Buying an Asset with a Mortgage or Debt Doesn’t Necessarily Change your Net Worth

I got into an interesting conversation with a commenter the other day on another blog and it made me realize that there are some people out there who don’t actually understand some of the basics of Personal Finance. I don’t talk about the basics to often on My Journey to Millions, because quite frankly, how hard is it to understand spend less than you earn? However, this conversation (and subsequently wanting to throw my computer out the window) inspired me to write a post about about a twist some may not understand in the basic balance sheet/net worth statement.

A little background is in order.  My fellow personal finance blogger, Ninja, from Punch Debt in the Face recently took on the topic of whether he prefers a 15 or 30 year mortgage (a topic I covered in the early days of this blog).  Side note: I thought it was interesting we came to the same conclusion despite his stick figure drawing abilities and hatred of alcohol while, I on the other hand am so untalented that I can’t draw stick figures and I love me a good drink. It was the during the course of 50 or so comments (post is up to 91) that a reader named “C” emerged.

C, is an angry commenter (I have my fair share) who decided buying a house wasn’t for her, and since we all know personal finance is personal I am all about listening to all sides of an argument if they are logical and coherent.  Well, you can probably tell from my tone, C was anything but that.  She was so irate and close minded I had to guess as to the essence of C:

ME:  Can I take a guess at the essence of C, without you being insulted? Single, young (22 to 26), underemployed (you have some income but you aren’t doing what you want) and you think you deserve more from life? Am I close.

HER: I’m 27.

I nearly pissed myself laughing when I saw that response.  It sucks she was so irate, close minded and to be quiet honest an idiot because if she stopped feeling sorry for herself for one second the conversation may have opened up to something really interesting.  Specifically, whether a home should be someone’s goal…ah such is life we need some people to bring down the curve.

But I digress.

Buying a Home or Any Asset with a Mortgage or Other Note Doesn’t Change Your Net Worth

One of the aspects of personal finance she didn’t understand is why when one buys a home with a mortgage, or if someone buys a business with a note why their net worth doesn’t necessarily change.  Let’s take John Doe’s balance sheet (it will be a little simpler than than this high net worth balance sheet that made me feel inspired):

  • He has saved a nice down payment of $50,000
  • Has other assets (retirement funds, grandma’s cash, etc. etc.) of $15,000
  • Credit Card Debt of $5,000

His net worth is easy to calculate he has $65,000 worth of assets and $5,000 of liabilities, or a net worth of $60,000.

Lets say if he goes and buys a home for $250,000 using his $50,000 as a 20% down payment (we will ignore fees for purposes of this exercise):

  • A Home worth $250,000
  • Other assets of $15,000
  • Credit Card Debt of $5,000
  • Mortgage of $200,000

What is his net worth?  His assets are $265,000 (home + other assets) and his liabilities are $205,000 leading to a net worth of $60,000.  The exact same amount!

Why Doesn’t Taking on Debt Doesn’t Always Reduce Your Net Worth

At this point it should be pretty self evident, but the reason is that there is a corresponding asset on the other side of the balance sheet.  If our made up individual decided to take his credit cards and buy something other than an asset then those liabilities would obviously have a detrimental affect to his net worth statement.

When I explained this to my muse her question was what if the house goes down? Well, then yes so would his net worth statement, but at the same time what if your grandmother had balls?  She would be your grandfather.  Of course there is risk in buying anything, but it is no different than buying stocks and people seem to have no problem in understanding that stocks have risk, but why should a home? But now I am going on a different tangent.

In the short term (i.e. that same day) in your net worth doesn’t change when you buy a house with a mortgage or a business with a note because there is a corresponding asset on the other side of the liability.  The power/risk presents itself when the liability stays the same (and goes down over time) while the asset increases or decreases over time.

Did you ever believe that taking on a mortgage would hurt your net worth in the short term? Or is that something you learned a long the way?

18 Responses to Buying an Asset with a Mortgage or Debt Doesn’t Necessarily Change your Net Worth

  1. “Did you ever believe that taking on a mortgage would hurt your net worth in the short term?” – No, but I certainly knew that the savings would be zeroed out. I mean, I bought a fixer because I knew that’s where the value is – sure, eventually the ‘forced savings’ of equity will probably kick in, but if I wanted equity I’d have to work for it.

    Proud to say we’re 1.5 rooms away from declaring it finished, and the 1.5 rooms in shambles are still functional/livable. Wonder what C would think?

  2. You’re right in the short term! In the long term the value of the home appreciates much faster than the reduction in debt because it is a leverage investment. Of course, the last few years may say differently. :)

    • 100% correct at first you are not making any moves on paying down the mortgage! So frustrating when I see how much principal I pay down monthly lol

  3. Yeap, net worth doesn’t change when you get a mortgage. The biggest thing you gave up is liquidity and probably cash flow in the short term. Living in a house is generally more expensive than renting.

  4. net worth does not change the moment you close, in fact it decreases (many garbage costs involved). however, that act positions you for expedited growth in network over time. some of the ups (and their flip-sides) as follows: 1) property may appreciate/or depreciate 2) rents may increase/ or decrease 3) equity will certainly increase as your tenants pay off your mortgage/or you become poorer due to vacancy and money out your pocket 4) back end tax benefits are a plus/ while continued repairs/investments are a drain

  5. A personal residence is not a productive asset. The only way leverage will increase your net worth is with unrealized value, or incremental productivity (as in financing a machine tool)

    • I am not sure if I would completely agree whether it is not a productive asset…it may not be a GREAT asset but it is certainly productive if you treat it appropriately

  6. Okay Evan, very nice explanation and I liked the quotes too. But, where is your tweet button, I wanted to tweet this article and couldn’t find a button :) Your blogging pal, Barb

  7. Well, doesn’t that assume the underlying value of the asset you’re buying stays the same?

    If it drops, as real estate values did in the late great popping of the bubble, then of course your net worth would drop, and the liability for the debt could be seen as exacerbating that, no? If the asset’s value rises, as housing values probably will over the next ten years, then your net worth would increase because your principal would increase.

    And I’m not sure 101 Centavos is entirely right in saying a personal residence is not a productive asset. Depends on how you look at it.

    You have to live somewhere; rent around here is now more than a mortgage on a comparable dwelling. Once the house is paid off, it actually saves you the amount you would have to pay out for a place to live. If the going rent for a $180,000 place is $1,000 a month, the paid-for house is saving you that much each month. Let’s say you’re retired and drawing 4% from your retirement investments. A 4% drawdown on $180,000 is $7,200; the house returns more than that by saving you $12,000 a year.

    Clearly that’s an oversimplification, since it doesn’t account for maintenance and repair costs; and it’s true that left in the market your $180,000 would return around 8% p.a., which is more than 12 grand. Still, once you own the house it does return the market cost of renting or paying mortgage premiums on the roof over your head.

    • Sure, depends on interpretation.

      But to clarify the difference between cost avoidance or potential value appreciation and *productive* capacity.

      A standard suburban home and lot is not a producing asset. It requires input (maintenance and repair) and has no output.

      A standard suburban home with a ground source heat pump, a fireplace and solar panels now produces *energy*.

    • We’ll focus on the first point

      “ou’re buying stays the same?

      If it drops, as real estate values did in the late great popping of the bubble, then of course your net worth would drop, and the liability for the debt could be seen as exacerbating that, no? If the asset’s value rises, as housing values probably will over the next ten years, then your net worth would increase because your principal would increase.”

      You are 100% correct which is why I carefully said the next day.

  8. Obviously it all depends on the value of the property. Ideally it will go up and take your net worth with it. But assuming you’re paying fair market value then at the time of purchase it should be a wash.

    “what if your grandmother had balls? She would be your grandfather”

    That line cracked me up!

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