HOMEOWNERSHIP: THE AMERICAN DREAM?
After living as a married couple in Salt Lake City for 18 months, Kellie and I decided to put some roots down. It was time to become homeowners. After A LOT of searching and a few failed bids, we secured our lovely condo. I’ll never forget Kellie saying that she felt like a queen when we moved in (I love having a wife who’s easy to please).
Our condo is currently being rented by wonderful tenants while our family lives our Star Valley dream. Being homeowners and landlords has given us a new appreciation for using real estate to build wealth. It’s been a great experience so far, but there are both material and unseen costs involved which take a toll.
Here are a few thoughts based on our own experiences, and why homeownership sometimes isn’t all it’s cracked up to be.
HOMEOWNERSHIP FEELS LIKE A GREAT DEAL
Owning a home has some financial benefits that are hard to ignore. Leverage, tax advantages and the potential for added retirement income are at the top of most lists.
Using Leverage to Build Wealth in Your Home
Leverage is borrowing money to (hopefully) have that money grow to a larger amount over time. Leverage is a powerful concept. It’s the same reason a fat man can be hoisted in the air by a little kid at the other end of a teeter-totter (this fact still amazes me). For most, a mortgage represents the largest use of leverage that any American will utilize.
For example, with a down payment of $40,000 a family can get a mortgage on a home costing $200,000. This reflects a down payment of 20% which can often be less depending on your qualifications or the nature of your loan, such as with an FHA loan.
Real estate historically is an asset that increases in value over time. To be able to borrow such a large amount of money at relatively low interest rates with little collateral to purchase an appreciating asset can be a great combination. It’s no wonder the majority of most American’s wealth is in their home (though I don’t think this is wise, as I’ll explain later).
Generating Future Rental Income
Eventually our condo will be paid off. When that time comes we don’t plan to sell it, but continue to rent it out for additional income.
We expect this to be a nice boost to our future income, especially in retirement. A retirement picture with multiple streams of income--investment income, part-time wage income, social security income, and rental income--can provide a well-diversified flow of cash. Not only that, but rental rates tend to increase over time.
Homeownership Tax Incentives...But Be Careful
In addition to using leverage and the potential for future rental income, the interest on your mortgage is usually tax deductible, as long as your mortgage doesn’t exceed $1,000,000 (Tim and Kellie’s condo: ✔). A family can typically take the deduction on a second home in addition to your primary residence. This deduction applies to traditional, single family homes, condominiums or even recreational vehicles (in case you’re livin’ in a van down by the river). If your state assesses property taxes, you might be entitled to a deduction for those taxes, too.
Where potential homeowners get themselves into trouble is allowing the deductibility of mortgage interest and property taxes to help persuade them to purchase a home. Let’s be clear. The costs of owning a home will never be off-set by the relatively small mortgage interest deduction a family can receive. Don’t let the tail wag the dog.
WHY HOMEOWNERSHIP MAY NOT BE WORTH THE COSTS
The tax incentive argument tends to be the tip of the iceberg when it comes to some of the half-truths of the benefits of homeownership. I’ve found there are arguments for owning real estate that don’t hold much water, while there are other characteristics that tend to be under-emphasized.
The “Rent is Throwing Your Money Away” Fallacy
I used to firmly believe that rent was throwing your money away. I mean, why rent a home when you can own one, right? I now wince a little when I hear it. Renting is anything but throwing your money away.
For starters, you have a roof over your head. If anything goes wrong with that roof--or anything else in the home for that matter--it’s up to your landlord to fix it, not you. When you rent, you’re not subject to all the other pressures that can affect you as a homeowner. If the local job market dives--you relocate. If the rent is too high for your tastes--you finish your lease agreement and move on.
Landlords must work to keep their rentals filled, since in most cases they still carry a mortgage or are dependent in some other way on the property’s cash flow. They can’t walk away as easily as a tenant can.
Kellie and I found that we had an incredible amount of bargaining power as renters. When we first moved to Salt Lake City we found a rental that we loved, but the price felt steep. With a good amount of extra cash on hand, we negotiated with the owner to allow us to pre-pay the lease by three months if he would decrease the rent by 5% for the entire term. This gave our landlord an assurance that we would be good tenants (tenants who pay on time, every month = good tenants), and in the process saved us about $600 over a year.
The next time you wonder if you’re throwing money away by renting, consider the tremendous flexibility and negotiating power that lessees can have.
Costs, Costs, Costs
Leverage, as described earlier, is a powerful tool for building wealth through real estate. But it goes both ways. What happens when the fat man jumps off the teeter-totter? The kid comes crashing down.
Following the financial crisis of 2008, home prices plummeted. This resulted in many homeowners owing more money on their homes than they were worth. This crash in prices left many homeowners with little or no equity (many lost their jobs, too), but they still had mortgage payments to make. That’s the downside of leverage.
Maybe the financial crisis didn’t affect you. Or perhaps you consider it a one-time, isolated event (as one New York Times commentator put it, “Labeling it a 'black swan' doesn't capture the tragedy”). Still, the material costs of acquiring, maintaining, and selling a home, regardless of the economic climate, can be steep.
Realtor fees can be one of the more impactful expenses. Depending on the terms of the transaction, buyers and sellers can each end up paying anywhere from 2-5% of the price of the home in closing costs. Assuming both the buyer and the seller pay 3% on a $200,000 home purchase, the closing costs will be around $6,000 for each side. When the home has appreciated and is later sold, those fees increase. I don’t doubt that many realtors add value to the process of a home purchase or sale, but the costs should still be considered.
Private mortgage insurance (PMI) is required for every home with a down payment less than 20%. Once your equity grows to above 20% your required PMI can go away, but depending on a variety of economic factors, building up enough equity to get to 20% could take years. For Kellie and I, putting 20% down on our condo and avoiding PMI saved us about $100 a month.
And how about homeowner’s insurance? You’ve got to insure that property, right? This will cost you, too--each and every month. By the way, do you also live in a potential flood zone? Tack on some additional coverage for flood insurance.
Property taxes and mortgage interest are often discredited because they may carry a tax deduction, but tax deductions don’t eliminate the cost (as described previously). Taxes and interest still need to be paid regardless of what portion of them may be deductible.
The list of costs goes on. Home maintenance can be an ongoing issue. Your home is a mostly wood, brick, and sheetrock--all of which have a tendency to rot and deteriorate over the life of the home. Yes, those remodeling projects can add up, too (even if it’s DIY).
There are also immaterial costs that must be considered, though they are more difficult to quantify.
The process of researching and doing your due diligence once a property is in your sites is perhaps the biggest example. According to Zillow, the average homebuyer searches for 12 weeks and visits 12 different homes before a purchase is made. This is a painful process for most buyers. Not only is it a tremendous time investment, but it's a particularly brutal experience to find the home you love, make an offer, and then be outbid, requiring you to start your search all over again (we’ve been there).
Robbing Peter to Pay Paul
Perhaps the biggest costs of homeownership are the opportunity costs of not embracing other financial opportunities. It’s too often that I hear about homeowners who view their home as their “financial plan” at the expense of not having money left to save for a comfortable retirement, a child’s college, or even a new car.
This isn’t because they don’t want to save for other meaningful things, but many homeowners were told they could quality for a mortgage loan up to $XXX,XXX...and guess what they bought? This “robbing” from other financial priorities too often results in underfunded retirements and homeowners having a disproportionate, undiversified amount of wealth tied to their home.
Have I Ticked You Off Yet? Stick With Me
If you’re a homeownership advocate, you may have reached the end of this article red-faced with steam seeping from your ears. I want to be clear on something: I’m a homeownership advocate, too. I believe the benefits of owning a home can ultimately outweigh the costs. This is especially true from the standpoint of owning a home in a community that you, your spouse, and your children love.
Just remember that there are serious costs involved, not just in buying and selling your home, but in other ways including:
- Your home is still bought with a significant amount of debt
- Tax incentives are real, but they don’t come close to netting out the costs
- Your home is mostly earthy material that eventually needs to be repaired, replaced, restored, and refinished
I hope at the very least this post helps you go into a home purchase with your eyes a little more open, and if you currently have a home, being realistic about the costs--and benefits--of owning it.