There’s a lot of polarized views about buying a home. Depending upon who you ask, a home might be the greatest investment you’ll ever make, or the greatest nightmare ever.
Let’s make no bones about it – housing is extremely expensive. Most people borrow to afford a home. That, I think is a tragic first mistake for a new homeowner. That large mortgage early-on in life puts them down the path of wage slavery for most of their lives. A mistake I hope my sons avoid when they finally grow old enough (and wealthy enough) to buy homes of their own.
Mr. Tako’s Note: First off, let me start by saying I’m NOT talking about investing in rentals. Rentals are a whole different ball game. I respect that many individuals can and will continue to make money with rental real estate. This post is about the house you sleep in every night.
OK Chief, What Now?
Most of us start out life trading our time for money. That capital gets spent on the necessities of life – food, clothing, and shelter. At some point, if you manage to save enough, you’ll want to buy a house. Afterall, you can’t live with Mom forever, can you?
Maybe you’ve gotten married, and are considering a nice house in the suburbs. Or, perhaps a hip downtown condo with easy access to bars and nightclubs. Whatever. Pick your poison.
Let’s get one thing straight: A home is consumption, not investing.
In the United States most housing markets typically appreciate close to the rate of inflation, plus a small amount for population growth (baby making and immigration). The data for this is available on the FHFA’s most recent House Price Index Report.
There are a handful of states that have experienced faster capital appreciation due to greater population growth, or stronger job markets. In particular, the Pacific coast states (Washington, Oregon and California) have seen the greatest price appreciation. The Middle Atlantic states have seen the lowest. It’s all there in the FHFA’s report.
Yes, those are outliers. For the sake of argument, let’s assume you happen to live in one of the fast growing markets on the west coast. You experience excellent price appreciation outside of inflation – say 3%. Combine that local market growth with normal appreciation (assume 3.3%), and you’ve got a potential 6.3% annual appreciation if all goes well.
Sounds fantastic right? That’s close to projected returns from total market index funds (roughly 7%)!
Hold on a second though….you’re missing something! Can you actually buy it for cash? Most people can’t, and therein lies the rub — You’re going to need a mortgage.
Most young couples save up a 10% down payment and buy a home as fast as they can…and it’s a terrible idea. Avoid it at all costs.
First, they’ll be consuming more housing once they buy a home. That means bigger monthly payments. The house is going to need furnishings, a lawn mower, a new fence, paint, HOA dues, maybe some renovation — and suddenly saving money every month gets much harder when you own a home. This is what I call the Housing Trap.
Assume for a moment you are able to put down 10% on a home and borrow at 3.5%. Only that 10% down payment is going to be earning our hypothetical 6.3% capital appreciation. The other 90% of the house won’t be — you’ll be paying interest for it. In the early years of that mortgage, you’re going to be paying a lot of interest….so much so that your return is actually going to be closer to 2.8% (nearly the annual rate of inflation).
Yes, after a decade or so, your blended return will rise as you pay off that mortgage — but that’s hardly a recipe for riches. Couple that with maintenance and property taxes, and it should become quite clear that a home is not a wealth builder. It’s a wealth consumer.
My Own Experience
When we purchased our home in the Pacific Northwest, I was well aware of this horrible math. We chose to go a different route — a route that allowed us to continue building wealth with increased financial stability.
After Mrs. Tako and I got married, we lived in a tiny one bedroom apartment for years. We saved money, like all young couples do….only we didn’t jump into the housing market as soon as we could. We just kept saving. We ended up saving more than enough to buy a decent home for cash.
That’s right, we could have just written a check for our home! Those savings gave us incredible investment earning power (at a young age) that has continued until today. Instead of actually spending that cash on a house, we kept it invested in the stock market.
Those initial savings gave us several advantages that continue to this day:
1. Cheap Debt – Who wouldn’t want to loan $500k to a couple with more than $500k in investments? Well, that was our situation. We got a lot of funny looks from lenders after we filled out the mortgage applications, but for them it was a sure thing. They gave us a great interest rate because their return was almost guaranteed. We were an incredibly low risk mortgage. Rule of thumb: Never borrow money when you need it. Borrow when you don’t need it. That’s when you’ll get the best interest rates.
2. Financial Stability. Choosing to save for a house first gives you incredible financial stability. During the seven years we’ve owned our home, we’ve had a couple periods of job loss. Our income was drastically lower. Were we in danger of losing our home? Not a chance! Clearly with that kind of savings we weren’t living paycheck to paycheck — there was absolutely no risk we’d lose our home.
3. Choose The Best Return – We could have paid for the house outright, but we didn’t. Instead, we left our money in the market, and earned rates of return that exceeded 7% (after fees). We chose to allocate our capital to the best returns we could find. It wasn’t our home.
Today, Zillow estimates our home value at $701,000. I don’t really trust that number, so I always use 90% of Zillow’s estimate. That more realistic number amounts to $630,900. Our purchase price was $515,000. After seven years of owning the property we would realize $115,900 if we sold tomorrow. It’s 3.2% annual capital appreciation — pretty terrible considering our mortgage rate is 3.5%…and I happen to live in one of those great west coast real estate markets!!
Clearly, our home isn’t the best place for our hard earned capital. Good thing we only pay the required minimums on the mortgage!
Avoiding The Housing Trap
We chose to do a lot of our saving when we were young — before we had a house, before we had kids. We saved first. We knew that once those large financial burdens came along, saving would be a lot harder.
Instead of paying down our mortgage faster, we kept our money in the market. Over time, that money has compounded, and grew at rates much faster than 3.2%. Every year that advantage grows as our money compounds faster than our home.
We’ve had good years and bad years. We’ve had periods of unemployment and recessions. Having our money earning the best investment returns possible gives us more than enough wealth to pay off the mortgage. It’s made us financially independent!! This gives us the financial stability most people will only dream about.
Changes In The Future
According to estimates, our home is worth $630k. That’s a pretty expensive house. We’re in a high cost of living area, and we know we’re consuming way too much housing.
We’re still in our first year of early retirement, so we haven’t made any major changes (yet)! Once we’re 100% certain we’ve got early retirement under control, Mrs. Tako is going to quit her job and we’ll sell the house.
Our intention is to sell in this HCOL area, and move into a smaller house in a lower cost of living area. If all goes well, this plan will free up some of the $2100/month we pay toward our mortgage. The end result should be an acceleration of our portfolio growth rate, and ultimately early retirement liftoff.
Good plan, right? Famous last words…
Yes, I know my way of thinking about these things is pretty unconventional, but anyone can avoid the Housing Trap. Don’t be afraid to follow an unconventional path if you see a better way of doing things. It might be a way to escape!
Consume as little real estate as possible. Rent for as long as you can stand it. Once you’ve saved-up enough to buy a home, don’t buy more than you can afford. Keep the money invested. With time and patience, better returns on capital will be in your favor.