At the end of a visit with friends a while ago, I took a little tour through the house to count the rooms that had gone unused through the long weekend.
There was a finished game room in the basement, a kids’ playroom on the second floor, the second guest room, a sitting room and formal living and dining rooms — all unvisited for three days while the seven of us hung out in the family room and kitchen. Finishing my tour, I found four big air-conditioning units humming beside the house, each as big as the single unit that cools my own home quite nicely.
Now, our friends are very successful small-business owners, and they can afford this house. But, wow! There’s a lot of money committed to owning and maintaining this palace — money that could be invested elsewhere, put back into the business or kept in reserve in case the business hits a rough patch. Is the home really a good enough investment to justify such expense?
We often hear that the home is our “biggest investment.” But there’s a good case to be made that a home isn’t an investment at all. On a purely financial basis, owning a home is generally more profitable over the long term than renting. But I believe an expensive home is generally not as good an investment as an inexpensive one — not considering the alternatives.
The problem is our views of our homes are muddied by their dual functions, as places to live and as financial assets. If it’s pleasing to come home to, we tend to settle for a careless financial analysis.
Over a lifetime, ownership pays off because a fixed-rate mortgage freezes your principal and interest costs, while rent would rise with inflation. In normal times, owning beats renting if you expect to keep the home past a break-even period of four or five years, when appreciation would outstrip the sales commission and other selling costs.
Since these aren’t normal times, it’s prudent to stretch that period to six or seven years. At the higher end of the market — with homes costing, say, $750,000 or more, depending on where they are — the break-even period could be even longer, as this market doesn’t seem to be bottoming out as quickly as the low end.
Assuming you will stick around, and that the market will return to normal, why not buy the most expensive home you can afford? The more you invest, the more you gain from appreciation, right?
In fact, appreciation is not all that great. The Yale economist Robert J. Shiller has found that U.S. homes tend to appreciate at about 1 percentage point a year above the inflation rate. Stocks, measured by the Standard & Poor’s 500, tend to beat inflation by 6 or 7 points.
Census Bureau figures show that from 1960 to 2000 the median home price rose from $11,900 to $119,600 — about 10 times. During the same period, $1 invested in the S.&P. 500 would have grown to about $92, according to this calculator. (Neither figure is adjusted for inflation or taxes. Reinvested dividends account for more than 40 percent of S.&P. 500 returns.)
In real life, the discrepancy is even greater. In 1960, mortgage rates ran about 6 percent, close to today’s level. Interest would have doubled the cost of purchasing a home, cutting the 40-year gain in half to five times the purchase cost. And, of course, real estate taxes, homeowner’s insurance and maintenance costs would have chewed the gains further.
With an S.&P. 500 index fund, in contrast, there would be no interest charges or other ongoing costs, other than an expense ratio of less than 0.2 percent a year. Even accounting for a 15 percent capital gains tax on selling the fund shares, the home buyer in 1960 would have done far, far better with a stock-market investment, had S.&P. 500 index funds been available back then.
Money put into stocks or other securities is easily accessible with a phone call or a few clicks of a mouse. Getting money out of a house means selling, refinancing or taking out a home equity loan – and paying interest to use your own money. That should be an important consideration for a small-business owner who could need cash fast.
Certainly, you can lose money in the stock market. But one of the things we’ve learned over the past two years is that it’s easy to lose money on a home as well. Before the current crisis, even most experts felt it was virtually impossible to have a nationwide collapse in home prices. Now we all know better.
There are some tax benefits to home ownership. Mortgage interest is deductible, for instance. But it doesn’t make sense to take on a dollar of debt just to save a quarter in taxes. Gains from home appreciation are tax-free, while other long-term investments are taxed at the 15 percent capital gains rate. But that’s not enough to offset the home’s poorer long-term returns.
My advice: See a house as a home, not an investment. If a big, expensive home thrills you, and your other investments or business assets will grow enough to cover retirement, college costs and other long-term needs, get a fancy house, by all means — and consider it a luxury, an extravagance. But if you have a volatile business that could need a cash infusion, don’t tie a lot of money up in more home than you really need.
Fortunately, fashions have changed and conspicuous consumption is “out,” at least for the time being. If you need to make a show of entertaining clients, take them to a nice restaurant.
Update | 12:24 p.m. Thanks for all of the comments on this posting. The subject of house-as-investment always stirs passions.
Some readers question the 1960-2000 time period used in the analysis, pointing out that stocks were at a peak at the end of that period. That’s true, but there were some severe downturns as well, and I think 40 years is long enough to be meaningful. One could argue that just about any single decade offers a distorted picture. The current decade has had two stock crashes, and an extraordinarily unusual collapse in housing prices.
Other readers argue that leverage boosts housing gains, a longstanding view that works wonderfully on paper: If you put only 10 percent down on a house that then grows 10 percent in value, you double your money.
I see two problems with relying on leverage. First, it works the other way, too. If that home’s value falls 10 percent, the down payment is wiped out. That’s what’s happened to millions of people who bought homes in the first half of this decade.
Secondly, gains due to leverage are trimmed by the mortgage interest cost. If you borrow 90 percent of the purchase price and pay 6 percent a year on the loan, the house has to appreciate by more than 5 percent a year just to offset the interest. If interest is not taken into account, a 5 percent gain looks like a 50 percent return on the down payment.
Also, the leverage diminishes over the years as the monthly mortgage payments reduce loan principal.
Some other readers have made very good points about the dangers of having many eggs in a single basket — a very expensive home.
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