Knowing what is the Wealth Effect is important since it impacts our everyday life as much as our future.

Knowing what is the Wealth Effect is important since it impacts our everyday life as much as our future.

Total wealth could be described as the result of two components: human wealth and non-human wealth.

  • Human wealth depends on the present value of current and future disposable income, as well as on the expected real interest rate.

  • Non-human wealth contains Stock market wealth and Housing wealth. Stock market wealth meaning stocks held by persons and unincorporated businesses. Housing wealth meaning residential structures net of mortgages.

Do you know what drives any economy? Primarily consumption. Research suggests consumption does not respond much to a permanent increase in stock market wealth, while a permanent increase in housing wealth leads to a significant rise in consumption.

But why is housing wealth directly affecting consumption and not stocks? Because the higher concentration of stocks is found among a relatively small group of households, used to the versatility and constant change of the stock market. We seem to perceive homes and their values differently since – unlike stocks – we can see and use our homes.

Thus, movements in wealth, especially housing wealth, directly affect consumption and influence the total demand for final goods and services in an economy. In simpler terms, when we know that the prices of our homes increase, we feel wealthier. This perception makes us willing to spend more money, even if our disposable income remains unchanged. When we all spend, it helps the economy grow. Other factors, such as increased mortgage refinancing and more frequent use of housing wealth as collateral, are likely to further increase the Wealth Effect from housing. To offer a practical example just between 2001 and 2003 Canadians obtained an additional $22 billion from the refinancing of their houses and the use of this asset as collateral.

Research also indicates the Wealth Effect can be reversed. When we learn that the value of our home is constantly reducing we lose our sense of wealth and start cutting back on our spending even if our disposable income remains the same.  The result is lower consumption leading to a weaker economy which in turn puts further pressure on the price of homes creating a vicious circle. Note that the real housing wealth is the value of the residence minus the debt/mortgage.

What the media refers to as a slow down in real estate was the intended result of all the actions taken by the provincial and federal government during the past 2 years. Yet, the bank of Canada announced a few days ago its decision not to raise the interest rates at this time. Partly because it is aware of the housing wealth effect and its impact on economic growth.

The general feeling is the GTA and Toronto real estate market is probably going through a period of stabilization. But is not out of the woods yet. It is obvious how the Wealth Effect has real implications in our everyday life. Additionally keep in mind our housing wealth will materialize only when we sell our house and pay off our mortgage. For instance if you own a property with market value of 1 million but have a mortgage of 700,000 you are not a millionaire. Similarly, stock wealth if in a pension fund is only released when we are 65 years old and are able to cash it in.

In both instances timing is of the essence. As is being alert and aware of what is happening in the market if we want to avoid surprises. For example if you are planning on using the money from selling your home to fulfill your retirement dreams you need to be careful on choosing the right time to do it to have the highest possible gain. If you want to buy identifying micro markets with reduced prices or even the trend in your area of interest is also key.