Avoiding The Housing Trap
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.
The 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…
Be Unconventional
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.
Mr. Tako, great post to make light of a common situation working people have to make every day.
I’ll be the first to admit that I was super eager to purchase our first home and promptly got caught up in all the frenzy with everyone else. After owning this property for over a decade, it hasn’t yielded any upside to us (other than living benefits). Luckily, in CA, there are wild swings in prices. Since the property cash flows enough currently, we’re able to sit on it until the next wave (at which point I plan to dump it).
If I had to do it all over again, I probably would have rented for much much longer, and instead bought more investment homes! Ahhh… everything is 20/20 in hindsight. 😉
Indeed! If I could do it all over again I think I would have rented for longer too!
Nice post, interesting to look at the rate of return. We’re in a HCOL area and probably have too much house. Look forward to following your story to move to a lower cost of living area.
No, sorry I dont agree.
Did you get a mortgage to purchase that house?
If you followed your own hypothetical example, then 10% deposit means you were leveraged, right?
The math should look like this:
Deposit 10% * 515,000 = 51,500
Cap gain = 630,900 – 515,000 = 115,900
ROE = ((115,900/51,500) -1 ) / 7 = 17%
Of course, you’ll need to take into account interest costs and repairs/maintenance. My point is your return is much higher than 3.2 because of leverage.
Sure – you can argue that you can leverage into stocks so its apples and oranges. But then, can you get such a high amount of leverage (90%) at such a cheap rate? Without being margin called?
I think you missed my point. You’re looking at this from a leveraged perspective and not taking into account interest, maintenance, and taxes. I am. The mortgage interest, taxes and maintenance *kill* any of that so called “leveraged” return. I’ve spent around $145,000 on all those things. Wealth DESTROYER.
3.2% < 3.5% = No levered gains.
Great perspective Mr. Tako, and one that more people need to understand. We’ve never owned a home, although we seriously looked before we got married last year. Breaking the lease of our apartment, so we could travel the world, was much easier and less costly than selling a newly purchased home and furnishings.
We do feel a little intimidated to get into investment properties without the experience of buying a home though.
I tend to agree on the housing trap. And buying as big of a house as you can afford can be a big mistake too. More expensive house = more interest, taxes, maintenance, furniture etc etc. Delay buying a house is good advice, and when you do, I’d recommend staying modest.
I really wish I would have rented longer too! As soon as I started working, I signed up for a mortgage. As a young person I was told that buying a house was an investment and renting was throwing money away! I think I even shared this advice with other young people. I know now that keeping your money in the market is a better way to go.
I received similar advice too! Maybe it works on paper, in the right market….but in my experience it’s better to just keep it in the market.
A house does require a lot of money. We bought a fixer upper. We have been replacing and spending a lot of money. Dishwasher, faucet, AC & furnace, new roof, new windows, updated kitchen….Oh not to mention furniture. Don’t buy a huge house because the expenses will be higher.
I have put off buying a home, but I like this perspective, it makes it way less frightening if you lose your job and gives you confidence to negotiate more and leave a bad job. I’ll keep saving until I have around 30% in my HCOL area or the wild downswing comes.
Totally agree. But….I had too many kids to keep on renting and would have had to save for 20 years to pay cash. I didn’t want to spend the 20 years saving that I could use to live in the house. We’ve enjoyed our house immensely the past few years – 3% down and paying less than we would if we rented. Much of this depends on your personal situation and the local housing market.
Absolutely agree. Depends upon you local market. It’s sooo much easier to save without kids too!
Thanks for the article Mr.Tako. It’s nice hearing how you and your wife got to where you are today. Great blog and thanks for starting it. I’m glad I’ve found you bud and looking forward for your journey. Keep it up and don’t stop! Cheers my friends.
Nice post and spot on, that is why we decided to go for the alternative route. We are in the process of finishing our latest real estate purchase, which is one large home which has been split into 3 apartments, has a large attached garage/workshop (with attic) and a separate 1 car garage and sufficient parking for 6 cars.
The plan is to live in the largest apartment, rent out the two smaller apartments and the garage/workshop (and potentially the small garage as well). We calculated that the income produced (after all costs/fees for taxes, etc.) will largely cover our mortgage. Such that we are practically living there for free. Once the house it paid off, we intent to keep it to rent our all units and generate extra income for FI. Hope all works out well!
It actually sounds like a really good plan!
In the US where you can tax deduct your mortgage interest payments on your principal resident, perhaps having a small mortgage makes sense. But here in Canada, we can’t tax deduct the mortgage interest payments on the principal resident, so saving up and pay your house in cash is a great idea, if you can afford that much cash. It really depends the local housing market. In a hot housing market like Vancouver where a new 2 bedroom condos less than 900 sqft can go for $800k or more, that’s pretty challenging to save up and pay it all in cash.
Agreed! Maybe that’s the local housing market’s way of telling you to keep renting. 🙂
Great line “housing is like a gateway drug to higher spending”! It’s so true, all of that dependable car you have been driving no qualms just doesn’t seem quite right, couple with the fact that if you ever carpool with your neighbor in their more expensive car….good luck resisting the lifestyle inflation.
I’m 28 and am still a renter. I plan to keep it that way as long as it’s financially advantageous. The flexibility of renting is huge. As soon as work gave me the okay to move west to be with my girlfriend, I packed my crap and bounced! I’ve also moved states for a job before. All this would of been a royal pain in the butt if I owned. I want to be willing to go where the income is and not limit my career to a 30 mile radius of my owned home. Maybe some day I’ll purchase a little lake or mountain home 🙂
My wife will definitely want to buy a house once we move back to Japan, but it’s even a worse investment there than it is here. I should seriously do the math… I guess the benefit though is that at some point you do finish paying the mortgage and you do own a place. Rent, on the other hand, is for life, so…
Yes, the market dynamics are significantly different in Japan. With inflation basically 0, and population on the decline I would guess the real return on a home is probably negative or flat. What are mortgages like there in Japan these days? 1 or 2%?
It’s hard to fathom how a home could possibly be a good place to put money…but I’d need to study it more.
Basic costs will be about $100-200 more when I buy, than renting. However my rent increases by about $50/ month /year. Where I’m buying shortens my commute, so I’ll save some $ there. I’m planning to stick with this job for the next 5+ years, it makes sense to me to settle. I’ve heard home ownership referred to as a forced saving plan. The principal I’m paying in, I can get back when I sell, and there is rental potential too. With my rent increases each year, and unpredictable as the apartment complex changed ownership, I keep revising my budget to spend less, but I’m not saving more. 🙁 Fixed expenses with the knowledge that appliances will need to be replaced periodically, will let me budget & save up for those. Part of my interest in FI is to have the flexibility to move to a lower cost of living area. But I’m still working & like the job & company, might as well make the best of it. 🙂
Good luck! Hope it works out for you.
One small quibble that you mention that this is advice to your children, but seem ignorant of the history that made real estate such a superstar for our parents in the 70’s and 80’s – high inflation! On our side is low inflation, which has made purchasing ‘too much house’ into a real concern that you point out. But when mortgage rates were 10-20%, people were much more careful and home prices were limited by what banks would lend. Our parents then benefited from both high inflation that made a fixed debt ‘smaller’ over relatively shorter periods as well as refinancing to lower rates as inflation slowed. So to conclude my quibble, we have no idea what advice is going to be good for our children. My parents experienced a market tailwind which made the advice ‘buy as much house as you can afford’ good advice. Folks like Robert Kiyosaki and Donald Trump took this concept and capitalized on it (or at least figured out that they could leverage the concept even if it were inherently unpredictable and risky). So I guess I’m just saying that it is hard to give the next generation ‘all or nothing’ advice, especially on what may still be the most significant financial choice that they make post college graduation.
Interesting point, and I appreciate your thoughts! Currently, those kinds of interest rates seem highly unlikely. If anything, interest rates have slowly marched downward since the early 1900’s…other than that blip in the 1970’s you mentioned. Negative interest rates seem like the most likely future scenario…but you’re right, we don’t know what the next 20 years will bring.
Long term returns on equity stayed about the same during the 1970’s and 80’s, but high interest rates forced PE’s down into single digit territory. It was actually a fabulous time to invest in the stock market. I think my advice is still pretty sound, tailwinds from inflation or not.
I agree with people buying too much house, but I actually have the opposite viewpoint for myself. I wish I bought that two bedroom two bathroom double balcony apartment in Manhattan on 21st and Madison Street back in 2000 for ~$800,000. It’s probably worth about $2.3M now! And I wish I bought to my max in 2003 in SF instead of 40% of what I could buy.
Oh well. I downsized in 2014 and enjoy my smaller home. Feels right!
The SF market is a very unique one, isn’t it? The appreciation you guys have seen really….it’s mind boggling!
Housing is something that we spend a huge amount on, it can’t keep increasing like this.
Melbourne is a pretty expensive city, Sydney is even worse. We’re currently renting and investing in shares, investing in the house would be an expensive mistake for us. I doubt we’re going to end up buying for another 10 years.
Tristan
Generally agreed, although I’ll spot you a twist to that logic that we’ve used to good effect – buy your house in a fantastic walk-index ‘hood, then renovate the heck out of it with three key things in mind 1. Efficiency; 2. Rent; and 3. Repay in 5.
If you plan to rent space from the get-go, it’s alot hard for lifestyle creep to take hold (still feels roomy compared to the tiny old tiny condo!). And a walk-friendly ‘hood certainly helps to keep costs low (we decided we’d buy a car if we needed it…8 years ago and counting). As the homeowner, we were the ones in charge of the renos which meant we could focus on minimizing all those nasty recurring expenses (heat, hydro, water, property taxes etc.) that just get passed on to renters…except, as Canadian landlords, we also get to write off a portion of those (admittedly rather small remaining) monthly amounts against the steady income stream from the rented portions of our house. Between the extra $ we get to keep from making the place more efficient and the lovely rental streams coming in each month, repaying the mortgage (and reno costs) in under 5 years was much more manageable. What’s not to like about that? 🙂
This is a great post. I’d add:
(1) You are on the same side as Warren Buffett, Robert Shiller (Nobel prize winner and originator of case-Schiller index), and some bloggers like Ramit Sethi and James Altucher.
(2) FINANCE, and buying a house IS 80% psychology and behavior and 20% math. EVERYONE I know and I live in DC gets into a psychological, keep up with the Jones, I’m an adult know, how big a house I buy shows my self-worth and how much I’ve made, TRAP. Look, you can get a great house, not just rental, and make a sensible, financially prudent purchase. The vast majority of people don’t feel the numbers when they buy. THEY BUY THE MOST THEY CAN, THE MOST IMPRESSIVE THING POSSIBLE, THE THING THAT MAKES THEM FEEL GOOD. I think that’s why a lot of times people just make catastrophically bad decisions with housing.
(3) People just repeat the same mantras: (1) I feel like an adult and I’m all grown up; (2) I don’t feel like throwing away money any more, blah, blah, blah. Follow the herd.
(4) Rentals CAN be great but a lot of work and you better be ready to learn. Stocks, you BETTER learn and find your investment style. But you can buy a few thousand and it won’t kill you.
Another US empire scam. “Buying” a house. You’re a US Debt and tax slave. Inflexibility, buying neighbors, a neighborhood that could go downhill, building/reno costs/design review hearings ($$$), etc.etc..It’s an yet another american scam. US corporations love love love employees/lackeys that have mortgages/heavy debts.
Even after that white picket fence flower propaganda mortgage BROKEr house is ‘paid’ off, stop paying your ever increasing property taxes …and you;ll find out real fast who REALLY owns ‘your’ house. NEVER EVER buy a house. Iliquid scam that barely keeps up with inflation, then the 5-6% realturd commissions, fees, taxes, stamps, escrotch, appraisal nonsense, home “inspection” hucksters, insurance dropping/massive increases, etc.etc..it/s the us hustle. NEVER EVER buy a house in the us. Total racket.
Also—You ONLY get that money back IF you can sell the house. NOT liquid. Many us buyers live paycheck to paycheck including many professionals. (docs, lawyers, etc). they barely put 3-5% down payment, then you wish, hope, and pray that that real estate deal goes through with some realturd joker selling ya that us pipe dream. Hustlers and hucksters galore. Unless you bought back in the 60s, 70s, 80s, early 90s maybe perhaps you did ok. However, add in prop taxes, insurances, fires, mudslides, EQ, hurricaines, flatulence, maintenance, repairs, renovations, garderners, etc..etc..it’s a bad US joke. RENT. No more us tax, corporate, and debt simping- slavery.