Your Home is not an Investment, It’s a Lifestyle Choice
In this article, I plan to take a hard look at the true costs of home ownership, its value as an investment, and how it fits into your plans for financial independence (FI).
I’ve heard it many times over the years from those I assumed were wiser than me, “Purchase a home, it’s a great investment.” or “Renting is throwing money away.” Then there was, “Buy as much home as you can afford.” After all, home ownership is the American dream. It’s just what you do… Right?
That logic has come under great scrutiny these days, especially since the financial crisis of 2008. I’m not going to tell you that a home purchase is a poor investment. Honestly, it depends on your unique situation and includes factors such as where you would like to live, the cost of purchasing vs. renting in your area, how nomadic you are, how disciplined you are with saving and investing, etc. To make an informed decision, you need to understand all of the costs of home ownership, sit down and do the math, as well as consider the value of your personal desires.
The True Cost of Home Ownership
Many home buyers fail to consider the true cost of home ownership (I use the word “ownership” lightly here because you don’t really own a home until you are mortgage free. Even then, you must pay property taxes or risk losing your home). They typically think only in terms of the mortgage payment (principal + interest) and their desire to start building equity. However, there is a myriad of other costs that go beyond the mortgage payment, as well as obstacles that get in the way of building equity. The true cost of home ownership involves Ongoing Costs, Opportunity Costs, as well as Costs to your Freedom.
Very simply stated, the ongoing costs of a home look something like this:
Mortgage + PMI + Property Tax + Insurance + Maintenance + Repairs + Remodels + Association Fees + Utilities = a Big ‘ol Hunk of your Income and Time.
In addition to these costs, many home buyers fail to consider the impact of the mortgage amortization schedule. An amortization schedule is a timeline for paying off a loan. The schedule breaks down the payments into interest and principal. As the mortgage is paid down, the ratio of payment between interest and principle changes.
Unfortunately for the home buyer, mortgages are front end loaded. In other words, during the early years of a mortgage payment schedule, the payment is mostly interest and the principle of the loan is reduced by very little. If the loan were payed off as scheduled, it would take approximately 20 years to get half way through a 30 year $200,000 mortgage at 4% interest.
What does this mean for the typical home buyer chasing the American dream of bigger is better? Every time a home buyer upgrades and takes out a new mortgage, the amortization of that loan starts over. As a result, it is very expensive to keep moving and “keep movin’ on up.” Now, combine that with the average 10% hit you take in fees when selling and buying a home. Well, you can see how this process inhibits your ability to build equity and prolongs the process of becoming debt free.
In regard to home ownership, opportunity cost is lost income due to money that is tied up in a home instead of being invested elsewhere, such as the stock market. For a more in depth description of opportunity cost, check this out: Investopedia – Opportunity Cost Definition.
Although home prices have consistently trended up throughout history (2007-2011 being a recent exception), you can see how ongoing costs can cut into the return on your investment. In addition, the S&P 500 has historically averaged a 7% return when adjusted for inflation. Now, calculate what that down payment and other ongoing costs would have yielded over that 30 year loan. You most likely come out head investing in index funds.
Do the math for yourself. There are plenty of calculators out there to help you tackle the rent vs. own debate. This calculator at Financial Mentor is one of the better ones I have come across: Financial Mentor – Rent vs. Buy Calculator. Not only does it consider opportunity costs, but it comes complete with terms and definitions at the end of the article. Start running the numbers and take it from there.
Costs to your Freedom
Generally speaking, real estate is not a very liquid asset and it can be difficult to sell unless you live in a hot market. Home ownership can tie your money up for long periods of time, making it difficult to move around as you see fit. In contrast, as a renter, you can move on when you are ready without the stress, expenses, or time required to sell a home.
The importance of this depends largely on how nomadic you plan to be. Do you plan on long term travel before and after FI? Are you unsure of your plans to stay put in a certain geographical location for at least five to ten years? Do you plan to regularly explore living in other geographical locations in the near future? If you answered yes to any of these questions, renting would be the better decision in terms of freedom, as well as financially.
The Case for Home Ownership
There are many arguments for the benefits of owning a home including tax benefits, providing an inflation protected asset, and diversification. However, the true benefits of these can, arguably, be obtained through other means. To many, home ownership is not solely a financial decision.
Most of the reasons for owning a home that hold any value for me have more to do with lifestyle choices rather than finances. They include increased options as well as psychological benefits. Consider the following examples:
Home ownership can provide you with more options regarding the type of home and area that you would like to reside. This is especially true if rental options are limited. If you happen to find your utopia, your home base, and plan to stay put, then home ownership becomes more valuable.
If you are the type of person who finds a sense of security in “owning” your home, or you are uncomfortable with a landlord having any degree of control over your life, then home ownership may hold more value for you.
Finally, if you have already gone down the path of home ownership and your mortgage is either paid or almost paid off, home ownership holds value here as well. Debt free and rent free is a good place to be, both psychologically and financially as you approach financial independence and retirement. Just remember to account for the opportunity and freedom costs of home ownership mentioned previously.
All of these reasons may come at a financial cost of varying degrees. Only you can decide how much of your life they are worth. Again, start by running the numbers and take it from there. Knowledge is power.
Don’t Buy as Much House as You Can Afford, Buy Only as Much as You Need
The bottom line is to make a choice that enables you to live well below your means, regardless if you rent or buy. In my article, Where I’ve Been and How I Started on the Path to FI, I revealed how the significant downsizing of my home has made a huge positive impact on our lives. It freed up a large amount of disposable income that we applied to our investment vehicle of choice, low cost index funds. I can’t emphasize enough how important this has been in our success toward FI.
I’m not suggesting you live in a shack. Just be realistic and do the math. Purchase or rent a home that doesn’t make you feel imprisoned by debt and allows you to maintain a VERY high savings rate.
Honestly, if I could go back with the same knowledge I have now, I would have put off home ownership for a while. Instead, I would have utilized that money to develop a strong financial base through investing early in life. The power of compounding interest would have started working its magic for me much sooner. As they say, hindsight is 20/20.