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Will Your Home Be A Good Investment

Will Your Home Be A Good Investment?

 

Buying a home has long been considered a good investment. But do you have to live in the home? Owning a home and renting it out may be the better choice.

You finally saved up an emergency fund and paid off your high interest credit cards. You believe you are ready to invest and buy a house, the largest purchase you will probably ever make. You need a place to live and you are tired of “throwing your money away” each month to your landlord. Your home purchase will make a great investment, right?

That depends. Do you actually want to be a homeowner or are you just doing what you think society dictates you should do next? Do you want a home or do you want an investment? Do you seek security or freedom?

There are a lot of articles explaining the trade offs between renting and buying but this article is not one of those. This is for the person who wants to invest in real estate but doesn’t know if the home should be where you live, a rental property, or if it can be both.

A Good Investment

A good investment is something that will pay you more than you paid for it. One of the most well known personal finance authors is Robert Kiyosaki. Kiyosaki’s teachings and seminars have generated controversy but I think his definitions of assets and liabilities in Rich Dad, Poor Dad are excellent and very simple to understand. An asset is anything that puts money into your pocket. A liability is anything that takes money out of your pocket.

So is a home a good investment? Does your personal residence put money into your pocket or take money out of your pocket? Rich Dad, Poor Dad examines why people consider owning a house as an asset, but by Kiyosaki’s definition, it is a liability.

Every month you have to pay the mortgage, insurance, property taxes. Even if the house is paid off you are still spending money maintaining the house and paying your taxes and insurance. The house is still taking money out of your pocket.

Your paid-off house might make your net worth look good but the equity is locked up in the home. So if you actually need to access that money, you either need to refinance or sell the house and then you are back to having mortgage debt or looking for a place to live.

But what about home value appreciation — does that make your primary residence an asset? It can if the purchase is timed just right, but most times it is not.

Let’s Do The Math

Imagine you financed your $100,000 home 30 years ago at a low 5% interest rate and today your home got appraised at $300,000! Wow, you got a total return of 200%! What a great investment, right? To answer, we must look beyond just the mortgage payment.

Over 30 years you paid $92,422.95 in interest to the bank. Add in $2000 a year for 30 years for taxes and insurance. This is a total price of $252,422.95 so far.

What about ongoing maintenance and repairs? A popular rule of thumb states you will average 1% of the purchase price in ongoing maintenance and repairs, so now we need to add in $1,000 for each year. That brings the grand total investment to $282,422.95. We didn’t even account for inflation which averages 3-4% a year.

The 200% total return, or 3.7% annual return, is now looking more like a 0% forced savings account. When you eventually sell the house you will get a nice big check but don’t confuse it with an investment, you are just getting money out that you put in over the years.

An Investment Property

So how is purchasing an investment property different? It’s not. There are still expenses that must be paid – the difference is you are not the one making the payments. Your tenant makes those payments.

On our $100,000 home example, you put down $20,000, and then for the next 30 years the tenant’s rent check covered the mortgage, taxes, insurance, repairs, and upgrades. You increased your rent to stay ahead of inflation and property tax increases each year.

Your $300,000 home is now a 1,400% return or 9.4% annual return based on the $20,000 you paid towards the house. Estimating a very conservative $100 per month cash flow over 30 years is an additional $36,000 into your pocket.

Assuming you invested in a good cash flowing home, your tenant gives you more each month than what it takes to own the home. You are leveraging someone else’s time and money and now that same home is an asset.

But…Where Will I Live?

But you still need to live somewhere! Take a look at your life and ask yourself: are you are going to be living in this same area five or ten years from now? The US Department of Labor says workers are with their current employer for a median of 4.6 years, and for workers between ages 25-34, it’s only 3 years.

Members of the Millennial generation move around more than their parents did and certainly much more than their grandparents. The world is evolving into a more global society and many people do not want to feel locked down into one area.

Sometimes it just makes sense to live in a rental. Maybe you could buy your perfect house for $300,000 or rent it for $2000 a month. You could afford the rent, but you can’t manage to save up the $60,000 needed for the down payment and the other $15,000 for closing costs.

In that case you can still live in your perfect home, just as a renter. Or if you know you will only live in the area for a few years it doesn’t make sense to spend so much money on closing costs and realtor commissions.

It might sound like I am against home ownership; I am not. Homes provide lots of intangible benefits. The pride of home ownership is a real thing. You are free to do whatever renovations you want inside your home to personalize it to your tastes.

You might know you are going to live in this town the whole time your kids are going to school because your school district is awesome and you want to really plant roots in your community.

Dr. Donald Haurin, economics professor at Ohio State University, published a research study showing that “for children living in owned homes rather than rental units, math achievement scores are up to 9 percent higher, reading achievement is up to 7 percent higher and behavioral problems are 1 to 3 percent lower. These results held true after the researchers took into account a multitude of factors that may have influenced the findings, such as the fact that homeowners earn more and have higher levels of education than renters.”

Those are all valid reasons to own a home. Homes can be a great purchase; just don’t tell yourself that your home is an investment. Math, specifically the opportunity cost of your down payment, says to invest in a rental property and not your personal residence every time.

Some personal finance gurus like Dave Ramsey advise you to buy your personal residence and pay it off as fast as you can. In fact Ramsey wants you to get a 15 year mortgage, live below your means, pay off all your debt and then you will achieve financial peace.

Paying down your mortgage might preserve wealth but it will not create wealth. It appeals to a need for security and the immense satisfaction of having no debt. People say home ownership is an excellent path to build wealth. I would change that to say rental property ownership is an excellent path to build wealth.

Ramsey has valid points though. If you have extra money each month and are trying to decide between paying off your mortgage and buying a new expensive car, please pay your mortgage. But if the decision is between paying off your mortgage and investing your money in the stock market or in a new investment property, I would disagree with Ramsey and tell you to invest first.

Retirement Income

No one can retire on paying off a mortgage alone — you need to create monthly retirement income to replace your current job income. Try not paying your property taxes and see who really owns your paid off house.

Retirement income might come from traditional places like social security, annuities or pensions. Or retirement income might come from investments like dividends, IRA withdrawals or rental properties.

But if you are planning on retiring early I believe you need to create those income streams now since there could be a large gap between retirement and when you start withdrawing from your traditional IRA and 401k (age 59 ½) or collect social security (age 65). Once you create enough income streams, you can travel, work, or fish all day while money comes to you. Your tenants are working the daily grind to pay your monthly bills for you.

If you still can’t decide between buying a personal property or an investment property, there are three ways you might get the best of both worlds. You have all the intangibles of home ownership with all the financial benefits of owning a rental property, either immediately or down the line. Since all three options involve initially living in the home, the interest rate on the mortgage will be lower than the interest rate you would get on an investment property.

Option One – Buy your home, live in it for a few years and then when you move out, you rent it and buy your next home.

Option Two – Buy your home and rent out the extra rooms to your friends so that they cover all your monthly expenses.

Option Three – Buy a small multi-family property (Duplex or Triplex), live in one unit while renting out the other units. If you want to read more about purchasing a multi-family property I recommend reading “Real Estate in your Twenties” 

All of these options are great ways to both put a roof over your head and diversify your investments into real estate. If this is your first home, you will also learn invaluable lessons about home maintenance and being a landlord that you can use for your next home purchase.

There is no right answer for everybody. You need to look at your reasons for buying or renting a home against your short and long term financial goals. Then you can decide what is right for you and your family. I am choosing freedom. The freedom to live wherever I want, to do whatever activities I want while the income streams I build up over my working years support all of my expenses in early retirement.

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  • alwaysconservative

    My only issue is with the ownership of rental property in retirement. Not that it is bad, but that you need to assess whether at age 80 or 85 you still want to deal with vacancies, repairs, deadbeat tenants etc. What might seem easy at age 40 or 50 becomes a monumental task when much older. And if you delegate the duties to a property manager, it obviously eats into your retirement income. A person needs to think very cautiously about having that responsibility.

    • framing god

      You can sell it and invest it in something else. Of course there will be costs to sell it and someone else will be taking a cut of your new investment. So bottom line right off the hop by owning a rental property you are creating your self a job that will never go away unless you want to pay someone else to manage it. Either way someone will be paid to manage your investment.

    • jb1907

      Selling after that long is better than still being a landlord. You can sell well before that as well. Why take in $1,500 a month if you can sell for $150K.

  • Allison

    Yes 40 years from now I am sure I will have a different outlook on my finances and where I want my investments to be. Right now I am very comfortable putting 30-40% of my net worth into rental properties but when I get older I am sure I will shift that money into different investments or give my properties to my children to manage.
    Thank you for your comment!

  • framing god

    I am fortunate to have a basement suite in my property to rent out. I have lived in my house for 9 years and the basement suite pays for all the taxes, utilities and interest. So now I live in a property which is really cheap to live in. I guess I have to pay for maintenance. If I keep the house and the basement suite for all time then it’s a great. I believe to rent my house portion of the house out would be around 2500 to 3500 per month. So right now I am paying maintenance @ approximately 400 a month to live in the house assuming 1 percent of purchase price (home is owner built so I don’t know the true cost)

    • Allison

      awesome that your tenant pays most of your expenses for you! Having an income suite in your basement or owning a duplex is a great and cost effective way to invest in real estate and have a good place to live.

  • Jesse Edwards

    Feel like my situation is different, but correct me if I’m wrong. If I hadn’t bought, I’d be saving about 600/mo. in expenses, but I would come out with no appreciation, which in my neighbourhood in Toronto is significant. Sure, appreciation is speculative, but so is assuming my investments will generate a significant return. I only see NOT buying if you are single as you can maintain a very affordable home. With children in the city, that affordability goes out the window unless you all wanna share a bedroom.

    • Allison

      Yup, everyone’s situation is different, Sounds like you are in a good situation. If you move frequently you might just want to rent to avoid closing costs and the stress of having to sell your home but if your in a great area with strong appreciation you should be happy with your choice either way.

  • bborz

    I am currently looking for a duplex (which will be the first property I own) and I plan to rent it out entirely, and rent an apartment elsewhere for myself to live in. EVERYONE I talk to thinks this is an idiotic idea but if I rent a separate place for myself, I actually save more each month and can live closer to work. Do you have any thoughts?

    • Allison

      I think it is a perfectly fine idea. People who think it is a crazy idea don’t fully understand real estate investing or are afraid of doing something different. Duplex’s can be great cash flow machines with a little less maintenance than a single family home. Would it be “safer” to live on one side while renting the other – sure, but you do not have to live in the same place you own. And if you can find a place to rent close to work while the duplex brings in some extra money each month it will be a win-win. Good luck!

  • jb1907

    Renting can be a big PITA. You aren’t guaranteed anything. you hope for a great tenant and no problems. We have 3 houses and only 1 has been pretty problem free. A house vacant for 2-3 months will kill your returns.

    • Allison

      No investment is guaranteed. Stocks, bonds, etc all fluctuate. You need to invest your money somewhere besides a 0% savings account. So pick your investments, diversity over several asset classes and hope it all works out in the end.

  • wags4321

    Good article as a start to thinking twice about buying vs. renting. It sounds like you know enough to then do a more advanced article about the major factors involved and how to explore them in more detail. For example, using price-rent ratios to judge whether the rental or purchase markets are out of balance. Or, assessing your tax situation with mortgage deduction vs. tax rate, etc.

    If you aren’t familiar with how to judge these factors, does anyone know a really good book on this issue? There are different rent/buy calculators online, and info spread around, but it would be good to have a thorough assessment technique.

    Like many long-term decisions in life, keep in mind that it’s impossible to predict every factor that can occur, and that external factors could bless or curse you. For example, high inflation is great for owning houses and horrible for renting – or stock market tripling could greatly favor renting. Or, someone may buy you out for developing some major area or new resources that are on your property, etc.

    We like to control everything, but you can’t control many of the factors that sway the rent/buy decision. Still, having the tools and assessment is worthwhile.

    p.s. – another point, buying would make much more sense in more cases if the Realtor racket wasn’t around. The 6% closing cost is a huge transaction cost that is artificially propped up by colluding Realtors and the forcing out directly or indirectly people trying to offer real competition on transaction rates. Houses are selling in days, and agents are getting paid $10k’s for so little work – ridiculous. (end of rant)

  • Zee Hamdani

    Great Article. Really digs deep into this debate of what you should do with respect to owning a home and living there or renting it out. And I really never thought on this topic like you have mentioned it. But after reading this, I think the option of buying a duplex is the best as it gives you the best of both.

  • Gene Short

    I like the true return example of owning a home, but when factoring in the total cash outflows, shouldn’t you be subtracting the rents that you would have paid over the 30 years. After all, you had to live somewhere. If the $300K in the example was just a return of all of your expenses over 30 years, doesn’t that imply that you lived rent-free for 30 years?

    • Allison

      Excellent point Gene that I forgot to factor in! Yes you have to live somewhere

    • jb1907

      If you buy your house for $200K and live in it for 15 years and sell it for $200K, you have lived for “free”. Most places you still have to pay for utilities and increases in taxes/insurance, which is baked into your rent. If rising taxes and insurance forces you to raise rents, it is reflected in your home taxes and insurance even if your Payment stays the same. Many people escrow and that amount will fluctuate based on taxes and insurance. You don’t have to fix anything yourself in a rental. You have the freedom to move somewhere else. We bought our house for $225K and we could sell it for $450K-$475K, but we have put about $150K into the house. You would never do that in a rental. My property taxes will be $7,200 this year and will only go up for the near future as long as our values rise. We hope to downsize when we retire, but we plan to travel, so we might just trade a house for a condo.

  • Oliver Sims

    I own a couple of properties in a very bad part of town that have been and continue to be under water. How do I rid myself of these dogs in order to buy better for the long term rental income stream? Any suggestions appreciated.

    • Oliver, if they are consistently draining your cash than it may just be best to take a hit on them and move on. The only other real option is to stick it out and focus on how you can make them profitable either in a month-to-month basis or when renters organically give you enough principle to sell the properties at break even. If you put $5k into the mortgage just to sell it at break even, it’s really no different than just selling it at a loss for $5k.

      • Oliver Sims

        Thanks Andrew. Taking a hit, a big hit, appears to be the only way out. Will explore options with my mortgage companies early January. I do believe in investment properties , even with the significant issues they have caused me.

  • jb1907

    The only way a house you live in puts money into your pocket is when you sell it. I don’t care what the equity is, you don’t realize any gain/loss until you sell it.