U.S. households grew richer by a collective $1.5 trillion in the first quarter of this year, according to the Federal Reserve. The increase was mostly fueled by gains in real estate values, which lifted more homeowners into positive home-equity territory.
An increasing stock market also contributed to healthier household balance sheets. Taken together, the housing and stock market gains on paper could lull people into feeling richer and spending accordingly -- the so-called "wealth effect."
Total household net worth now stands at $81.76 trillion, pumped up by a $758-billion increase in the value of residential real estate. Households currently have a collective 53.6 percent equity in real estate, compared with approximately 39 percent from 2008 through 2011.
Dangers of the wealth effect
Barry Taylor, financial planner with Integral Financial Solutions in San Francisco, says the gains in portfolios and home values since the recession should not be a reason for forgetting the financial lessons from the recent past.
"Are people richer since the financial crash? Yes. Should they feel richer? Yes and no," he says. "I think people are feeling more assured than they were a few years ago. That said, my concern would be that our memories seem to be short," he adds. "It's only a matter of time -- if it hasn't happened already -- before people start taking on more risks, chasing yields, for instance, by investing heavily in alternative assets or junk bonds."
Smart spending habits also seem to relax when people begin feeling the wealth effect, he says, sometimes resulting in higher debt to finance purchases. "If people start spending based on what they see on paper, as they did a few years ago, they could get overextended."
Lock in gains
Taylor suggests that his clients, particularly those close to retirement, lock in current gains as much as possible, given the uneven recovery of the underlying economy and the uncertainty around the Federal Reserve bond-buying program.
While it's tricky to respond to short-term uncertainty in the economy, Taylor says interest rates are likely to head north as early as next year.
Homeowners who have been lifted into positive home equity might want to consider refinancing into a lower mortgage rate, he says. Others, particularly those nearing retirement, might consider locking in their home equity by selling and downsizing to a smaller house.
It's a little more difficult to lock in gains in the stock market, especially if you still need equity for growth. Taylor advises being diligent about rebalancing by selling the assets that are gaining and reallocating them to maintain your target asset allocation.
Be a turtle, not a hare
Despite the double-digit gains in the stock market last year, so far, the year ahead looks like it will be much slower going, says Taylor. The key is to keep your eyes on your financial goals and not get sidetracked by performance.
"We know over the long term there are boom and bust cycles," he says, and because we're still recovering from a bust cycle, now is not the time to embrace a high amount of risk. "This remains a time to be cautious."
Thinking of cashing in on your home equity? Check out the top five housing markets on the rise.
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