The Hidden Cost of Home Buying
I hate to start the week with math, but that’s exactly what’s about to happen.
A few months ago, I wrote a post titled “Why a House Is Not a Home,” and in it I questioned the conventional opinion that real estate is always a good investment. The point I made is that real estate, like any other asset, is not always "safe" and comes with opportunity costs that most people ignore.
To drive this point home, I’m going to provide a real life example from a recent trip Jennie and I took to Denver.
Housing Prices in Denver, Colorado
A member of Jennie’s extended family owns a house in Denver, which was purchased in the mid 1980s for $87,000, and is now worth $400,000 in 2017, supported by the hot real estate market in Colorado (and historically low interest rates).
That’s a 460% return.
Here’s the thing: on an annualized basis, assuming a thirty year horizon (it was longer but let’s use thirty for simplicity), the rate of return was 5.2% per year.
Inflation over that period was 3.5%.
5.2% minus 3.5% nets you a real return of 1.7% per year. This is assuming the original home was purchased in cash - that it wasn’t financed with a 30 year mortgage paying interest. If that’s the case, the real return would be less than 1% - maybe even negative. But I’m an optimist, so let’s go with 1%. To lock in this 1% return, you’d need to eventually sell this house and incur costs on top of that.
At this point, I haven't factored in any of the pros and cons of owning real estate. Like a stable roof over your head to raise a family and the advantage of using leverage to boost your net worth. I also haven’t factored in the maintenance and remodeling required on a house over thirty years. As home values rise, generating wealth on paper, the additional property taxes you pay on the value of your home is a real cash outflow.
I don’t care about any of the above. That’s largely a personal decision to be made based on personal values.
What I care about is opportunity cost.
The Opportunity Cost of Owning a Home
$87,000 invested in a low cost index fund by January 1, 1987, and held through ‘Black Monday’ ten months later, the dot-com bubble and the Great Recession would be worth $1,000,000 in 2017. Even if only half of it was available in 1987, it would still net you $500,000, enough to buy a decent sized retirement home in thirty years (no downsizing necessary) - even in a period of historically low borrowing costs and historically high home prices.
Which means historically speaking, the opportunity cost of taking out a 30 year mortgage in your 20s is anywhere between half a million to a million dollars.
Does this mean we should bet the farm on index funds in 2017? Alas, it’s not that simple.
However, the prescription of a slow and consistent accumulation of low cost index funds over a long period of time, through the ups and downs of the market, will almost certainly outperform real estate on an inflation-adjusted basis.
It all depends on whether we have the emotional fortitude to be, as Warren Buffett says, “fearful when others are greedy and greedy when others are fearful.”
In practice, this means having the courage to stay the course when everyone else is calling for the end of the world.
When it comes to home-buying, I’m not saying that one size fits all. I’m simply pointing out the hidden costs (and risks) of a long term mortgage.
This is just my personal opinion, but I think Americans have developed a disturbing comfort level with debt, debt that’s largely been subsidized by the federal government. This is great when interest rates are falling, but disastrous when the cycle turns or when half the jobs that exist today start to disappear.
Which is to say that by taking out a mortgage in your twenties, you’re making an implicit bet on stability over growth.
I guess it all depends on when we should value stability:
a. when we’re young, ambitious and mobile, or
b. when we’re older and ready to settle down.
If reading this has made you a little more unsure about the buy vs. rent decision, then good. Only idiots are certain all the time. In fact, it’s their natural disposition. And while the ignorant have always occupied a fixed percentage of our population, they seem to have grown awfully confident these days.
And that's exactly when everyone else needs to get cautious.