This article, originally published in 2008, continues to be one of our most popular posts. Please keep in mind that it is possible some of the facts offered have changed throughout the years, but our sentiments about this topic have not. To learn more about this subject, check out Are Reverse Mortgages Ever a Good Idea?
The conventional wisdom used to be: Pay off your mortgage as soon as you can. Retire with a paid for home. Some personal finance writers still believe that. I used to believe it too, but not any more.
No debt is as bad as too much debt. I used to be a zero-debt advocate, but now I think zero debt can create a diversification and liquidity problem. If I have too much of my net worth tied up in home equity, I am very sensitive to falling real estate prices, and I am going to find it very difficult to tap my equity if I need it.
The Problem with Home Equity
The problem with home equity is that the more I need it, the harder it is to get to. What lender, for instance, is going to give me a home equity loan when I have just lost my job? What kind of bargaining power do I have in the sale of my home if a loved one is sick and needs hugely expensive out-of-pocket medical treatment?
In response to my previous posts on this topic, some have suggested that taking out a home equity line of credit (HELOC) and letting it sit there unused is the answer to freeing up the equity in your home in case you ever need it. Sunday’s New York Times shows us why that is not necessarily the solution.
Apparently, lenders across the country are freezing HELOCs across the country, even if you have a perfect credit score. In the last month, lenders have sent hundreds of thousands of letters to consumers telling them those home equity lines of credit they paid money to secure, can no longer be tapped.
Most of us think of diversification in terms of asset classes. You also have to think in terms of diversifying liquidity. On the liquidity continuum, cash is obviously most liquid. Businesses and limited partnerships are probably least liquid. In between you have a broad range.
Having an emergency fund is key. I believe in at least a six month supply of cash on hand. Next comes cash flow. Interest, dividends, option premium, rent, and royalty payments are all forms of short term liquidity. After that are items that can be readily bought and sold in efficient markets. This would include stocks, bonds, options and futures. From there, liquidity becomes murkier.
Some investments have lock-up periods in which you cannot sell them or you will pay a big penalty to sell them. Others, like real estate, can be easy to sell at times, but almost impossible to sell at others. The more complex the asset, likely the less liquid it will be.
It is helpful to consider that most companies don’t go bankrupt because they lose money, they go bankrupt because they don’t have sufficient liquidity to meet their daily obligations. Think of Bear Sterns.
The same is true of individuals. Most individuals who file for bankruptcy have jobs and assets. It is just that their cash inflows don’t properly match up to their cash outflows. When this happens, you have a liquidity problem.
The Bottom Line
Your job, as family CFO, is to structure your assets so that no matter what happens, your cash inflows match up to your cash outflows. In on other words, liquidity has to be a primary consideration.
As a general rule, I like to think of liquidity as being inverse to assets. The less resources you have, the more liquid you need to be. As your assets increase, you can afford to put more and more of them in less liquid assets.
If you haven’t already, sit down and list out your assets. Stack rank them from most liquid to least liquid. Then ask my favorite question … “What if?” Ask yourself, what if I had no income coming in for two months? Where would the money come from? What about six months? A year? Two years? What if I was permanently disabled? What if I was sued or someone in my family became ill?
Asking these questions forces you to examine your resources in terms of liquidity. If you don’t like the answers you come up with, it might be time to restructure your assets or get going on augmenting your savings.
1. Morgenson, Gretchen, “You Thought You Had an Equity Line.” New York Times, April 13, 2008 http://www.nytimes.com/2008/04/13/business/13gret.html?_r=1&oref=slogin (accessed April 15, 2008,).