Are you familiar with the expression of being “house rich and cash poor?”
You might be wondering how that’s even possible. Or, you might be wondering what it even means. I see it more often than you’d expect. On today’s podcast I describe a typical situation, with 4 tips to follow.
I tell the story of Jim and Sally – not their real names – and how they became “house poor” because they were spending so much of their income on mortgage payments, property taxes, utilities and maintenance that it jeopardized their financial well-being.
Jim and Sally have two young kids and since it was hard for them to find a three-bedroom apartment in a good school district, they decided to buy a house. They had saved a 5% down payment and took on a big mortgage.
Once they moved in, they noticed that their heating and air conditioning bill was much higher than they expected. Their furnace and air conditioner were old and not energy efficient. Their windows also needed replacing.
So, they decided they would ‘bite the bullet’ and put in new windows, and a new furnace and air conditioner. The total cost was $30,000.
They paid for it all by borrowing against their line of credit because the interest rate was relatively low.
Their decision had a positive impact on their hydro bill, which saw a $100 reduction a month, but since their line of credit was unsecured (meaning, not backed by an asset like a house or a car) with a 6% interest rate, their interest payments each month were $150, so even with hydro savings, their overall cash flow actually decreased.
So, that’s when they decided to make interest-only payments on that loan to save cash. But then the amount they owed never went down.
They had a few other hiccups in their financial life.
A work injury forced Sally to take a month off sick. To add to their troubles, Jim was laid off work and it took him two months to find another job. Their children were also involved in extra-curricular activities, which cost money. So, Jim and Sally turned to credit cards to make ends meet during their time off work.
This didn’t happen overnight, but over a period of three years, they ended up owing $30,000 on another bank loan and on four different credit cards. After a few years of living in their house, Jim and Sally realized that owning was more expensive each month than renting because it wasn’t just the mortgage payment. They also had property taxes, repairs and maintenance, and the payments on their line of credit.
To help them make ends meet, they decided to conserve cash by cutting out all unnecessary expenses. So, no more movies or dinners outside, and no long-distance vacations either.
In a way though, Jim and Sally were luck. Their house was going up in value.
This, folks, is what it means to be “house rich and cash poor.”
They were able to take advantage of their home’s increased value to borrow an extra $60,000, secured, at a 4% interest rate, so their interest payments on that secured loan came to $200 per month.
Before this, they were paying $150 per month on their unsecured line of credit and around $1,000 in interest and minimum payments on their credit cards and other debts, so dropping from $1,150 per month to $200 in payments made a huge difference in saving.
Because their house had gone up in value, they were able to refinance, and not have to go bankrupt. But they used up their home equity to refinance. And what if their home hadn’t gone up in value, or hadn’t gone up enough? The end of this story would’ve been very different.
So what are some lessons here, then?
I’ll share 4 tips to avoid being house rich and cash poor:
Assume that your house won’t go up in value forever, and therefore you should assume that you won’t be able to refinance or sell your house to pay off your unsecured debts.
Before you buy a house, make sure you fully understand all of the expenses. Take into consideration: the property taxes, condo fees (if applicable), hydro, and any repairs and maintenance costs as well. This way, you’ll have a more realistic understanding of how much you will have to spend monthly.
Consider the life emergencies. Sure, job security will most likely allow you to keep making mortgage payments, but what happens if you get sick or laid off, or get a divorce and can no longer make payments? Should you face any of these situations, your home may become a liability rather than an asset. So, it’s important to consider whether or not you can protect yourself in case of an unexpected problem.
Ask yourself: What kind of life do I want? Basically what I’m saying is, if you have to take on a lot of debt to buy a house, and if your level of debt increases while you own your house, it may just be better to rent. I’m not saying don’t own a home, but I’d recommend carefully evaluating your financial situation before making such a large purchase so that you can avoid becoming house poor.
For more insight into how to avoid being house poor, listen to the podcast.
Resources Mentioned in the Show
FULL TRANSCRIPT – Show #173 How to Avoid Being House Poor
Doug Hoyes: Have you ever heard the term “house rich but cash poor”?
What does that mean?
How can you avoid being house rich but cash poor?
Let’s ask an even simpler question: how can you avoid being house poor?
That’s the question I’ll answer on today’s edition of Debt Free in 30.
Why am I answering this question today?
Because real estate was a big topic of discussion in 2017, and I suspect it will be an even bigger topic in 2018.
Tune in next week when Ted Michalos and I broadcast our annual year end recap and predictions show where we will go into more detail on this topic, but let me give you a quick preview: we will have a lot to say about real estate next week.
We will likely mention that mortgage debt continued to increase in 2017, and is now over $1.36 trillion, which isn’t surprising given that house prices were up early in 2017, but of course you know that house prices declined in many cities in the last half of 2017.
What will happen in 2018? More on that next week, but for today, let’s get back to the issue of being house poor.
Here’s a typical situation that I see.
The average person who files a bankruptcy or consumer proposal with my firm, Hoyes Michalos, has unsecured debts of around $50,000. “Unsecured” debt means debts that are not secured by an asset. A secured debt is something like a car loan or a mortgage, because those debts are secured by a car or a house.
Here’s the key:
My average client has around $50,000 in unsecured debt, but if they happen to own a home at the time they file a bankruptcy or consumer proposal with my firm, their unsecured debt is over $72,000.
So they owe money on a mortgage, but in addition to their mortgage they also owe over $72,000 on other debts like credit cards, bank loans, and even income taxes.
Most of that $72,000 in debt is credit cards and personal loans, but amazingly, 13% of my clients who own a home also owe money on payday loans.
So how is this possible? How can you own a house, but still have lots of other debts? In other words, how can you be house poor?
It’s actually relatively simple to understand.
Let me tell you about Jim and Sally. That’s not their real name, and I’ve changed some of the facts since I don’t want to reveal any private information about my clients on this show, but here is their story, which is a very typical story.
Jim and Sally have two young kids, and since it was hard to find a three bedroom rental in a good school district, they decided to buy a house. They had saved a 5% down payment, so they took on a big mortgage, but it seemed like the right decision.
Once they moved in they noticed that their heating and air conditioning bill was a lot higher than they expected; it turned out the furnace and air conditioner were old, and the windows were really old, and not energy efficient. So, they decided to “bite the bullet” and put in new windows, and a new furnace and air conditioner. The total cost was $30,000. They paid for it all by borrowing against their line of credit because the interest rate was relatively low, so it seemed like the right decision.
Their hydro bill immediately dropped by $100 a month, so that was good news.
However, because their line of credit was unsecured, the interest rate was 6%, so the interest payments each month were $150, so even with the hydro savings their cash flow actually decreased a bit each month. They decided to make interest only payments on the line of credit to conserve cash, so the amount owing never went down.
They had a few other hiccups in their financial life. Sally was off sick for a month after an injury at work. Jim got laid off and it took him two months to find another job. Their son and daughter were both involved in sports, so there were costs associated with that, so to make ends meet during the time off work, and to pay for their kid’s activities, Jim and Sally turned to credit cards. It didn’t happen over-night, but over a period of three years they ended up owing another $30,000 on another bank loan, and on four different credit cards.
After a few years of living in the house Jim and Sally realized that owning a house was more expensive each month than renting. It wasn’t just the mortgage payment; they also had property taxes, and repairs and maintenance, and the payments on their line of credit.
They decided to conserve cash by cutting all unnecessary expenses.
No more taking the family out for dinner; no more movies; and this year, no long-distance vacation. At least they could say that their house was going up in value.
That, my friends, is the classic example of being house rich and cash poor.
Their house may be going up in value, but if every available dollar they earn is going to pay for the house, and the debt associated with the house, what’s the point?
When Jim and Sally came to see me, they were stressed out about their cash flow. They had no money to live. They were thinking that perhaps they should consider bankruptcy.
I didn’t think that was the correct solution.
Now Jim and Sally were lucky. They bought their house a few years ago, and it did go up in value. When they bought their house they had a 5% down payment, so their “equity” was only 5%. With house prices increasing, and with a few years of paying down their mortgage, they now had built up more equity.
So my advice to them was to talk to the bank about converting their unsecured line of credit and their other debts into a secured line of credit.
Remember what I said earlier in the show: secured means “attached to something of value”. When they got their line of credit there was virtually no equity in their house, so it was an unsecured line of credit. But now that the house has gone up in value, the equity has increased, so now they can qualify for a secured line of credit.
Why does that matter?
Easy answer: interest rates.
Their unsecured line of credit has a 6% interest rate, because it was based on their situation at the time they got the loan. Today they could qualify for a secured line of credit at a 3.5% interest rate.
The other $30,000 they owed on their bank loan and other credit cards had interest rates ranging between 9% and 20%, and with credit cards you can’t just pay the interest, you have to pay back some of the principal each month as well, so they were paying around $1,000 per month on those debts.
I suggested they talk to either their bank or a mortgage broker to see if they could either increase their mortgage by $60,000, or get a second mortgage or a secured line of credit for $60,000, at a lower interest rate.
Jim and Sally were lucky. Their house had gone up enough in value that they were able to borrow an extra $60,000, secured, at a 4% interest rate, so their interest payments on that secured loan were $200 per month.
They were paying $150 per month on their unsecured line of credit and around $1,000 in interest and minimum payments on their credit cards and other debts, so dropping from $1,150 per month to $200 in payments was a huge savings.
Because their house had gone up in value they were able to refinance, and not have to go bankrupt.
That’s a nice story with a happy ending; they got to keep their house and not go bankrupt.
But is that really a nice story? Is it really a happy ending?
Yes, they kept their house, but not including what they have paid down on their mortgage they now have around $60,000 more in debt than when they bought the house.
Jim and Sally were house poor. The costs of the house left them with no cash to enjoy life. That’s not a happy story.
They were lucky that real estate prices went up and they could refinance. If house prices had dropped, they would not have been able to refinance, and the story would not have had a happy ending.
So what’s the take-away message here? How can you avoid being house poor?
I have four tips:
First, don’t expect that real estate prices will go up forever. They won’t. It’s mathematically impossible. The first half of 2017 saw big price increases. The second half of 2017 resulted in declines, and this is not the first time in history this has happened.
The average house price in Toronto in 1989 was just under $274,000. By 1996 it was $198,150.
That means if you bought a house in 1989 and sold it in 1996 you would have owned your house for 8 years and lost 28%. House prices did not recover to 1989 levels until 2002.
I know, that is a distant memory for us today, but that’s what happened back then, and could happen again in 2018 and beyond.
So tip number 1, assume that your house won’t go up in value forever, and therefore you should assume that you won’t be able to refinance or sell your house to pay off your unsecured debts.
Second tip: Before you buy a house, make sure you fully understand all of the possible costs. I hear people say all the time “I’m paying $2,100 per month in rent, and my mortgage payment will only be $2,000 per month, so it’s obviously cheaper to rent than to own”.
Of course that’s an overly simplistic analysis, because you are ignoring property taxes, condo fees, and repairs and maintenance costs. It also ignores the fact that your hydro bill in your one bedroom apartment will probably go up when you move into a three bedroom house.
So my advice is to talk to a few friends and family members who own houses, and ask them what they pay each month, for everything.
Your mortgage payment, property taxes and condo fees are easy to figure out. You can talk to the city and the condo association to get those numbers.
But how much is hydro? Ask your friends what they pay, and calculate the per square foot cost so you can estimate what it will cost in your new house. Even better, ask the owners of the house you want to buy for copies of a year’s worth of hydro and gas bills so you can see what they are actually paying.
How old is the furnace? What’s the average life span of a furnace? What will it cost to replace?How old are the windows? What do new windows cost?
In my experience, almost every person I’ve ever met with who became house poor did not accurately consider the costs of home ownership. Don’t make the same mistake.
Tip Number 3: Consider the risk. If you keep your job forever, you will probably be able to make your mortgage payments.
But what happens if you get laid off, or get sick, or get divorced, and can’t make your payments? If that happens, a house can become a liability, not an asset.
My fourth tip is my most important tip: ask yourself this question: what kind of life do I want?
Do I want to live in a big house and never go out? Do I want to be house poor? Or, do I want to live in a small house, or rent a smaller house or apartment, so that I have cash to spend on going out for dinner, or going on the occasional vacation?
Do I want my only investment to be my house, or do I want to have some cash available to make other investments, like putting money into my RRSP, or saving for my kid’s education, which might help me in the long run?
That’s what being house poor means: it means that because all of your money is going to your house, you are too poor to do anything else.
Poor does not just mean “penniless”. One of the dictionary definitions of the word poor is “lacking sufficient money to live at a standard considered comfortable or normal in society”. That’s why owning a house, which is supposed to help you build wealth, can actually make you poor, meaning you don’t have sufficient money to live a normal life.
Now let me be clear: I’m not saying you shouldn’t buy a house.
I’m saying you should crunch the numbers first, so you can make an informed decision.
For many people, renting is the correct decision. It can be cheaper, and less risky.
There’s a great book on this subject; it’s called The Wealthy Renter by Alex Avery. I’m going to try to get him as a guest on the podcast in 2018 to explain how it is possible to be a wealthy renter, so stay tuned for more information on that.
So to conclude: if you have a big down payment, and a stable job, buying a house can be a great idea.
But, if you have to take on a lot of debt to buy a house, and if your level of debt increases while you own your house, you can soak up all of your cash, and that can make you house poor.
Don’t be house poor. It’s not fun.
Crunch the numbers, evaluate all possible costs, and make an informed decision. That’s our show for today.
A full transcript of today’s show can be found at hoyes.com, that’s hoyes.com, and I’ll include a link to my book, Straight Talk on Your Money, where on page 138 I talk about how to avoid being house poor, and I’ve got three full chapters on real estate, so be sure to check it out.
Until next week when we do our annual recap and prediction show, where we will talk a bit about real estate, I’m Doug Hoyes, thanks for listening, that was Debt Free in 30.