There is a very hard reality when it comes to the issue of housing that a lot of people are resistant to accept, your home — the place you live — is not an investment, it is an expense.
Before I go on, it must be said that this does not mean a house is necessarily a ‘bad purchase’. It just means it isn’t the slam dunk smart money move that it’s so commonly believed be.
What Is An Investment?
In short, an investment is “the action or process of investing money for profit”. A home you live in doesn’t fit that description, especially when you evaluate it against other options.
The 2 common supports for housing as an investment:
- Houses appreciate.
- If you finance, a portion goes toward principle which builds over time.
Let’s look at each of these arguments individually to see how they hold up.
Yes, homes do tend to appreciate over time. The conventional rule of thumb places it about 3% per year. However, that is the average over a long time frame. It varies year to year depending on economic conditions, and as we learned from the national housing bust of 2008, we can’t necessarily depend on positive increases year after year, not to mention the potential losses that might occur during a severe recession.
Given that inflation rates are also roughly 3%, this means the home isn’t actually gaining in value, it’s simply keeping pace with inflation.
In order to make a profit on an investment, your investment must beat inflation. If your returns are less than the inflation rate, you are suffering a loss because those dollars are losing purchasing power. If an asset simply keeps pace with inflation, you are just breaking even.
If you buy a home cash, it just means you aren’t losing due to inflation, however you are locking that money in an asset that isn’t producing returns above inflation.
If you purchase with a mortgage, any gains you see from appreciation are offset by your interest expense and closing costs.
Under either scenario, the often forgotten maintenance expense reduces the remaining potential for profit from appreciation.
Accumulation of Principle
The idea here is that at least you aren’t ‘throwing money away’ on rent, and instead, a portion of your payment (if you purchase with a mortgage) is going toward principle. While this seems like a profitable position compared to renting, you have to account for the closing costs associated with the loan which often take several years of payments to recoup. Even if you have a loan with lower closing costs, you will pay higher interest. You end up paying one way or another.
In addition, accumulation of principle doesn’t really begin to add up until many years into the mortgage, because of the way loans are structured.
Your mortgage payment is split up into two parts, interest and principle.
Interest is the ‘rent’ you pay to borrow the money. The principle payment is the amount that goes toward paying down your balance.
In the beginning of your loan, most of the money you pay toward your mortgage goes towards interest with a smaller amount going toward principle (the amount you owe). Over time the interest portion decreases as your outstanding balance decreases and the portion that goes toward paying off your balance increases.
This means it takes a while before you start putting a major dent into your loan with regular payments.
The principle you store up over time through this process isn’t ‘investing’, it is more along the lines of a savings program. It’s not entirely a bad thing, but it’s important to understand it isn’t an investment, especially when you factor in the costs associated with the loan and ownership.
The Forced Savings Plan
You might know a friend or family member who sold a home they’ve owned for a while and got a nice check at closing. This means they made a great investment, right? The answer is: not necessarily.
The simple explanation for this is that buying a home is a kind of forced savings plan. You have to pay your mortgage or you lose your home. Since it must be paid, most find a way to prioritize for it.
Even if they lack the discipline to save otherwise, they will generally end up with equity after a few years or more, but keep in mind, they have to pay transaction costs when they sell.
If they use a real estate agent, commissions are typically 6% of the selling price (3% to the buyer’s agent, 3% to the seller’s agent). Traditionally the seller also pays for title insurance and transfer taxes.
While many will point to the hidden costs of home ownership and the overstated financial benefits of home ownership to make absolute arguments against buying a home, the forced savings plan aspect does have some value for those who otherwise lack the discipline to save. While it may not be the technically smart money move, for many, it may be the best chance some will have to store up some of their hard earned cash. Provided they don’t take it out when they refinance or with a Home Equity Line of Credit.
Why Do Homeowners Have More Wealth Than Renters?
While it is easy to jump to the conclusion that owning a home is what is making these people rich, it represents a biased sample for each group. Most people who buy a home have a down-payment that renters don’t have, or can qualify for a loan that renters can’t due to income.
It would be similar to a study that showed Ferrari owners were more wealthy than Ford owners.
In other words, people who buy homes tend to be wealthier than renters in the first place, they aren’t wealthier as a result of owning a home.
Why It’s Important to View Your Home as an Expense
Viewing it from this standpoint can help guide your decisions, or at the very least, help put them in perspective in terms of cost, including opportunity cost.
No matter if you are buying or renting, you should view the costs as an expense and anything beyond what you “need” as a luxury.
Not all luxuries are bad even for those who are frugal. However, viewing it in this way can help moderate decisions you might otherwise make that ultimately would affect how much you are willing to spend for the luxury.
It is easy to view housing as an expense when you are renting because the common perception is that you are “throwing money out the window” when you pay rent. So it is easy to understand that the more expensive the rent, the more money you are “wasting”.
However, this concept becomes a little more difficult to see when you buy a home. After all, if you buy with debt, a portion of your payment is going toward principle. In addition, homes tend to appreciate over time.
While these assumptions are generally true, neither give license to buy the most expensive home you can fit into your budget.
It is easier to see if you evaluate the choice to buy if you had the cash for the full purchase.
If you can afford a $400,000 home, and all indicators show you should buy vs rent, it might be a smarter move to buy a $200,000 home, and use your excess buying power to purchase an additional property to rent out.
If you buy a $400,000 home, you are consuming the full amount of that purchasing power. However, if you split it up, you can position a portion of that $400,000 toward an actual investment, a rental property.
A rental property is an investment because it produces cash flows (return) on the invested money. A primary home is a place to live, it is not an investment.
Is Buying a Home a Bad Idea?
Not necessarily. As we mentioned before, it isn’t a slam dunk smart money move, but it isn’t necessarily a bad purchase. There are tangible benefits to owning a home.
However, viewing it as an expense can help you to keep the purchase in perspective so that you don’t trick yourself into buying a more expensive home because you think you will get a bigger “return”.
If you are occupying the home, you are consuming it. While it is not the same as buying a new luxury car, recognizing your home as an expense is extremely helpful in making rational and wise decisions whether it’s to buy or rent, and avoid the temptation of talking yourself into spending more on a primary home than you should because you think it is somehow a great investment.
- Related: Growing Wealth vs Consuming Wealth