As an older Millennial (I liked it better when they briefly called us Digital Natives, but unfortunately I don’t control the generation-naming zeitgeist) I grew up with all of the Boomer authority figures drilling into my head that buying a house is a great investment.
Renting is just throwing money away. Nobody is going to be making any new land any time soon, so home prices can only go up!
And then 2008 happened.
Any investment can lose value, of course. The fact that the housing market collapsed in on itself does not in and of itself make a house a bad investment. Anyone that tells you they have a high upside investment that can never lose money is either lying or misinformed.
But it at least dispels the myth that home prices can only go up and should make us look at houses a bit more cautiously. So while I may have already tipped my hand (not my most subtle title), let’s examine whether a house is actually any good as an investment.
Houses as Investments
To get a rational look at housing as an investment, we first need to separate out the intangibles and the emotional connection. We can get to that later. For now, let’s specifically look at the qualities of your house as an investment.
First: the returns! How much money will you make on your investment? On average, you will potentially make a little more than nothing.
Well, a little more than nothing after inflation. Home prices since 1890 have barely beaten inflation. That means your home provides a better return than the cash in your savings account, but not much else.
“But what about the leverage?” you might be thinking. The value of your whole house is going up, but you only put in the down payment and a few mortgage payments!
True. And if you bought a house in 1997 and sold it some time before 2008, then you made a lot of money off of that leverage.
If you bought a house shortly before 2008 and wanted to sell it after, that leverage destroyed you. In November 2009, 23% of all mortgages in the US were under water. Some places were even worse. 65% in Nevada. 48% in Arizona.
As with any investment, leverage increases the risk and increases the potential reward. The difference with a house is that it is both an investment and a place to live. As James Altucher has said, “Leveraging up 400% in an illiquid investment with no diversification is a scary concept to me and should be to any rational person.”
If the stock market crashes and you lose your job, you can get a new job in another city if you need to and take your stock with you. If your house loses value and you lose your job (and large layoffs in one area can cause home prices to drop there, so these risks are positively correlated) then you are forced to sell low and lose money in order to move to a new job. Or, you are unable to sell and move to a new city and your options are drastically limited because you are tied to this one location.
This is related to another problem with a house as an investment: lack of diversification. Even if you don’t know anything about investing, you’ve heard of diversification. You know that you shouldn’t put all of your eggs in one basket. And, yet…
For most people, a house is a very large percentage of their net worth. Nobody would recommend putting 50% of your net worth in Verizon stock, but people have no problem with sinking that much money into a single house in a single neighborhood in a single town in a single state. The fate of your entire financial future is now tied to that one location. If a factory shuts down and lays off thousands of people, your home value and your net worth could drop drastically. Your town raises real estate taxes and you are stuck with increased costs that you didn’t budget for. Your state finally follows through on its threats to secede. A natural disaster wipes out your neighborhood. Termites destroy your foundation. Any number of risks could completely sink your financial well-being.
A house is also very hard to sell on short notice. If I need cash and have stocks to sell, I can sell my stocks and have the money in my bank account within a few days. If I need to sell my house, it’s not quite so easy. It can take weeks or months. And if I need to move before the house sells I may need to do a lot of traveling back and forth. That’s not so bad if I move a few towns over, but if I need to move to another state this can become quite problematic.
Buying and selling also involves quite a few transaction costs. You need to pay your real estate agent. You need to pay for title insurance. You need to pay for home inspections, loan origination fees, attorney fees, and transfer taxes. There are a lot of costs involved in purchasing or liquidating this investment. There are no costs at all to set up a Vanguard account and buy VTSAX.
You will also need a large down payment when you buy. This is not a surprise to anyone. If you are planning on buying a house, then you know you need a down payment and you are saving towards that amount. The thing that people often fail to consider is the opportunity cost involved in tying that pile of money up in your house.
Let’s take a situation where all other costs between renting and buying are exactly the same and the only difference is the down payment. If you put a $50,000 down payment on your house, it will likely keep up with inflation and be worth right around $50,000 in real terms at the end of your 30-year mortgage. If you continue renting instead (with the same monthly expenditures) and put that $50,000 in the stock market, it will potentially be worth right around $360,000 after the same 30 years (using a return of 6.8% after inflation, the average long-term return on stocks according to Stocks for the Long Run).
Obviously you will never end up in a situation where the monthly costs of renting and buying are exactly the same, but the opportunity cost of passing up other investments is a very real thing that you need to consider.
Isn’t Renting Throwing Money Out the Window?
Okay, so housing isn’t a great investment. But I need somewhere to live, and isn’t renting just throwing money out the window when I could be building equity?
Mortgage payments consist of principal and interest. Other costs included in buying but not renting include real estate tax, maintenance and repairs (1% of the home value each year is an accepted estimate for average maintenance and repair costs), and insurance (renters often must have renter’s insurance, but it is much cheaper than homeowner’s insurance). If renting is throwing money out the window, then everything other than the principal payments on your mortgage is also throwing money out the window. Take all your costs other than principal and compare that to the cost of renting in your area. Which option is throwing more out the window where you live?
(For the record, I don’t consider either of these to be throwing money away. You are paying money for a place to live. Having shelter is not a waste of money.)
Next, you need to look at the opportunity costs. Your down payment will be increasing much slower on average in your home equity than it would be in a portfolio of index funds. It’s not throwing money out the window, because you are still saving and slowly growing your money, but it is throwing the opportunity for more growth out the window.
The same applies if the total costs you are paying every month for your home are greater than what you would need to pay to rent in your area. The small part of your mortgage payment that is going towards principal will grow much more slowly than an equal amount put into the stock market.
You’ll notice that I didn’t say that renting is a better deal or that buying is a better deal. It depends on your market. Right now, where I live, it is much (much much) cheaper to rent than to buy. Crunch the numbers for your area. Take the cost of the mortgage payments, HOA fees, real estate taxes, and estimated repair costs, and compare that to the price of renting. If buying is cheaper, then decide whether the savings (and the emotional benefits of owning a house) are worth the upfront and opportunity costs of the down payment and the loss of geographic flexibility.
Reasons to Buy
I am not telling you never to buy a house in any situation. There are plenty of less tangible reasons why people like homeownership. You can remodel the house however you would like without dealing with a landlord. You have more control over your long term costs. You have more permanence (although you should make sure you actually want to be in that one spot for many years or you will get stuck with all of the issues of inflexibility and illiquidity discussed above).
If you really want to buy a house, then buy a house. But don’t pretend that you are doing it because it is a good investment. Recognize that you have weighed all of the options and decided that you want to buy a house even though it is a bad investment.
As a full disclosure, my wife and I do intend to buy a house. Not now, but eventually. And in a time and place with a much more reasonable difference between rent prices and home prices. I recognize that a home is not a good investment, and so I am working to build up my investment portfolio first so that the home equity is not such a massive portion of my net worth and so that I am not as harshly impacted by the ups and downs of the housing market.
I felt that this disclosure was necessary because of the harsh treatment of homes in this article. They are a really bad investment, but they can still be a good life decision as long as you approach the decision with open eyes and weigh all of your options properly.
Please don’t tell me that the mortgage interest deduction is a good reason to buy a house. Don’t do it.
The first thing to remember is that laws can change. Especially tax laws. Are you really willing to lock yourself into a 30-year mortgage because you expect Congress to keep this particular incentive in place for the next 30 years? Simplification of the tax code has been an issue in the last several presidential campaign seasons and the idea of scrapping the mortgage interest deduction is coming up more and more often.
Next, even assuming the continued existence of the mortgage interest deduction, it only matters if you spend enough to itemize. This means that in 2015, a married couple needed to spend more than $12,600 in interest for it to even show up on your tax return. After that, the actual difference is ([interest paid] – [standard deduction]) * [marginal tax rate].
So if you paid $20,000 in interest and are in the 25% tax bracket, you will save $1,850 on your taxes. Are you really telling me that it makes sense to spend $20,000 to save $1,850?
Plus, if you make significant money and take a large itemized deduction, you very well could get hit by the Alternative Minimum Tax and then lose much of the benefit of that deduction anyway.
So sure, if the costs of renting and buying appear to be very close, then go ahead and consider the discount that the Mortgage Interest Deduction might give you. But just like you should not be using the idea of a home as an investment as a justification to buy, you should not be using the Mortgage Interest Deduction as a justification to buy.