Let Me Clarify

Have you ever heard someone say that your home is your greatest investment? We work with many people who subscribe to this theory, and our job is to challenge those assumptions. The personal finance industry is full of dos and don’ts that create a base of financial decisions for many consumers. This especially hits home when advice is received from a parent, friend, or relative. Focusing on home ownership for this article, we look to break down what a traditional investor considers an investment and how a home may or may not fit into that definition.

First, we start with the definition of an investment. My simple rendering of the idea could be stated as this: ‘The purchase of an asset for the purpose of income generation or the eventual sale for profit’. Examples of income generation would be buying a business or an investment property. It may be possible to be sold at a gain, but the primary purpose is income. An investment could also be purchased with the sole intent of selling in the future. Think of a non-dividend paying stock. It is purchased only to be sold at a gain.

Most homeowners don’t use their home for generating income unless they rent out the home. If they did, that would be for investment purposes and would be quantified differently (income of the property, expenses, taxes, etc.). For a home to be an investment, in the traditional sense of the concept, it would need to be sold for profit in the future. I think this is where the confusion lies. People who have owned their home for 15 or 20 years could look at the equity in the property and justifiably say that they could sell the home for much more than what they originally paid. That would be factually true. However, they likely haven’t factored in the costs of homeownership nor are they viewing this from the lens of an investor. Without getting into the gritty financial details of homeownership, let’s simply break down the financing costs. Property tax is dependent on city and state. Maintenance will depend on build quality and previous owner’s care.

Let’s assume for this example that a home buyer puts 20% down on a $300,000 home and finances $240,000. On a 30-year note at 5.0%, they will have paid $19,242 in principal and $56,771 in interest by the end of the fifth year. Keeping the amount financed and the rate the same, if we change to a 15-year note, the principal paid will be $59,915 and interest $52,601 over the same five-year period. Doesn’t feel like much of an investment with those numbers. At a rate of 5.0% on a 30-year note, it will take 28 years to pay an equal amount in principal compared to what will be paid in interest to the lender (at 5.0%, the breakeven on a 15-year note happens in the middle of the second year).

A 30-year note is structured to pay most of the interest before the principal. Freddie Mac estimates that about 90% of Americans choose a 30-year fixed mortgage to finance their home. The National Association of Realtors says the average homeownership is about 13 years dependent on region and demographic. Referring to our previous example, and using these figures, the principal paid in 13 years on a 30-year note would be about $62,635 and interest paid would be roughly $137,062. If someone brought this ‘investment’ strategy to Warren Buffet illustrating it would take 28 years to break even, he probably wouldn’t validate their parking.

It is difficult to see the financed purchase of a home as an investment when some buyers could pay more to the bank in interest than in principal if they kept the loan until maturity- never refinancing.

An argument can be made that real estate has appreciated drastically in value over the past few years and most homeowners have seen a rise in equity in their homes. Does this present an opportunity for investment? The gains are great to see on paper but let’s analyze what happens when a homeowner looks to use that appreciation in equity. The buyer’s current home has rapidly risen in value but so has the market. They will sell a price-inflated home to buy another and simply carry that equity over- now taking another mortgage and resetting the length of time they will pay a lender. There are opportunities in real estate to buy property then sell it at a higher price. However, a distinction should be made that buying a personal-use home with the appreciated equity form a current home does not meet the definition of an investment.

This article is not designed to deter the purchase of a home. It is meant to educate readers on what it means to own a home and challenge those who see homeownership as a literal investment. A home is a place to live, be with your family and friends, and enjoy the fruits of your labor. That is an entirely different concept than what constitutes an investment. There are alternatives to invest in real estate outside of buying tangible property. We, as investment advisors, believe that real estate can be a powerful enhancement to a portfolio and is a wonderful tool for diversification. Talk to your advisor if real estate is something you would like to explore.