Buying a home is not same as buying any other investment. It is part consumption, part investment, part logic, and a bigger part emotional.
If you are on the journey of home ownership, here are three important concepts to master in order to balance consumption, emotion, and investment. Be sure to read to the end to find the four habits of success.
Concept #1: Investment - or Not?
Is owning residential real estate an investment? Yes. Absolutely. Well, most of the time, absolutely. To earn investment returns, however, you must be mindful to pivotal detail. Details such as:
- How much you borrow.
- How quickly you repay.
- How you budget for maintenance and upgrades.
- How you create a world-view that distinguishes between wants and needs.
Although technically a house can be viewed as an investment, a personal residence becomes a home. It yields emotional value. As a piece of real estate, it is a 'store of value' and a forced savings account.
In general terms, an asset is considered an investment if it produces cash flow and/or capital appreciation. Your primary residence provides no actual cash flow and, on average, yields a capital appreciation equal to inflation. (You can read the technical reasons here.) And, yes, there can be significant short-term variations due to demographic and desirability patterns, which are really elements of 'timing' the market. Over the years, however, house price appreciation tends to revert to inflation-(ish).1
Don’t feed the emotional value with unnecessary improvements under the guise of “investment." No one in the property market will pay for the emotional value you "invest" in the house. This is when “improvements” become nothing more than consumption, eating away at your asset value.
This concept is important to understand. Let's repeat it.
Invest only the amount, and improve only the features, that a stranger would be willing to pay.
A primary residence does not yield investment returns in the same way an exogenous investment might. Developing clarity around this principle will go a long way to modifying your future behavior when you find yourself juggling between wants rather than analyzing needs.
Concept #2: Buy vs Rent Decision
Deciding to buy your first house is frequently a “buy vs rent” discussion. It goes something along the lines of “We're paying X in rent. At these interest rates, we could buy a house with monthly payments of Y.” The ‘Y’ might be a little more or a little less than rent.
Adding in upfront costs, interest, property taxes, insurance, regular maintenance, and occasional upgrades (because the a/c does fail and the kitchen/baths will need to be remodeled in the next 30 years), most people will find that the first 10 years of a typical US mortgage are net negative cash flow relative to renting (+ investing).2
In fact both buying and renting (+investing) generate negative returns over 30 years. When you look at the Buy vs Rent trade-off, there is a small benefit. The net difference generally yields a benefit roughly equal to the inflation rate over a 30 year span.2
Similar to the time-delay in the power of compound interest, owning your primary residence begins to yield its real value … once you ... Pay. The Mortgage. Off.
Once you repay the mortgage, this “investment” of yours begins to generate cash flow in the sense that you are no longer paying to live somewhere. At this critical point, you need to invest that "mortgage payment" you no longer pay. Don't be tempted to spend it. Your mortgage has forced you to save. The bank required payment. Be the bank of your future. Continue to save.
Concept #3: Your Loan Officer is Not Your Advisor
When you are looking for a house, your realtor will ask you to ‘get a letter from your lender.’ Going to the mortgage broker, you are typically told the maximum amount over the longest period. Good to know, however, over-indulging is bad for you!
Just because the bank lending criteria is generous does not mean that you can actually afford that much debt. Banks are in the business of selling debt. You, however, control how much debt you buy. You decide. Do you want to spend the maximum the bank will allow? Do you want to build up your retirement savings? Do you want to save enough to pay for education or a car? What happens if you lose your job?
You hold the power to decide how much you want to spend on housing and how much you want to save for your future. Remember that the investment return on a personal residence roughly equals inflation, which means selling the house when you retire is not likely enough to get you through retirement.
Mortgage lenders will also provide information on shorter loans of 10, 15, and 20 years. Those are the ones you want to consider. Ask for these calculations too.
Taking on too much debt - even if you "qualify" - can destroy returns. It is analogous to buying debt while all the time thinking you're buying an asset. Don’t buy debt!
Don’t buy debt thinking that you're buying an asset.
The Upshot? Develop Habits of the Wealthy
- Pay no more than 25% of your risk-adjusted pre-tax income to put a roof over your head:
- 15%-20% if renting. The higher your income, the lower the percent you should spend on rent. It's lower than buying because it is pure consumption. Necessary consumption, but still consumption.
- Up to 25% if buying, but be sure to include ALL costs of ownership, including principal, interest, taxes, insurance, HOA/Condo fees, maintenance, and upgrades.
- Risk-adjust your income if there is any instability in cash flows, inconsistency in work, high industry turnover, or future plans to take time out to raise a family. In other words, reduce the amount of income allocated to housing.
- Use the power of leverage wisely, with just the right amount, and no more. Current mortgage rates are approximately the same as long-term inflation. That’s one of the beauties of buying your own home at this moment in 2020.
- Pay your debt in 15 years. Your future self will thank you for making the sacrifice now.
- Like a "We might be able to retire early" thank you.
- Like a “Let's turn this into a rental property and move somewhere else” thank you.
- Invest the defunct “mortgage payment you no longer pay" and do this the very month your mortgage is paid off, before you get used to the extra cash.
- Let the power of compounding cushion your retirement.
That's when a house ~ YOUR HOME ~ is an investment!
Having been through many real estate cycles and psyches, we wish you the power of discipline.
Thanks for reading!
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