Originally, this was to be a two-part series discussing the pros and cons of buying a home as opposed to investing. The purpose wasn't to pick a winner or loser, per se. (After all, one of the main tenets of Get Rich Slowly is that you really should do what works for you.) Instead, the purpose was to highlight the strengths and weaknesses of both options in case you were faced with a choice for some reason.
Holly Johnson's article should you buy a home or (invest?) was first; and she said that, if she had to make that choice, she “would invest for the future and forgo the house in a New York minute.” I intended to explain the benefits of the opposite side of the hypothetical.
But you stole my thunder! So many people made great comments in response to Holly's post that I thought it would be better to explain what was left over or unclear for some reason. We both started by looking at the past.
The (more common) way to build wealth
Two activities have stood the test of time throughout history as the best ways to make money:
- Real estate investing
If you look at America's list of millionaires and what they did to get there, you will observe the most common path to millionaire status in America has been real estate.
Sure, you have the Warren Buffetts who did it by investing in stock, and you have the Zuckerbergs and Gateses who did it by starting new companies and riding them to fortune. But most of the lower profile millionaires built their wealth with real estate.
There is a reason for that. As my dad always used to say: “Everyone has to live somewhere.” The world's population is expanding, but Mother Earth isn't. So it isn't hard to see the math of supply and demand working in favor of real estate investing.
Limiting the price for shelter
Consider the precept that, if you want to build wealth, one surefire thing you can do is to limit your expenses. Look at your budget. What is your largest expense? Housing. Whether it's your rent or a mortgage payment, unless your house is fully paid off, chances are there is nothing you spend more money on than that. (Well, okay, if you're leasing two Ferraris and a Mercedes, your cars may cost you more, but then you admit you're not typical.)
Jeff nailed this concept in the comments of Holly's article:
My mortgage will end while rent never does. When I buy, I am locking in my price. Housing can go up and down in value but my mortgage doesn't change based on that, what I owe is what I owe, even when prices rise 20% or crash 20%.
When you think about your future, what offers you better security than having a shelter of your own choice … with no rent or mortgage payment?
Look around you at retired people who are living comfortably, and look at their finances. Nine out of 10 will have a paid-for home. Not only have they locked down the price of housing for the term of their mortgage, they effectively brought the expense down to zero as compared to rent once the mortgage is fully paid.
You can't get there if you don't buy a home.
To me, one of the biggest reasons to buy a home first is that it puts an (inevitable) expense on a track to become an asset. Like all investments, that difference usually starts out quite small, because in the beginning most of your monthly payment to the mortgage bank is interest. However, as time passes, more and more of that monthly amount transitions from expense to an asset, i.e., the equity in your home.
That, to me, is nothing short of a thing of beauty; and to my mind, it's the biggest single reason people who are secure in retirement got there.
The concept of leverage
Ec was one of the few that mentioned leverage as an advantage to buying a home over investing your money:
Secondly, the other big advantage of owning your own home is leverage. If you had 30k to invest in 1940, based on a typical ltv ratio of 80/20 you could buy a home worth 600k. Would you rather have 600k growing at a slightly lower rate or 30k growing at a higher rate?
But judging from the fact that only three comments mentioned it, I thought it would be good to explain the concept.
Most of us know that debt is more evil than good … except, of course, when it comes to buying a home. One of the big things that makes buying a home the first step in most people's financial security is that debt. Home mortgages are usually the cheapest loans out there, so the burden imposed by paying interest is relatively minimal.
How leverage works
Here is where the math becomes compelling, and it's rooted in (of all things) inflation. Home prices over the long haul have gone up in most places. That is something we love, isn't it? That appreciation is also called inflation … but it's the kind of inflation that works for us.
And leverage is how we make inflation work for us. Here's the math:
Let's say you buy a home for $100,000 (to keep the numbers round) and you put down $20,000. Then let's say that, over a 30-year period, inflation averages 3 percent. Chances are your mortgage rate will be a couple of points above that, say 5 percent. At first blush, that sounds like a bad deal, because you're paying more than you're getting in inflation-driven appreciation. But wait.
After the first year (again, just using rough numbers) you will have 5 percent of $80,000 in interest: that's $4,000. (It's less after taxes, but let's ignore that for the moment.)
In the same year, your home will have appreciated by $3,000 (3 percent of $100,000). You may think you made 3 percent, but no, that's not correct. You only invested $20,000 of your own money to get appreciation, so the real return on your money for that first year was ($3,000 Ã· $20,000 =) 15 percent!
How many investments give you that?
That is an over-simplification to be sure, but the purpose is to show in math what so many people know in their gut: Your home is often your best investment.
Why not make the best investment first?
The tax break — a possible misconception
Uri brought up one of the more widely known advantages of home ownership:
Let's not forget about the favorable tax treatment that residential homes get. there's the mortgage interest income tax deduction, which will be highest in the earliest years of the mortgage – those savings can be put right in your investment fund. And there's the capital gains tax exclusion for the first 250K (500K if married) of gains. of course, some financial investment instruments get favorable treatment, too.
Many people like to hold out the income tax break you get in the United States as a reason why buying a home is a better way to go than saving for retirement. It's true, for many people, the deduction you get for income taxes is a help — but it's often not as big as you might think.
If you file a simple tax return, as most wage earners do, you simply take the standard deduction and the mortgage interest deduction disappears.
Also, if you are fortunate enough to make a lot of money, the mortgage interest deduction fades away.
So, in practice, the tax break is not quite as powerful a reason to go the route of buying a house as proponents make it out to be. But, under the right circumstances, it is a help.
My wife and I have always had the tax benefit because we never made that much money and because of other things, like charitable donations and stuff like that, which allowed us to file itemized tax returns every year where we got the deduction for interest.
Rent inflation – the ultimate wealth killer
Unless you inherited a dwelling which has been paid for, you are going to have to pay for a place to live. If you don't buy, you will have to rent. We know two couples in California who have been renting the same place for more than 20 years.
During that time, their rent has close to doubled. If they had purchased, their payments would not have doubled. Even if they took out a 100 percent loan at the time when those were common, and the rate was variable, their payments still would not have doubled.
Inflation kills renters' wealth and puts real dollars in the pockets of homeowners — a double whammy. To my mind, that's a compelling reason to make a home your first investment.
But there are a couple of caveats to consider…
The moment you begin selling and buying homes, that math goes out the window, because the transaction cost in selling and buying real estate will often turn that equation upside down. Therefore, if you plan to move a lot early in your life, it may make more sense to start with a focus on your retirement savings.
Also, the math becomes quite unattractive if you begin your home ownership at the top of an economic cycle, because that puts a serious damper on that long-term appreciation. (I made that mistake and paid dearly for it, which is how I know.)
If you avoid those two caveats, I believe finding a way to buy that first home as soon as you absolutely can is most likely going to be the anchor of your investing career.
Are you in a position to leverage your home? Would you do it? What conditions prevent you from making a home your first investment?
William Cowie spent 30 years in senior management (CFO/CEO) before retiring. He has a bachelor's, a master's, and a partial doctorate in management and strategy. Author of the book “The Four Seasons of the Economy,” William also assists medium-sized businesses in the use of the Four Season Strategy to help them capitalize on economic cycles. He runs two blogs: Bite the Bullet Investing (investing) and Drop Dead Money (the economy) and writes for several other blogs in addition.