How to think about your biggest financial purchase
IN 1972 MY grandparents purchased their home in California for $28,000. Today it is worth around $600,000, or over 20 times what they paid for it. Even after adjusting for inflation, their home has increased in value by a factor of three. But in addition to their financial return, my grandparents also raised three children in that home, including my mother, and partially raised seven grandchildren there, including me.
I love that home. I’ve spent nearly all my Christmas Eves there. I remember eating stacks of my grandmother’s delicious, peanut butter covered pancakes in the kitchen. I remember the permanent indentation in the couch where my grandfather would sit and watch television. I remember the bricks outside where I fell and slashed open my left eyebrow as a kid. Every time I look in the mirror I see the scar and am reminded of it.
Hearing stories like this it’s easy to see why home ownership has been touted by so many over renting. Not only can a home help you build financial wealth, but it also can help you build social wealth as well by providing a stable foundation to raise a family. Some consider this emotional return on investment priceless.
But before we crown home ownership the winner in the renting vs. buying debate, we need to consider the many other costs of home ownership as well.
The Cost of Home Ownership
In addition to paying the mortgage, home ownership has an array of both one-time and ongoing costs. The one-time costs consist of the down payments and fees related to buying, while the ongoing costs consist of taxes, maintenance, and insurance.
The first time you buy a home you should expect to put down anywhere between 3.5%–20% of the home’s purchase price. Saving up this much money can take time, but the next chapter will discuss the best way to do this.
After saving for your down payment there will also be closing costs which will be roughly 2%–5% of the home’s value. These closing costs include: application fees, appraisal fees, origination/underwriting fees, and much more. While some sellers may cover these closing costs for buyers, this depends on your (or your real estate agent’s) ability to negotiate.
Speaking of real estate agents, this is one of the other big costs of buying a home. Real estate agents typically charge a 3% commission for every home they help buy/sell. In the event there are two real estate agents involved in the transaction (one for the buyer and one for the seller), that means 6% of the total value of the home will need to be paid in commissions.
In full, the one-time costs of buying a home can range anywhere from 5.5%–31% of the value of the home depending on the down payment, closing costs, and real estate agents employed. If we ignore the down payment, the transaction cost associated with buying a home ranges from 2%–11% of the home’s value.
This is why buying a home usually only makes sense for people who will stay in it for the long term. The transaction costs alone can eat away any expected price appreciation if you buy and sell too often.
In addition to the one-time costs of buying a home, the ongoing costs can be significant as well. After paying for the home itself you will also need to pay property taxes, maintenance, and insurance. Fortunately, property tax and insurance are typically included in the monthly mortgage payment.
However, the size of these added costs will vary based on a handful of factors. For example, the taxes you pay on your home will be determined by where you live and the current tax law.
When the Tax Cuts and Jobs Act of 2017 raised the standard deduction, one of the primary benefits of being a homeowner (deducting mortgage interest) was effectively eliminated for many homeowners. This is one of many changes to the tax code (and future changes to come) that will affect the cost of homeownership.
When it comes to insurance, where you live and how much money you put down when you buy your home will determine how much you have to pay. Anyone who puts down less than 20% of their home’s value typically has to pay for private mortgage insurance (PMI) in addition to homeowner’s insurance. This will cost you anywhere from 0.5%–1% of your loan value annually. So if you have a $300,000 mortgage, you are looking at an additional cost of $1,500–$3,000 per year, or $125–$250 a month for PMI.
Lastly, the ongoing maintenance on a home can be considerable from both a financial and a time perspective. While the financial costs will vary depending on where you live and when your home was built, most experts recommend budgeting for 1%–2% of your home’s value in annual maintenance costs. This means that on a $300,000 property, you should expect to spend anywhere between $3,000–$6,000 per year keeping it intact.
In addition to the explicit financial costs associated with maintaining your home, there are also significant time costs as well. I’ve heard far too many anecdotes from friends and family about how being a homeowner is like having a part-time job. Whether you are scheduling repairs or doing it yourself, home maintenance can take up more time than you might initially imagine.
This is one of the more overlooked costs of being a homeowner. Unlike being a renter, when things break, you, as the homeowner, have to fix them. Though some people will find joy in being the designated repair person around their home, many won’t.
Whether we examine the one-time costs or the ongoing costs of homeownership, a home can be more of a liability than an asset at times. Of course, renters aren’t immune from these financial costs—as they are likely already included in the monthly rent.
However, a renter and a homeowner experience these costs very differently from a risk perspective. Because a renter knows exactly what they will have to pay for the foreseeable future, while a homeowner doesn’t. For example, the maintenance costs for a given property could be 4% of the home’s value within a given year, or 0%. This is something that would affect a homeowner but would have no effect on a renter.
As a result, homeownership is generally more risky than renting in the short term. Over the next year, the costs associated with being a homeowner are far more variable than the costs associated with being a renter. However, if we look over longer periods of time, this changes.
The Cost of Renting
The primary cost of renting (outside of the monthly rent payment) is long-term risk. This risk shows up in unknown future housing costs, instability in living situation, and ongoing moving costs.
For example, though renters are able to lock in the price they pay for housing for the next 12 to 24 months, they have no idea what they will be paying for housing a decade from now. As a result, they are always buying at the market price, which can fluctuate widely. Compare this to a homeowner who knows exactly what they will be paying for their housing into the future.
More importantly, when you are a renter your housing situation is far less stable from year to year. You might find a place you love only to have the owner raise the rent considerably, forcing you to move yet again. This housing instability can cause both financial and mental turmoil, especially for those trying to raise a family.
Lastly, given their housing instability, renters have to move far more often than homeowners do. I know this well since I have lived in eight different apartments across the U.S. since 2012 (about one a year). And while some of these moves were easy thanks to friends and family, some of them required movers and were far more costly.
No matter how you look at it, renters face long-term risks that many homeowners don’t face. However, one risk that renters are unlikely to face is whether they will get a good return on their investment.
Housing as an Investment
When it comes to housing as an investment, unfortunately, the data isn’t that promising. Robert Shiller, the Nobel Prize-winning economist, calculated the inflation-adjusted return on U.S. housing was “only 0.6% a year” from 1915–2015.44 More importantly, most of that return came after the year 2000.
As the following chart illustrates, from the late 1800s to the late 1900s, U.S. housing was basically flat after adjusting for inflation.
That is 100 years where U.S. housing saw no major changes in its inflation-adjusted value. The last few decades have seen increasing U.S. home prices, but I’m not confident that this trend will continue into the future.
Anytime you look at U.S. housing as an investment, you have to compare it to what an investment in another asset would have done over the same time period. This is known as the opportunity cost of the investment.
For example, my grandparents bought their $28,000 home and paid a $280 monthly mortgage from 1972 to 2001. Around 2001, their home was valued at around $230,000. But what if instead of buying that home, they had invested that money into the S&P 500?
If they had put $280 a month into the S&P 500 from 1972 to 2001, they would have had over $950,000 by 2001, after reinvested dividends. And this doesn’t even include their down payment! Had they invested their down payment as well, they would have had over $1 million by 2001.
Despite my grandparents living in California, which has had one of the best multi-decade returns in U.S. real estate history, their house earned them roughly one-fourth of what a similar investment into a broad basket of U.S. stocks would have earned them.
Of course, holding U.S. stocks for three decades is much harder emotionally than paying off a mortgage. When you have a home, you don’t get the price quoted to you daily and you probably won’t ever see its value cut in half. However, this isn’t true with U.S. stocks. In fact, from 1972–2001 there were three major market crashes (1974, 1987, and the DotCom bubble), and two of those crashes had declines of over 50%!
This is what makes housing a fundamentally different asset than equities or other risk assets. While your home is unlikely to crash in value, it’s also unlikely to be your long-term ticket to wealth either. More importantly, even if you see your home price increase significantly, you can only extract that value if you sell and buy a cheaper home elsewhere, or if you sell and go back to renting.
Does this imply that you should rent forever and invest whatever money you would’ve spent on a home into other assets? Not necessarily. As I have stated previously, there are non-financial reasons to own a home that you need to consider. But, more importantly, there are societal reasons why you should consider home ownership as well.
Buying a Home Isn’t About If, but When
Though your home is unlikely to be a stellar long-term investment, there are societal reasons why you should probably own one. According to the Survey of Consumer Finances, the home ownership rate in the U.S. was 65% in 2019.45 And if you look at those households with higher levels of income and wealth, the homeownership rate only seems to increase.
For example, researchers at the U.S. Census Bureau found that in 2020, the homeownership rate was nearly 80% for those households with an income greater than the median income.46 And my own calculations suggest that the homeownership rate is over 90% for those households with a net worth greater than $1 million in the Survey of Consumer Finances.
Why is homeownership so universal? In addition to government subsidies and cultural norms that promote homeownership, it is also the primary way that many U.S. households accumulate wealth.
Using 2019 data from the Survey of Consumer Finances, researchers found that housing represented “nearly 75 percent of the total assets of the lowest-income households… but for the highest income households that percentage was only 34.”47 No matter where you are on the income spectrum, your home is likely to be a source for building wealth, even if it isn’t the optimal one.
More importantly, buying a home will probably be the biggest financial decision you ever make. And this decision is socially acceptable and critically important for so many other things in life. Housing determines what neighborhoods people live in, where their children go to school, and much more. If you decide to be a lifelong renter, that is fine—but you could be excluded from certain communities as a result.
This is why most people who can afford a home usually get one. Therefore, the more important question you need to be asking yourself isn’t whether you should buy or rent, but when you should consider buying instead of renting.
When is the Right Time to Buy a Home?
The right time to buy a home is when you can meet the following conditions:
· You plan on being in that location for at least ten years.
· You have a stable personal and professional life.
· You can afford it.
If you can’t meet all of these conditions, then you should probably be renting. Let me explain.
Given that the transaction costs of buying a home are 2%–11% of the home’s value, you will want to ensure that you stay in the home long enough to make up for these costs. For practical purposes let’s choose the middle of this range and assume that the transaction cost of buying a home is 6%. Using Shiller’s estimate for real U.S. housing returns of 0.6% per year, this means it would take ten years for the typical U.S. home to appreciate enough to offset this 6% transaction cost.
On a similar note, if you plan to stay in an area for ten years but your personal or professional life isn’t stable, then buying a home may not be the right choice. For example, if you buy a home while you are single, you may end up needing to sell it and upgrade to a larger home if you decide to build a family. In addition, if you are always changing jobs or your income is highly variable, then taking out a mortgage may put your finances at risk. Either way, instability makes it more likely that you will pay more in transaction costs in the long run.
This is why mortgages work best when you are better able to predict your future. Of course, the future is never certain, but the more insight you have about how your future will look, the more likely you can buy a home with ease.
What makes buying a home even easier is if you can afford it. This means being able to provide 20% as a down payment and keeping your debt-to-income ratio below 43%. I chose 43% because that is the maximum debt-to-income ratio you can have for your mortgage to be considered qualified (i.e., lower risk).48 As a reminder, the debt-to-income ratio is defined as:
Debt-to-Income Ratio = Monthly Debt / Monthly Income
So if you plan to have a $2,000 mortgage and you currently have monthly gross income of $5,000, then your debt-to-income ratio would be 40% ($2,000/$5,000), assuming you have no other debt payments. Of course, if your debt-to-income ratio is lower, then that’s even better.
Additionally, you don’t have to put down 20% when you buy your home, but you should be able to. This distinction is important. Having the ability to put down 20% shows that you have the financial responsibility to save sufficient cash over time.
Therefore, if you can put down 20% but choose not to, you will probably still be fine. I understand that putting all that cash into an illiquid investment such as house can be risky in the short term. However, putting down more means you can generally afford a more expensive (and likely bigger) home.
If you are deciding whether you should save up and get a bigger home or get a starter home and then transition later, I recommend waiting for the bigger home. Given the transaction costs, it’s probably better to wait to buy something a little outside of your budget than to buy a starter home and then sell it within a few years.
I know this sounds risky, but when you buy a home, the riskiest part is in the first few years. As time goes on, your income will likely grow with inflation, but your mortgage payment won’t.
My grandparents experienced this firsthand after their mortgage payment was cut in half (in real terms) due to the high inflation of the 1970s. They were paying half as much for housing in 1982 as they had a decade prior. A renter wouldn’t have had that benefit.
Whatever decision you end up making when it comes to buying a home, the important thing is to do what is best for both your personal and financial situation. Since buying a home will probably be the largest, most emotional financial decision you ever make, you should spend time to get it right.
No matter where you are in your renting vs. buying journey, you should know the best way to save up for a down payment. This is where we turn our attention in the next chapter.
44 Shiller, Robert J., “Why Land and Homes Actually Tend to Be Disappointing Investments,” The New York Times (July 15, 2016).
45 Bhutta, Neil, Jesse Bricker, Andrew C. Chang, Lisa J. Dettling, Sarena Goodman, Joanne W. Hsu, Kevin B. Moore, Sarah Reber, Alice Henriques Volz, and Richard Windle, “Changes in US Family Finances from 2016 to 2019: Evidence From the Survey of Consumer Finances,” Federal Reserve Bulletin 106:5 (2020).
46 Eggleston, Jonathan, Donald Hayes, Robert Munk, and Brianna Sullivan, “The Wealth of Households: 2017,” U.S. Census Bureau Report P70BR-170 (2020).
47 Kushi, Odeta, “Homeownership Remains Strongly Linked to Wealth-Building,” First American (November 5, 2020).
48 “What is a Debt-to-Income Ratio? Why is the 43% Debt-to-Income Ratio Important?” Consumer Financial Protection Bureau (November 15, 2019).