Granite counter-tops! Stainless steel appliances! Open floor plan!
For most people, buying a home is an emotional decision. They buy because it provides a sense of pride, feelings of accomplishment, and a place to make their own.
And almost everyone gets told that buying a house is a good investment.
According to Investopedia, an investment is an asset or item acquired with the goal of generating income or appreciation.
You can turn your house into an income-generating machine using roommates or Airbnb. It’s not the reason most people buy a home. And assuming that your home will appreciate is just another way of speculating that home prices will rise.
Odds are very good that you aren’t Warren Buffet. But, there could be a chance that you suffer from superiority bias. The belief an individual has in their skills and abilities being better or greater than others with the same set of skills and abilities.
AAA conducts an annual study of US motorists. They discovered that almost 75% of drivers believe they are better than average drivers. Which is statistically impossible! And the reason most people think they can beat the market.
Housing is an important topic. It is the largest expense American households face. But is buying a house a good investment?
Mortgage payments are the first thought that comes to mind when owning a home. In 2019, 86% of buyers got a mortgage when they purchased.
The St Louis Fed shows the median home sales price is $327,100. And the National Association of Realtors (NAR) states the median down payment of all buyers was 12% in 2019. Using this data we can compute the median down payment was $39,252 and the amount financed was $287,848.
During the same period, Bankrate shows that the 30 year fixed interest rate hovered around 4%. Using a loan balance of $287,848 and a 4% interest rate, we can calculate the median principal and interest payments to be $1,374.
The typical home buyer did not make a full 20% down payment. So, they incurred the extra expense of mortgage insurance. This is estimated at $131 per month using a mortgage insurance calculator. And is based on the median credit score of 706.
Home ownership also comes with property tax and insurance bills. The average property tax expense is $2,279. And the average cost of insurance is $1,445 per year.
The total monthly mortgage payment (also known as PITI) for the average homeowner is $1,815.
The cost of owning a home doesn’t stop with the payments. They are just getting started! You also have to consider the future repairs and replacements that your home will need years down the road.
Bob Vila, a well-known home improvement expert, calculates the average home size is 1,760 square feet. And most insurance companies recommend saving at least $1 per square foot per year for property-related expenses (a low figure in my opinion).
If I know one thing about owning homes, it’s that things break. All the time. I have had to replace roofs, siding, and even dry out flooded homes (more than once!).
Also, consider the additional costs of yard work, pest control, and Homeowners Association (HOA) dues. For simplicity, we’ll use $150 per month for all these expenses. After all, you do have the option of spending your time working on them. And not every home has an HOA.
The average homeowner’s total expense is $2,112 per month!
Home ownership is expensive and a lot of work. Which presents a question: Do you own your home or does it own you?
Anytime you make an investment it requires you to part with some of your hard-earned savings. In real estate, this is your down payment and closing costs.
Above we learned the typical sale price is $327,100. And buyers make a 12% down payment, which equates to $39,252.
Closing costs vary between every county in the country. Each municipality sets the amount they charge for things like recording fees and transfer taxes.
Typical closing costs are 3% of the purchase price. And it’s customary in most of the country for them to get split between the buyer and seller. So, when buying a $327,100 home, you would be responsible for $4,906 in closing costs.
The total investment the average home buyer makes is $44,158!
Above, we determined the initial mortgage payments are $2,112. But, even though you took out a 30 year fixed rate loan, your payments aren’t fixed for the entire life of the loan.
Yes, the principal and interest part of your payments won’t change. But, your taxes and insurance will fluctuate every year. And by fluctuate, I mean increase!
To account for these hikes and inflation, we will assume a compounding growth rate of 3%. This yearly rate gets applied to the taxes, insurance, maintenance, and HOA/pest/yard expenses.
There is one piece of good news. Your payments will go down in year 2 because you can remove your monthly mortgage insurance (MI)!
This policy is required on loans above 80% Loan to Value (LTV). It’s additional protection for the lender if you default on your payments.
You can request that your mortgage servicer remove the MI on conventional loans when you hit the 80% LTV mark. Otherwise, it will automatically drop off at 78% LTV.
Keep in mind, both of these LTV figures are based on the original purchase price. Not the current value. So, when you contact your servicer they usually require that an appraisal gets completed to confirm today’s value.
The home’s value reaches 80% LTV in year 2. This occurs from both the loan principal getting paid down and the home’s value appreciating.
The Case Shiller Index is one of the best measures of home value appreciation. The Shiller, in Case Shiller, publishes housing data dating back to 1890. Using this data, we can compute the historic annual growth rate of real estate to be 2.7%.
For our investigation into whether buying a house is a good investment, we will use a slightly higher growth rate of 3%.
Many new first time home buyers trade up to a more expensive home after they have owned for a few years. And the National Association of Realtors (NAR) has determined that 13 years is the median duration of home ownership.
So we will look at the holding costs for 5, 10, and 15 year periods. They are:
Not only do you incur costs on the buying side of the transaction, but even bigger ones on the selling side. According to NAR, 89% of sellers use a real estate agent to sell their home.
The typical commission realtors make is 6% of the sales price. Three percent goes to the listing and 3% to the selling agent.
Like purchasing a home, you also have to pay closing costs when you sell. And this expense grows because it’s based on the higher future sales price.
In total, a seller pays 7.5% of the sale price in commissions (6%) and closing costs (1.5%).
Many people like to brag about the ‘returns’ they made on their home. They look at only the amounts that were invested and netted from the sale.
Based on this method the returns are:
But, this method is flawed!
If you owned a dividend-paying stock, you would include both the dividends and capital gains when calculating your total return on investment.
Similarly, when you view your home as an investment you must include the monthly expenses as well.
Taking into account the yearly cash outflows for PITI and maintenance changes the narrative. We input the following numbers into the Internal Rate of Return (IRR) calculator:
Please note that in Year 5 you Net $97,124 from the sale of the home but also would have paid $24,686 in payments and property-related expenses. So, when the property sells, the true net is $72,438.
We continue this same process for both the 10 and 15 year hold times. And the final results for determining if buying a house is a good investment are (drum roll please):
Every holding period yields a negative return!
Deciding to buy a house is a big responsibility. You are committing two of your most important resources to it, your time and your money.
Before you decide to start looking for a home, understand your needs. And determine the payment that fits into your budget.
Don’t purchase a house you think you deserve. Avoid buying one based on the largest amount a bank says you can afford. And don’t let lifestyle creep trick you into buying a bigger home than you need.
People fall into the trap of buying a more expensive home than they should. They believe a more expensive home means they are making a larger investment. When in fact, they end up with a bigger housing expense and negative returns!
Buying a home also leads to purchasing additional goods. A new home often means new furniture and decorations are needed too!
I am not telling you to not buy a house. I own the one I live in. And I still remember how great I felt the first time I got the keys and pulled into MY driveway.
Even if you decide not to buy a home, you still need a place to live. Housing will still be one of your largest monthly expenses, regardless of whether you rent or buy.
Remember, the purpose of investing is to make money. A home doesn’t provide either income or net positive appreciation.
The primary function of a home is to meet one of your most basic needs, shelter.
When you choose to buy a home you are not making an investment decision. But rather one based on consumption and your wants.
What’s the largest investment you’ve ever made? Comment below.
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