Net Worth and Leverage

Jun 12, 2012

PBS NewsHour ran a story today, about a triennial Federal Reserve Board report on household income and net worth in the United States. Median household income fell 7.7% in the three years from 2007 to 2010, while median net worth fell over the same period by a deeply sobering 38.8%. The report has gotten lots of media attention and needs no further commentary here; instead, I’ll focus on the quantation aspect of a number like a 38.8% decline in net worth, which highlights the significance of debt and leverage in our personal finances.

The dominant contributor to the decline in net worth was the decline in home prices. Home prices have indeed taken a tumble, but the S&P/Case-Shiller National Index – the most widely-used measure for home prices – at the end of 2010 was “only” (and I use that word advisedly) 31% below the absolute peak that it reached in early 2006, and above any pre-2003 level. How could that translate into a 38.8% drop in net worth?

The answer is “leverage.” If your only asset (let’s keep it simple) is a home worth $200,000 on which you have mortgage debt of $160,000, your “net worth” is $40,000. If your home drops in value by “only” 10% (from $200,000 to $180,000), since your mortgage debt remains at $160,000 your net worth drops by 50% (from $40,000 to $20,000).

The use of the term “leverage” (or “gearing,” as it’s called in some other countries) lies in the fact that if only one-fifth of the asset price comes from your own equity and the rest from debt, then any change in the asset’s value will have a fivefold impact on your net worth. The explosion of mortgage debt during the bubble, at high loan-to-value ratios, made millions of homeowners exposed to both the benefits and the risks that leverage can offer.

The good news is that if and when home prices begin to trend upwards, homeowners will see similarly leveraged increases in their net worth. There are no such signs of that these days, but in the long run home prices tend to move with inflation in general.

Debt is indeed a two-edged sword.

“Painting with Numbers” is my effort to get people talking about financial statements and other numbers in ways that we can all understand. I welcome your interest and your feedback.

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