The American Dream, sold to Americans at a young age partly begins with a personal ownership component, purchasing a house. Home ownership and upward mobility generate inspiration for working and living in a great country like the US. At TPM, we bought into the concept well before analyzing if it was the right decision.
For some, home ownership is not enough. They want to “move on up.” The term starter home was coined. This concept, most likely created and spread by realtors (I have no proof here,) was to encourage young families to buy a small house, maybe a two bedroom, two bath. This initiates them into the American Dream. Then later, that same realtor might be asked to sell the starter home and move the family into a larger home. Each step of the process will fatten the realtor, government and attorneys pockets.
As a basic necessity, everyone should have a roof over their heads. Whether you choose to buy a home is a very personal decision and depends a lot on your locale. The point of this post isn’t really about buying a home or not, but I will touch on the decision making process to illustrate my point.
I have heard cases from both sides that home ownership is an expense or it is investment. I find myself sitting somewhere in the middle. I’ll call it a quasi-investment. Let me explain.
Appreciation is the Real Return you May See but mostly offset by Expenses
If I purchase a home for $200,000 and sell it ten years later I may see a $100,000 capital gain. That sale comes with hefty expenses like a 6% realtor fee. Luckily the US Government provides an incentive by not taxing you on the capital gain. This incentive is up to $250,000 for single and up to $500,000 for married filing jointly.
Historically home prices have appreciated only slightly above inflation. So real returns (above inflation) will be minimal over time. However, there are always anomalies (looking at you San Fransisco.)
Added Benefit Courtesy of US Government
As a homeowner, you are also entitled to deduct interest expense. The amount of interest you pay will get deducted from your earned income from the year providing you with a saving on your tax bill.
Housing Expense will Decrease Over Time
Assuming you took out a fixed rate mortgage, the amount you pay will be fixed for the duration of the loan. Your escrow may increase due to a tax increase or insurance increase, but the principal and interest should remain flat assuming you don’t refinance. Alternatively, rents will continue to rise over time with inflation.
Eventually, you will pay off the principal and will be responsible for taxes and insurance only. One could argue that not having to pay a housing expense could be a quasi-dividend. You could sell that home and move that capital to stocks or bonds returning cash in your hands to cover rent.
One time expenses on home purchases usually occur during the buying and selling. These expenses are quickly forgotten, but still can be very expensive. Your actual expenses will determine how soon you can recoup your money and establish a real return on your home. This list isn’t meant to be an exhaustive, but will provide some insights into the expenses with home ownership.
- Down Payment – This is the biggest hurdle for new home buyers. 20% is the traditional amount to put down, but you can probably find lower. However you will need to have an additional insurance called Private Mortgage Insurance (PMI.)
- Title Insurance – to me this is the biggest scam in the real estate business. You are essentially buying insurance to make sure the seller of the property is actually the owner of said property. This is required.
- Fees – There are endless fees you will incur, attorney fees, courier fees, escrow fee, underwriting fees. The list goes on and on.
- Home Inspection – An inspector will create a list of issues with the home. The buyer can negotiate with the seller to have items remediated before the transaction is closed.
- Home owners association fees – Some HOA’s will charge a one time fee for new residents. Buyers typically will also pay back any prepaid HOA fees to the seller.
- Realtor Fee’s – This is usually 6% of the sale price.
- Title Insurance – Some states require to seller to pay for this one. Please check with your state’s rules.
- Fee’s – Again the list is endless, attorney fees, courier fees, notary fees etc
- Prepayment Penalties – Your loan may have a prepayment penalty. Some do, but not all.
- Transfer Tax
On Going Expenses
- Exterior Maintenance – Roofs, painting, gutter cleaning, window cleaning and many others. Will you be doing this yourself or outsourcing? As a renter your landlord will handle these.
- Lawn Maintenance – Mowing, fertilizing, irrigation, watering and plantings. How good is your green thumb?
- Remodeling – Do you really love every part of your new home? How many compromises did you make?
- Home Owners Association – Some neighborhoods charge you for landscaping, clubhouse, pool and tennis.
- Pest Control Bond – Nobody wants termites.
- HVAC System Maintenance
Lets make some assumptions.
Lets assume a buyer purchases a house for $250,000. She puts 20% down and pays 5% in closing costs. Her initial cash outlay is $62,500. The remaining $200,000 is a loan at 4%. For year 1 the buyer will have: 50,000 (down payment) + 4,403 (principal payments) + 7,500 (appreciation at 3%Y/Y) + 3,273 (approximate tax deduction) – 12,500 (closing costs) – 4,400 (principal) – 9,920 (interest) – 2,500 (tax at 1% of home value) – 1,000(insurance) – 3750 (1.5% of home value) and no remodeling. At the end of the year she has $31,103
Instead she decides to rent. Lets say she can find a similar place for $2000 per month growing at 4% annually. Instead of a down payment she invests in a mix of stocks and bonds that returns 8% per year. At the end of the year she has $43,500. $62,500 + $5,000 (investment gain) – $24,000 (rent.)
Who does better after one year?
The renter of course. Home ownership is a long term commitment and comes with a large one-time cash outlay.
How does this hypothetical scenario play out over 30 years? The first 4 or 5 years the difference is negligible. After a while, buying becomes a better option.
Buying Comes with a Big Assumption
She will need to stay in her house for a long time to obtain the rewards of home ownership. If this person “moves on up” she will push the reset button. She will also incur selling closing costs and another round of buying closing costs. These costs will significantly sway the model in favor of renting.
Renting comes with one added benefit, liquidity. Money is inaccessible in real estate (except for home equity line of credit.)
Back to the purpose of this post…
Home Ownership is Mostly an Expense
I think we can agree, renting a property is monthly expense. It comes with a benefit of not tying up a significant amount of investment capital. In my opinion, home ownership is an quasi investment that comes with additional expenses, many of them outlined above.
We lived in our home for almost ten years. We plan on staying in this home for a long time. Long term home ownership provides a few investment like characteristics including:
- Hedge against inflating housing expenses.
- Investment in our future self that does not include mortgage payments. (Dividends or expense reduction)
- Appreciation in value.
- Home Equity – an asset on your families balance sheet.
How do you view home ownership? Is it an investment or an expense?