Last month I wrote about How High Income Can Lead to High Debt. It seems to be an unlikely connection, but there are tangible reasons why it happens. Today I want to discuss a related, but also seemingly unlikely toxic debt association, the high asset – high debt connection. Record stock market values make this an incredibly timely topic.
You might use debt to improve your lifestyle, under the rationalization of “I don’t want to disturb my assets/investments”. Never does that seem more logical than when investment assets are rising in value. It can seem like solid financial thinking, but it’s a theory that has more than a few holes in it.
Rising Asset Values as a Justification for More Debt
If you have $50,000 in assets, and $10,000 in consumer debt (say, credit cards), you might feel justification in increasing the debt level to $20,000, or even $30,000 or more, two years later when your asset value has grown to $100,000.
It seems logical, after all your wealth is growing, so there’s room to take on additional debt without putting yourself in financial jeopardy.
But this practice can become a Catch-22 if you steadily increase your debt level as your assets grow in size. It’s a way of living off your assets without actually liquidating them. After a few years, you might have $200,000 in assets, but carry $100,000 in consumer debt (now expanding to car loans and other installment debt) as well.
You’ll still feel richer – after all, $200,000 is a lot of money. You may even get caught up in thinking that you’re actually worth $200,000, when you’re really only worth half of that once you subtract out the amount of debt you owe.
That’s a big delusion, but one that more than a few people participate in. This is complicated by the fact that many people overestimate their assets. For example, they may overestimate the amount of home equity that they have. They may also assign a high value to personal property, such as furniture, entertainment and recreational equipment, clothing, jewelry and appliances.
In my mortgage days, such exaggeration was common, with both home equity and personal possessions. A person might assign a $100,000 value to personal property that could be sold for no more than $5,000 or $10,000 in a forced liquidation. They feel rich based on asset values that don’t even exist.
But that’s not the worst of it
The High Asset Liquidity Trap
The two biggest assets that most people have are their house and retirement accounts. And granted, each may have a generous amount of value. However, neither asset is particularly liquid. And if you were to liquidate either, you would have to pay either high transaction costs or income taxes, or both. As a result, the “melt value” of these assets is usually considerably less than what the owner believes them to be.
Home Equity Liquidity Limits
Let’s say that you believe that your house is worth $550,000. You have a mortgage against it that you estimate to be about $350,000. That gives you equity of $200,000.
Here’s a not too uncommon outcome. One day you decide to sell the house in the hopes of trading up to a larger one. You find out from real estate agents that it’s really only worth about $500,000. It’s lower because your estimate was based on the highest priced house to sell in your neighborhood, but you ignored the fact that that house was superior to yours in most respects. Right there $50,000 worth of equity is gone.
You also find out that between paying a real estate commission, seller’s closing costs, and offering to pay for the buyers closing costs as an incentive to purchase your home, you will pay about 10% (this is a typical percentage) of the sale price of the property. Another $50,000 ($500,000 X 10%) worth of equity is gone!
When you contact the bank about your mortgage, you find that the actual payoff balance is $360,000, not the $350,000 you suspected. You’re out another $10,000.
The net result is that the $200,000 of home equity that you believed you had, shrinks down to just $90,000 in the event of a sale.
Retirement Savings Limit
This is where most people have by far the largest share of their liquid assets. But the reality is that retirement assets are only semi-liquid at best. Since both the contribution and investment earnings are only tax-deferred – and not tax-free – you’ll have to pay ordinary income tax on any money that you withdraw. Then there is also the 10% penalty tax if you withdraw money before turning age 59 1/2.
If you have $200,000 in your employer sponsored 401(k) plan, and you are in the 25% tax bracket, any liquidation of the plan will cost you 35% of the value (25% tax plus 10% penalty). That means that your $200,000 retirement plan has a liquidation value of just $130,000.
Combining the two situations, you may have believed yourself to have $400,000 in assets, based on $200,000 in home equity, and $200,000 in your 401(k). In reality, the liquidation value of your home is $90,000, and your 401(k) plan is $130,000. That’s a total of $220,000, which is only a little more than half of what you thought you had.
If you got a little bit carried away with debt, because you thought you had the assets to cover them, this could be a rude awakening.
High Assets Usually Aren’t Income Streams
This is the second limitation of high assets. Assets are not income, and they often do not generate a cash flow of any usable sort. A house is a primary example. Not only does it not generate income – no matter how much equity you have in it – but it also costs you money keep it.
Retirement plans are no better. Though they may earn income from both capital gains and interest and dividends, it’s all reinvested back into the plan, unless of course you’re retired.
Since debt requires monthly payments, high asset values do not generally supply an offsetting income stream.
When Asset Markets Misbehave
Financial markets do decline, and sometimes they crash. When they do, your asset values plummet. The same is true of your house. Though most homeowners are loath to admit it, house prices can decline. Worse, when they do, real estate usually becomes extremely illiquid.
This could be the unkindest cut of all. When your asset values fall, your debt obligations don’t decline in step. They remain stubbornly fixed while your assets bleed. You can lose 50% or more of your asset value, and your debt levels stay right where they’re at. That’s a completely unequal arrangement.
Why High Asset Values are Best Ignored in Your Everyday Life
When you consider that the types of assets most people have don’t generate income, and that debt levels are fixed even when assets decline, high assets should never be seen as justification or an offset to support high debt levels.
No matter what the value of your house is, or how much money you have sitting in your 401(k), your best course of action is to completely ignore that you even have them. Your debt levels should always be based on income, and never somehow enhanced by the fact that you have a lot of assets.
The ultimate goal of having investment assets is to grow them to the point where the income they ultimately generate will make your earned income unnecessary. But if you’re increasing debt consistent with your asset growth, you may be undermining that whole strategy. It’s easier than you think to get caught up in that trap.