If you’re a homeowner, you can be subject to a phenomenon that could put you in the poor house — the “wealth effect.” Huh? How could anything called the wealth effect make you poorer?
What Is the Wealth Effect?
The wealth effect is the result of an increase in home value. It makes people feel richer, and so they go out and spend accordingly — five to seven percent of the increase in home value, according to the Center for Economic Policy Research. They may actually tap that wealth with a home equity loan, or they might just spank the VISA and bring home an ATV, a new wardrobe or tickets for a cruise.
Right now, many Americans are feeling a bit of wealth effect kicking in – The Commerce Department reported today that home sales have increased 29 percent over January 2012, and the S&P/Case-Shiller index that tracks home cities in 20 metro areas indicated that prices rose by 6.8% from one year ago in December. If you have a $200,000 home, a 6.8 percent increase adds $13,600 in home equity. That might trigger $952 in extra spending — even without an increase in income.
Deeper and Deeper
This tendency can have a profound effect on finances — if you ordinarily spend everything you bring home, and you spend an additional thousand dollars without increasing your earnings, that puts you $1,000 in debt. Do that every year your home value increases and you can do some serious damage to your financial health. That goes double if the added debt is financed with credit cards.
Avoiding Wealth Effect Debt
There is a lot of pent up demand in this country — recession-era scrimping has people craving some splurges and good times. However, it’s not time to go crazy. You can celebrate turning a financial corner, but do it intelligently.
- Budget for your splurge. Determine what you can afford and don’t exceed that amount.
- Pay cash. It’s too easy for a budget-friendly indulgence to morph into crazy extravagance when you put it on credit.
- Rethink spending. Choosing to upgrade your home instead of your wardrobe could pay dividends when you sell.
- Use home equity to retire debt. It’s one use of home equity financing that can really improve your finances. be honest with yourself, though, about your ability to refrain from running up debt again. If in doubt, consider putting yourself in the hands of a debt counselor who can help you stay on track.
Many economists say that the United States economy is turning the corner. By exercising a little restraint, you can make sure your personal economy does too.