To begin, let me state that I am a happy homeowner and that I wouldn’t change that for a second. As you’ll see, however, the reason I am a completely happy homeowner is due entirely to the subjective value I derive from it—a place to raise my kid, a place we can call home, a place where I don’t have to answer to anyone if the remote “accidentally” gets thrown into the wall during NFL season (editor’s note: my wife disagrees with that last statement). I don’t dispute the value of being a homeowner in that regard. I do, however, dispute the value of your primary residence from a purely financial point of view.
I think it’s important to draw a distinction between the financial value and the subjective value of your home primarily because I see too many jump into a home purchase focused on the former. To begin, let’s start with what you give up when buying a primary residence—namely, flexibility. First and foremost, I’ll always encourage those that want to buy a home to make sure that it’s likely they’ll want to be in that home for the next 5+ years at a minimum. If you’re unattached to your current city and think it’s possible you’ll move for whatever reason, I stress caution before you lock up a significant portion of your net worth in an illiquid asset.
Let’s examine a hypothetical mutual fund investment. It has a 1% commission on the front-end, it has a 1.8% expense ratio, and a 7% load on the back end. As an added bonus, this mutual fund only buys one concentrated, illiquid asset with a historical return of less than 5%. If I recommended going on margin (borrowing) to buy that fund, I should be fired as an advisor. But that’s exactly what we do with a home purchase!
For example, let’s assume we’ve bought our dream home for $300,000. We’ve been saving for it, so we are able to put 20% down, such that we take on a $240,000 mortgage fixed for 30 years at 4%. The monthly payment on principle and interest for that is $1,142. Let’s say seven years later, our life has changed and it requires a move. Fortunately for us, the economy has done well and we’re able to list our home for $500,000 and accept a full offer shortly thereafter. Seven years of paying our mortgage has left us a balance of roughly $206,500 on our loan; instead of “throwing away” $1,142 every month on rent, about 1/3 of those payments built some home equity which is now nearly $300,000—$293,500 to be exact. For our investment of a $60,000 down payment, that seems like a nice rate of return.
Of course, there will be closing costs on both ends—something like $5,000 when we bought and closer to $35,000 when we sell since we’ll be paying both broker’s commissions at 3% a piece. Let’s add $40,000 on to our investment for those costs so that we’re sitting at a $100,000 investment initially. Don’t forget that we added a backyard for $25,000 and remodeled some bathrooms for $10,000, which brings us up to $135,000 for our investment. And living in a home for seven years doesn’t come without its maintenance costs—our garage door broke, our A/C needed a repair, maybe we had to refinish the roof, pay landscapers, HOA fees, etc. Let’s be generous and say that only ran us about $4k per year (most estimates put the average maintenance cost of a home at a bit over 1% of the value every year) over those seven years for a total maintenance cost of $28,000. So, total investment in our home is now:
$60,000 down payment + $40,000 closing costs/commissions + $35,000 home improvements + $28,000 maintenance costs = $163,000 total investment
From there, we can figure out our rate of return. To turn $163,000 into $293,500 over seven years is about an 8.7% rate of return. Unfortunately, I forgot we were paying property taxes that average about 0.8% in western states, so that drops our total return to 7.9%. Still pretty good. Or is it?
To be fair, I assumed the home price appreciated at 7.5% on average, or about 150% as much as the long-term average of less than 5% according to the Case-Shiller Index. Also, over the last seven years, the S&P 500 had an average return of 14.77% which would have turned our $163,000 investment (in the event we were a renter and didn’t take on those costs) into about $427,000, so there was an opportunity cost to tying those resources up in our home.
Most importantly, this is a fairly rosy picture of home price appreciation. What if you saw little to no home appreciation over the last seven years either because you happened to live in a lousy real estate market or a sewer line broke in your neighborhood and undermined the foundations of about 20 homes? This happened in my old neighborhood, by the way. What if you bought your home in 2006 and actually saw a dramatic decrease in price? From a financial point of view, your primary residence is a large, undiversified asset and is subject to much more uncompensated risk than a diversified global portfolio of stocks after all.
Some will point to the mortgage interest deduction (MID) as another benefit of home ownership, but I think this is overrated. The MID effectively just lowers your cost of borrowing—if I’m paying $10,000 in interest and I’m in the 25% bracket, I get a $2500 deduction on my taxes so that in effect I’ve only paid $7500 in interest. It would effectively reduce your interest rate from 4% to 3% in our example, but it’s still an interest rate you are paying. It’s a nice bonus as a homeowner, but not a reason to become one.
This brings up another point which is that most people who have had good fortune with real estate do so because of leverage. In our example, the home only appreciated about 7.5% per year, but our return was 8.7% even after all those additional costs because we borrowed money to purchase the asset. You can do the same thing by going on margin in a stock portfolio, by the way, though I don’t recommend that. Leverage goes both ways and can burn you badly as people found out when their home price plummeted and they were upside down on their mortgage.
The point here is to not say all of this can’t be justified or that you can’t end up in a situation where your local market is in a boom and you end up profiting handsomely. I wouldn’t bet on the latter case, however. I could choose to buy an individual stock and hope it does better than the market, but we’ve shown many times here that I’m basically flipping a coin in that situation—it’s not a solid plan. My own situation with my previous home is quite similar to the scenario where there was no price appreciation, for example. Nevertheless, I can quantify what we spent to enjoy being a homeowner for all of the subjective reasons discussed before and be quite satisfied that it was worth it (it definitely was!)
There is a very strong culture in America that says home ownership is the BEST way to build wealth—it’s not. It is still extremely valuable, however, for subjective reasons—peace of mind, stability, etc. I urge you to prioritize those values when deciding on home ownership and only consider your primary residence from a financial point of view secondarily.