Jim, a close friend of mine, has mentioned to me more than once that he feels a bit behind-the-curve. He’s 35 and has never owned a home or any sort of real estate. He’s a manager for a large telecommunications company and is paid well. That said, he just recently paid off some credit card debt that he racked up in the past.
Jim lives in the Washington, DC area now, and is considering relocating within the next couple of years. Ultimately, he’d like to end up in Florida, and so he mentioned that he’s had some thoughts about buying a place in Florida and potentially renting it out (for rental income) prior to moving to Florida.
Now, I’ll stop here — based on the title of this post, you might assume that it’s all doom-and-gloom discussion from here — that I’m going
to tell you why it’s a bad idea to buy a house. Well, full disclosure — I own a home and an investment property. So, obviously, I don’t think home ownership is a terrible idea.
Here’s the thing — there seems to be an assumption, at least in the United States, that there is something wrong with you if you don’t own a home and that home ownership is automatically the right move.
Maybe I was reading into things when we spoke, but Jim and I are good friends and speak openly about our thoughts and feelings — and I got the vibe that Jim felt somewhat bad about himself. After all — many of Jim’s peers are homeowners. So Jim feels like he isn’t quite where he “should” be in life.
So, I shared my thoughts with Jim — I simply stated that buying a home is not always the “right” move, in my opinion. His response was “Yeah, but at least I’d be building equity.” True. Sort of.
The Equity Myth
Sure — it’s true that buying and owning a home allows you to build equity. In fact, to some extent, it can be considered “forced savings.” Effectively, when you have a mortgage, saving money becomes automatic. If you don’t want to destroy your credit and have the bank to take ownership of your house, you will make the required monthly mortgage payments. Without this level of pressure, some people may not naturally find the motivation to put money away each month to save. For those who like spending and find it difficult to save, I agree — being forced to save is a good thing.
“Yay, now I get to build equity!”
Not so fast. But seriously — not so fast. Sure, you will build equity by paying down a mortgage, but be aware that this is a very slow process. Standard 30 year fixed mortgages are designed so that the payment amount stays the same each month throughout the life of the loan. This means that early on, your payment amount is made up mostly of interest.
For example, let’s assume that you bought a house for $375,000 and put down 20% ($75,000). So, you take out a $300,000 mortgage. On this loan, at 5% interest, you pay $14,899 the first year in interest. Why? The average balance on the loan is roughly $297,630 during the first year. You’re paying 5% on this balance.
Have a look at the table below:
Principal paid off the first year is only $4,426. While that’s significant, you spent $19,325.52 but only truly increased your equity by $4,426. That means that you “spent” $14,899 — just like you would have on rent… well almost.
As you’re probably aware, in most cases, tax rules allow you to deduct the cost of interest on your primary residence from your income. While this does not mean that this interest is “free,” it does reduce the cost to you — provided that you have an income to offset the expense. For tax purposes, you can reduce your income by your mortgage interest expense. While this example is oversimplified, if your average overall tax rate is 25%, you would save 25%. This means that on the $14,899 you spent, you’d save about $3,725 — meaning that you actually spent $11,174.25.
When I bought my first home at a young age, I don’t know if I had fully thought this through. Call me naive, but for some reason, I think my natural assumption or gut feeling was that by owning a home, I was no longer “throwing my money away” as I would have on rent — but that all of the money spent on my mortgage was effectively building equity.
In the example above, it’s like you’re actually spending $11,174.25 in the first year you own the house. Now, that may be ok with you. After all, you would have spent that much per month on rent — or maybe more. At least you get a place to live — and you will eventually begin to build more equity as you pay down your mortgage.
Take a look at the table below showing how much interest you’ll be paying for the first 10 years.
|Year||Cumulative Interest||Cumulative Principal||Balance||Cumulative Payments||Yearly
Ok… now see a version of the table below with a “Tax-Adjusted Interest” column (representing the amount paid of interest paid after factoring in the assumed 25% tax discount) and a “Cumulative True Cost” column — which is the cumulative amount of money spent on interest after tax savings.
|Year||Interest||Tax-Adjusted Interest||Cumulative True Cost|
Note that the above table is only talking about money spent on interest. The true cost is reduced by tax savings, assuming that you have an income and that your effective average tax rate is 25% (in our example above). But there is still an actual cost. The $102,961.47 is actually money spent — that you won’t get back.
In addition to spending this money, you have also “spent” almost $56,000 in Principal, however, this is where your equity comes in — this isn’t money that truly was “spent” — this is your money. This is the money that you effectively put into “savings.” You paid down the cost of the house, and you’ll get that money back some day. More on that subject later.
So, looking at the true cost of the mortgage, after year 5, you’ve spent about $54,000. That averages out to $10,800/year, roughly — or $900/month. In most cases, it’s safe to assume that a $375,000 house is going to do better for you than an apartment that you would rent for $900/month.
But wait… there are more costs.
Before I get there, let’s look at the difference between the words “cost” and “investment.” For something to be an “investment,” there is an expectation of positive or profitable returns. “Cost,” however, is simply an expense — something that you need to spend money on that will yield no return.
When discussing the purchase of a home, it makes sense to view the down payment and the portion of your monthly mortgage payment going toward principle as an “investment.” The rest is really just an expense. This is because the value of the asset — the house — is what is going to rise. When you spend money on interest, upkeep, or taxes, those don’t truly yield a return. You can consider these other costs to be “carrying costs,” of sorts — and they should be factored into the big picture.
Here are some costs we haven’t looked at yet:
- Real estate taxes
- Homeowner’s Insurance
- Closing costs when you buy
- Transaction costs of selling the house when you sell
- Home repairs and maintenance
- Opportunity costs
- Other “soft costs”
Real Estate Taxes
According to this article on Wallet Hub, the mean property tax rate across all US states in 2017 was roughly 1% (I scrolled to the middle of the chart ranking each state). This means that property taxes on a $375,000 home will cost you roughly $3,750/year.
Now, this varies widely by state. In Hawaii, it’s as little as about $1,000/year (0.027%), and in New Jersey, it’s almost $9,000/year (2.35%). Keep in mind that many towns/municipalities/counties will also assess, a tax, which can, in some cases, effectively double the tax rate that you pay.
To keep it simple, we’ll stick to the $3,750/year in costs here.
According to Zillow, you can expect to pay about $35/month for every $100,000 in home value. On a $375,000 house, that’s $131.25/month, or $1,575/year.
While it’s true that as a renter, you’d want to purchase renter’s insurance, as this article states, the average cost is only $12/month or $144/year. The main reason for this is that renter’s insurance does not generally cover the property value or the building value; just your possessions (and in some cases, liability).
According to Zillow, closing costs average between 2 and 5% of the purchase price. At 3.5% (right in the middle of Zillow’s range), we’re at $13,125 in fees on a $375,000 home.
Sales Transaction Costs
As mentioned in the above, the buyer clearly pays certain closing costs when purchasing a new home. But when you buy a home, a portion of your fee goes to the seller’s real estate agent, and a portion goes to your real estate agent. Traditionally, it has been 3% to each agent, for a total of 6%. Some discounted options, such as Redfin now exist, however it is safe to say that each time a home is sold, about 4.5% in commissions will go to realtors.
Now, as we all know, the seller actually pays this fee. What is not often discussed is that in some cases, sellers — especially those who haven’t stayed very long at the property, often feel the need to pad their asking price in order to cover realtor fees. So, in a sense, I would argue that realtor commissions do impact the buyer… but since it’s difficult to calculate the true impact of this on the buyer, let’s ignore the realtor fees on the purchase of the home.
Inevitably, some day, you will sell your home. Barring a major change in how homes are bought and sold, you can probably expect to spend 4.5% in commissions. Assuming no change in the value of the home, on a $375,000 home, that puts your realtor commissions at $16,875.
Home Repairs and Maintenance
HGTV recommends setting aside 1-3% of your home’s purchase price for maintenance and repairs. While the article talks more about fixing problems with your house, there are also other property maintenance costs, such as maintaining your yard, mowing the lawn, raking leaves, etc..
Now, you may enjoy yard work. So, let’s leave that out of the equation. And let’s assume that you’re also a “do-it-yourself-er.” Let’s assume that between all of this, you only spend 1% of your home’s cost on maintenance. That’s $3,750/year.
We won’t get into these details here, but before assuming that you’ll do all of your own housework, repairs, and outdoor/yard maintenance, you should think about whether or not you truly enjoy that kind of work, whether you have the skills and knowledge to do that work, and whether or not your lifestyle affords you the time to do this work yourself.
Most people don’t think about it much, but there is also an opportunity cost associated with buying a house. Let’s put aside the other “soft cost” items, such as lack of flexibility or the fact that once you purchase a house, moving becomes more difficult and more costly. After all, there’s no way to truly quantify the cost of those items. While the opportunity costs associated with buying a house may be thought of as “soft costs” to some, in that they don’t represent a tangible payment that you need to make each month, they are, in fact, a cost. An opportunity cost is basically the loss of the potential gain that you could have seen by putting your money elsewhere.
This comes as a surprise to many, and even came as a surprise to me when I first read about it, but multiple studies and data analyses demonstrate that historically, real estate is a bad investment.
In his article for Moneywatch, linked above, Larry Swedroe writes:
Yale professor Robert Shiller, in his book “Irrational Exuberance,” argued that home buyers may also be influenced by comparing simple returns on infrequent real estate transactions. Assume that a home in 2005 sold for 10 times the price it sold for in 1945. While that produces a simple return of 900 percent, the real (inflation-adjusted) annualized return was less than 1 percent.
The article mentions an assumption of approximately 1% in annual maintenance costs (a reasonable assumption, in my opinion), moves the needle and brings the “investment” into negative returns.
In today’s current market, it is relatively easy to find municipal bonds that pay 3% — typically tax-free if you purchase a muni bond from your state, or if you live in a state that does not charge income tax, you can purchase muni bonds from any state. At a 25% average tax rate, this truly yields closer to 4% as compared to a standard investment taxable at ordinary income tax rate.
If you had taken your $75,000 down payment and put it into one or more municipal bonds pay 3%, you’d bring in $2,250 tax-free each year. Assuming we paid cash for the closing costs ($13,125), that’s $88,125 we could have invested, earning $2,643 per year, tax-free.
While investing in the stock market could even yield double this, even after taxes, it can be significantly more volatile — and not everyone has the stomach for that type of investment.
Other “Soft” Costs
Here are a few things to consider. I won’t go into an incredible amount of detail here, but homeownership has some drawbacks. Mostly, the below items are just “food for thought.” They may represent an actual “hard” cost at some point, but at the very least, they may result in less flexibility and/or a large investment of your own time.
- While you’re not “stuck,” once you buy, you’ve made a commitment to a home, and along with that home, the town and state that it is located within. Can you move, sure? But keep in mind that with transaction costs and fees, if you only live in a home for a few short years, you’re likely spending significantly more than you would have by renting a comparable place. Would your decisions on where to live and work be influenced by the fact that you might lose a significant amount of money on your home if you move too quickly after buying the home?
- Going along with #1, what if the real estate market crashed shortly after buying your home? This could leave you with a home that is worth significantly less than what you paid. Depending on your mortgage amount, you may not be able to afford to move. This can happen when a home is “underwater” — the amount borrowed to buy the home is more than the home’s value today.
- Landlords generally cover any sort of property repair. Homeowners bear this entire expense. There’s no way to know what will break, and you can protect yourself to some extent with a home warranty, but you’ll likely still spend money each year. Some of these costs can be significant, and can come all at once — such as the cost of replacing a roof — the average homeowner spends about $6,600 to replace a roof, but depending on various factors, you may end up spending a lot more.
- Everyone pays for utilities, such as electric, natural gas, cable, etc., but in many cases, homeowners will pay more for these since homes are generally larger than apartments or townhouses (which are more frequently rental properties). Whether you’ll spend more in utilities depends on the type of home that you buy — but it’s something to think about.
The True Financial Picture
One of the main points that I’ve been trying to deliver is that certainly, not all money “spent” on a house is an investment. Much of the money “spent” is truly just an expense — money that you’ll never get back. Sure, as you pay down your mortgage, you will increase your equity, and thus, the principle portion of your monthly payment is not an expense. But other things, like closing costs, interest payments (even after considering the tax benefit), real estate taxes, homeowners insurance, opportunity cost, and upkeep of the house are what I’d consider “true” expenses.
The table below lists most of those expenses. For now, we’ll leave out costs that may be considered “soft costs,” including opportunity costs. After all, you don’t have to write a check (in most cases) to cover these soft costs.
Disclaimer: As with many of the examples, for the sake of simplicity, the table below is somewhat oversimplified. It does not reflect changes in real estate tax costs due to changes in the value of your property over time. There are several other factors that we don’t account for, however, I feel that it gets pretty close to representing the bulk of the expense of homeownership.
|Year||Expense||Cost||Total Money Spent|
|1||Real Estate Taxes||$3,750||$28,022|
|Year 1 Total||$33,347|
|2||Real Estate Taxes||$3,750||$48,102|
|Year 2 Total||$20,080|
|3||Real Estate Taxes||$3,750||$68,003|
|Year 3 Total||$19,901|
|4||Real Estate Taxes||$3,750||$87,717|
|Year 4 Total||$19,714|
|5||Real Estate Taxes||$3,750||$107,233|
|Year 5 Total||$19,516|
|Cumulative Total Money “Spent”||$112,558|
What happens if you go to sell the house? Well, it really depends on what the market has done, but we’ll talk about that now. In any case, after 5 years, you’ve spent almost $113,000.
If you sell the house after only 5 years of owning it, assuming a 1% annual increase per year, compounded, your $375,000 home is now worth $394,129. Congratulations!
But let’s see how the numbers play out.
- You list the house with a broker at $394,129, and because the market has gone up by 1% per year, you get your asking price.
- You find a discount broker to sell your house, and pay a total of 4.5% in commissions — $17,736.
- $394,129 – $17,736 = $376,393.
- Congratulations, you just “made” $1,393 — the gap between the $376,393 that you got to keep after selling the house and your purchase price of $375,000.
So, not factoring in all of the potential soft costs, you yielded $1,393 in returns. That’s a total return of a whopping 0.37% — which, annualized, comes out to a return of less than 0.074% (factoring in compound interest).
But wait… factoring in your true costs over the 5 years, listed in the table above, we’d add $112,558 to your costs.
So, let’s take the $376,393 and subtract this amount — yielding $263,835.
Congrats! Your “investment” yielded you negative $111,165! That’s a return of -29.64%.
Ok, so let’s be fair here. You did live in the house… you got something out of it… and you would have spent money on rent if you did not purchase this house.
What if you would have rented?
I just went on a very quick, and very unscientific fact-finding mission to figure out what the “rental equivalent” of a $375,000 house was. So, for example, if, on average, a house that sells for $375k in a given area has 4 bedrooms and 2 bathrooms, I wanted to see what I could rent an equivalent house for. I found a house in South Plainfield, NJ listed at $370,000 that had 4 bedrooms and 2 baths. This house looked a bit older and, in fact, was built in 1969, but appeared to be in decent shape. A quick, cursory look at other houses in the area yielded similar results in terms of square footage, as well as the number of bedrooms and bathrooms.
A more updated single family home in the area, also with 4 beds and 2 baths, is listed for rent for $2,150/month.
- $2,150 per month, annually = $25,800 per year.
- $25,800, escalated at 3% per year, which is somewhat average in the rental market looks like this:
- First year: $25,800
- Second year: $26,574
- Third Year: $27,321
- Fourth Year: $28,192
- Fifth Year: $29,038
Over the course of 5 years, you’d spend a total of $136,925.
But wait, that’s still higher than the $111,165 that I would have spent on the home.
Not so fast. Let’s assume you took the $75k down payment and $13,125 in closing costs and invested that money in 3% municipal bonds as mentioned earlier. This would yield you $2,643/year, tax-free. Over 5 years, that’s $13,215 earned. This brings the cost of renting down to $123,710, factoring in the income that you would have had by putting your down payment into a better, but still relatively safe, investment.
The gap between renting and owning a home is now just $12,545, or just over $2,500/year. So, you did marginally better by owning a home over the course of 5 years than you would have done by renting… not factoring in those other “soft costs” that I mentioned.
The picture would be very different if you had only lived in this house for one year — and only at about five years does it start looking like the decisions was even possibly a smart financial move. Without stepping through all of the math here, let me show you the impact of moving after years 1-5.
- Year 1: You lose $23,484 over renting.
- Year 2: You lose $16,015 over renting.
- Year 3: You lose $7,585 over renting.
- Year 4: You gain $1,940 over renting.
- Year 5: You gain $12,545 over renting.
- Year 6: You gain $24,211 over renting.
- Year 7: You gain $37,140 over renting.
- Year 8: You gain $51,205 over renting.
- Year 9: You gain $66,502 over renting.
- Year 10: You gain $83,072 over renting.
Best and Worst Case Scenarios
The examples that I’ve given in this post are based upon average rates of return, average tax rates, average maintenance costs, etc.. If anything, in order to ensure that this post did not appear biased, I think that I underestimated the cost of homeownership.
That said, reality could be much better or worse than my projections. You may have to replace the entire roof of your new house for $15,000 during the first year. You could be buying the house at the height of the housing bubble (like early 2006), not knowing that in some areas, home values will drop by about 50% in the next few years.
Maybe you’re purchasing at an opportune time — when values have hit their near-term bottom and will continue to rise steadily for years to come.
You never really know. But one thing that you do know is that nothing is a completely “safe bet.”
So What is the Would-Be Home Buyer Left to Do?
My main purpose in writing this blog post is to share some of the potential pitfalls and caveats of homeownership. I feel as though in our society, there’s a strong bias toward homeownership. My goal is to convey the fact that while owning a home has its benefits, it is not the panacea that many assume it to be.
Owning a home presents significant risks. These risks are exacerbated if you’re not sure of how long you’ll truly live in the home that you purchase. When buying a house, there are also many costs that most people don’t think about — and then there are unexpected costs that can arise as well.
It is true that over the long-term, owning a home will likely be a better financial investment than renting. But are you sure when you buy a house that you will be in that house for 5+ years?
Younger folks who haven’t truly established roots in an area tend to be more transient — and often, even when they think that they will stay in a certain area, plans change. Things come up. You get a job offer in another city. You decide that you’re looking for a change. You get a divorce. Sometimes even when you think you know what the future holds, you don’t.
There’s no getting around the fact that one can never be 100% certain. My recommendation is to ensure that you’ve considered all factors before you make the decision to buy.
If you can check the below boxes, I think that buying may be a smart move for you.
- You plan to stay in the house (and obviously the area) for a minimum of 5 years. Some “sub-factors” to consider are the following:
- Is your job stable? Do you like your job? Are there plenty of other opportunities in your area if you lost your job, or left your job?
- What’s the chance that you’ll get tired of the weather, the traffic, or the pace of life where you live?
- Are you married, in a relationship, or single? Is it a possible that a new relationship could take you to a new city?
- If you are married, are you and your spouse on the same page? Are you both committed to the area? Is your relationship solid?
- Do you have children or plan to have children? If you plan to have a family, does the home you’re purchasing meet the needs of this growing family? Good school district? Enough room for everyone to spread out?
- Does the home you’re considering meet your lifestyle needs? Might you need things like a home office? A play room for the kids? An exercise room? A kitchen with room to cook elaborate dinners? Consider your needs, and talk them through with your spouse and/or your family. Make sure you’re getting into a home that meets your needs.
- You have enough money saved to put down at least 15-20% of the home’s cost. Certain home buyers may qualify for a much smaller down payment — or even no down payment. But doing so can lead to serious financial stress (remember that new roof that I referenced earlier?). While outside the scope of the article, I’ll say that there are many drawbacks to buying a home if you don’t have enough savings to cover a significant down payment.
- You have income to cover the mortgage. NerdWallet.com recommends that 36% or less of your monthly income should cover your mortgage and monthly debt payments. Said another way, look at your monthly income after taxes. If you won’t have roughly 2/3 of this payment left after covering your mortgage and other debts (such as student loan repayments), think very carefully before you commit to buying a home.
- At a minimum, you have an additional 3-5% of the home’s cost saved up in a savings account, low-risk (and liquid) investment account, or other emergency fund. To feel even safer, I’d recommend 5-10%. Things come up. While you could get potentially get a home equity line, there’s value in knowing that you have some cash put away. This becomes even more important if you choose to put less money down on the home that you purchase. If you lose your job, can you continue to make mortgage payments until you find a new one? Can you afford to be out of work for 3-6 months?
- You have thought a lot about owning a home — the pros and the cons, and you really feel that it is for you. You recognize that there will be frustrations — things will break and you’ll have to either spend the time to repair them yourself or hire someone to do so. You realize that the market may take a bit of a dip, and that if you move or sell the house in a few years, you’re ok with that. You know that there is risk, but you believe that the benefits outweigh the disadvantages.
As a departure from my usual cautious approach, I’ll add something here. Some people may realize that owning a home may not be the best financial investment, but may want to purchase a home anyway. Why? Well, it affords you certain intangibles, such as the ability to feel more “at home” when you’re at home. You can customize your home however you like — decorate, paint, and even renovate to your heart’s content.
If owning a home is something that you know you want to do because it will add to your quality of life, ignore #1 in the list above. While it’s still a good idea to know that you plan on staying in the area (and in the home that you purchase) for a while, it may be ok for you to “throw caution to the wind” and buy a home. Here’s the thing, though — at that point, it’s very important to be able to solidly check boxes 2-5 above. In fact, if you’re buying a home knowing full well that you may end up moving before the five-year mark, I’ll boil it down to a simpler rule:
Before buying the house, have at least 25% of the home’s value available to you in liquid assets (such as cash in a savings account or a low-risk investment account). Ensure that 36% of your monthly income will cover your mortgage payment and other monthly debts.
You may choose to take that money and use it to put 10%, 20%, or even all 25% down when you purchase the home — but ensuring that you have immediate equity in your house (or a large emergency fund) will offer you some protection if you sell your house soon after buying.
I’ll detail my reasons for this recommendation in a future blog post.
If you have 25% of the home’s value available to you in liquid assets (that you either plan to keep liquid or put toward a down payment), and if 36% of your monthly income will cover all monthly debt payments, then even if buying a house is not a financially smart move, you may simply want to do it anyway — because living in a house is the lifestyle that you’re looking for. And that’s ok — you can probably afford it.
If you are first-time homebuyer, though, and you are “light” on liquid assets, buying a house before you are truly ready can open a financial can of worms. Before proceeding with buying a house, stop to think about your overall goals as well as your ability to handle unexpected expenses or life events that may arise.
Edit: A Quora user pointed out the fact that most people may not fully benefit from writing off the interest expense on their taxes since in order to do that, you need to give up the standard deduction. In 2017, the standard deduction is $6,350 for an individual and $12,700 for a married couple, filing jointly. Therefore, you may not receive any tax savings. This further increases the cost of home ownership and creates even more of a case for renting.