14 Feb 2020 Your Home is Not An Investment (You Probably Won’t Downsize)
Home prices, both nationwide and in the Triangle, have surged over the past few years. The escalation in prices across the country brings back memories of the boom period prior to the financial/housing crisis of 2007-2009. There isn’t evidence to suggest that is what’s taking place this time, but the rapid rise in home prices is nearly unprecedented.
The chart above, taken from Robert Shiller’s website, displays four pieces of data: home prices, building costs, population growth, and interest rates. Looking at home prices in blue, you can see the massive bubble that was building from 2000-2007. The home price index (left hand measurement) grew from roughly 126 to nearly 195, an increase of over 54% in seven short years.
Given the more recent surge, it’s natural to begin thinking about your home as an investment. If you’re a homeowner and the type of person to track your net worth from year-to-year, you’ve no doubt enjoyed what your home has added to your balance sheet over the past 5-7 years.
Yet, we encourage you to think of your home as a lifestyle asset rather than an investment. Viewing your home as an investment, or going into the home buying process in hopes of making a profit, is risky. Homes can be highly illiquid and are financed with debt, two qualities that add risk to any type of investment. Also, the rate of return on residential homes isn’t what many perceive it to be: Going back to 1942, where the home price index bottomed out around 68, through the end of 2019 where it topped out at 176, the average compounded annual return on home prices has been approximately 1.25%. That’s less than inflation and government bonds and doesn’t take into account the costs associated with owning a home: replacing an HVAC, property taxes, a new roof, fixing the water heater, etc.
Here’s how you should approach home ownership:
First, your home is a lifestyle asset, something that enhances your overall quality of life and allows you and your family to be a part of a community.
Second, it needs to fit comfortably into your budget: Mortgage lenders may approve you for loan payments up to 35% of your gross income, and typically want to see a total debt payments-to-income ratio of 43% or better. Does that mean you should buy the biggest house you can qualify for? Absolutely not! If nearly half of your gross income is going towards debt payments, it leaves very little for things like savings, travel, giving, daily necessities, or unexpected expenses that are bound to pop up.
Third, the purchase of a home should be viewed as a long-term commitment. Not only are you signing up for a 30-year mortgage (typically), but you should be committed to staying put for at least 5-7 years. Any shorter of a timeframe and you should probably rent.
Fourth, target freedom from debt by retirement. Our experience tells us that retirement is more enjoyable when there’s no debt; There’s a freedom that comes from having a fully paid for home. It also increases flexibility and makes it easier to reduce spending if your investments takes a hit. Have a goal of being debt-free by the time you retire.
Finally, acknowledge that you probably won’t downsize. I’ve heard many people justify the purchase of a home that’s out of their budget because “We’ll probably downsize when we retire.” My experience tells me that won’t happen. You will get used to your neighborhood that looks a certain way with a particular kind of neighbor that drives a certain kind of car and who has a house that looks a kind of way you like. And all those things are fine! It just means you probably won’t downsize.
Get in touch if you’re looking to buy your first home or upgrade to your dream home. It’s one of the biggest financial decisions you will make, so let our experience help you make the wisest choice, one that balances the trade-offs between where you truly want to live and the type of lifestyle you desire to have, both now and in the future.
