At End of First Period Holding Period
$0
-$168,653.73
Assumption
Annual Appreciation First House
0.01
0.01
Calculation
House Price At End of Holding Period First House
$348,291
$321,641
Assumption
Sales Commission on Old House and Closing Costs on New House
0.10
Calculation
Loss of Equity due to Commission and Closing Costs
32,164.06
Calculation
Available Equity First House
$120,823
Assumption
Fraction Used for Down payment First House
1
Calculation
Down payment Second House
$120,823
Assumption
Price Second House
$321,641
Calculation
Mortgage Second Home
$200,818
Assumption
Mortgage Term Second Home
15
Assumption
Mortgage Interest Rate Second Home
0.05
Calculation
Mortgage Payment Second Home
-$1,588.06
Assumption
Holding Period Second Home
8
Calculation
Mortgage at End of Second Period Holding Period
-$112,357.98
Assumption
Annual Appreciation Second House
0.01
Calculation
House Price at End of Holding Period Second House
$348,291
Assumption
Sales Commission
0.06
Calculation
House Equity After 15 Years
$348,291
$215,036



The loss in equity is smaller but still considerable when 30-year mortgages are used instead of 15-year mortgages.   This is so because equity accumulation under 30-year mortgage is very slow until the final years of the mortgage.

The decrease in the tax deduction of the mortgage interest for the person who entirely pays off their mortgage will offset part of the equity difference but the offset is relatively small.

Author’s note:  I have recently published a number of financial math posts like this one, which are solved with Excel financial functions.   Topics covered include, evaluating different mortgages, calculating the repayment period for a person with multiple credit cards, impact of student loans and consumer debt on the mortgage qualification decision, affect of end-of-career market downturns on 401(k) balances, and the choice between a Prius and a Corolla.

These problems are all described on the following page.



Links to answers for 10 of the problems and links to my workbook are included on that page.





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