You have just graduated from college (or more likely grad school) and you’ve been renting since you’ve lived with mom and dad. All your friends are are buying houses and you’re starting to feel like you’re falling behind. If that’s you, then you’re probably starting to fall prey to the “a house is an investment” fallacy (yes, I just made that up). The perception is that when you rent, you’re spending money that you’ll never see again. Compare this with a mortgage payment where you’re actually buying something that you can keep. Mortgages seem like the money-wise decision while renting seems like flushing money right down the toilet. Well, let’s just crunch a few numbers to see if we’re right.
Let’s say you’re interested in buying a house that costs $155,000. Like most Americans, you don’t want to tie up too much of your monthly income so you opt for the 30 year fixed rate loan at a rate of 4.875%. You also put the minimum of 3.5% down. So your mortgage is about $152,000. You decide to use this account to also pay for property taxes and home owners insurance, these payments are called “Escrow.” Every month the bill comes in the mail and every month you are happy to write your check for $1,200. It’s a lot more than your previous rent of $800/mo. but you remind yourself than these payments are for something and you aren’t just flushing good money down the toilet. Sleep easy.
You wake up at night realizing that 30 years of payments add up to just under $400,000. A steep price to pay for a $155,000 house, but you remember that this house will be appreciate and be worth a lot more. Sleep easy.
Once more you wake up when it hits you that $400,000 is a ton of money and you’re worried than your house isn’t going to appreciate that fast. A quick Google search might lead you to an article in the Real Estate section on MSN.com by an economist who believes that based on historical returns, home prices are expected to increase after inflation 1-2% per year through at least 2020. Giving yourself the benefit of the doubt, you assume a 2% return add quick add it up. Your stomach drops when you realize that this economist expects your home to be worth $275,000 in 30 years (a difference of -$125,000). Does he know you paid $400,000 for it? So what happened?!
The perception is that a mortgage payment is bankable cash. This is an illusion. That $1200 check you write each month goes toward a lot more than simply the principle and interest on your mortgage. Modest property taxes and even reasonable home owners insurance, along with private mortgage insurance (for not coming up with 20% down), all eat into that “bankable cash”. Within your payment in those first years: $600 goes toward interest, $415 goes toward owner’s insurance, taxes, PMI, leaving a measly $185 goes toward your actual principle. Add it up and you’re flushing over $1000 a month down various toilets. Suddenly that $800 rent payment doesn’t sound so bad anymore.
Unfortunately, it gets worse. Your neighbors are finishing their basements, tiling their floors, updating paint colors, and replacing the carpet. There’s no way way your house is going to appreciate at 2% unless you sink some serious cash into it. You previously considered these projects an investment because they increased the value of the home, but you depend on these improvements simply to get your home to be worth the $275,000. If you didn’t spend your Saturdays weeding, mowing, and fertilizing the outside while painting the inside, you’d lose even more money than the $175,000 already mentioned!
Today we’ve learned that an average house, for an average family, in an average neighborhood, is essentially a -1.4% return on investment after inflation. If you still consider a house an investment, I’d like to sell you some more “investments”. Perhaps you’d be wise to continue renting that $800 apartment and saving the extra $400 in your sock drawer. You’d come out ahead.
One one final note, it’s worth mentioning that in many cities the most desirable neighborhoods are often not for rent. You’ll also find that the $1200/mo. home is much nicer than the $800 apartment. Furthermore, there may be something to be said, for intangibles like being able to get to know your neighbors and customizing your own house. And who knows, maybe you’ll sell during the next bubble and come out ahead! The bottom line is that buying a house is wise if you call it a home not an investment.
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