Is This the Most Important Investment You Can Make?

Many people believe that their home is the most important investment they'll ever make, but I tend to disagree.

Source: wikipedia

While it's true that your home is an extremely important purchase, I don't like to think of a primary home as an investment. The word "investment" can cause people to buy a bigger house than they actually need, and to sink more money into luxury items than they really want.

This isn't to say that you shouldn't buy a home. On the contrary, owning a home can be a very important component of long-term financial security. However, don't confuse an asset with an investment.

Why your home isn't a good "investment"
In the sense that your home will most likely appreciate in value over the long run, it fits the definition of an investment. However, there are two big reasons why your investment dollars are better used elsewhere.

The first has to do with the price appreciation you can reasonable expect. And for the record, the double-digit gains we saw year after year in the early to middle 2000s were not reasonable or sustainable. In a healthy market, home values can be expected to rise by about 3%-4% per year. Just to give you an idea of what to expect in a "normal" economy, look at the chart below. The market from around 1990-1997 was healthy. Between the late 1990s and 2007, it was not.

US House Price Index Chart

Other asset classes deliver higher returns on a somewhat consistent basis. Over the past 20 years, the S&P 500 has averaged a total return of 9.4% annually, and even long-term bond funds average about 6% per year.

The second problem is liquidity. A solid investment is one where there is a solid market for it, meaning you could sell it at full market value at a moment's notice. For example, if a stock I own is trading at $50 per share and I hit the sell button, I can expect to actually get $50 per share (or a few pennies less) immediately.

On the other hand, if my house has a "market value" of $200,000, I'll need to list it and wait. And, if I want to hold out for "market value," it could take months or even years to sell. Also, the commissions involved with selling a house generally cost around 6% of the total price, much higher than selling stocks, bonds, or mutual funds. The commission is so high that it can wipe out a year or two of price appreciation all by itself.

But, it's better than the alternative for most people
Even though a house isn't a great investment in the traditional sense of the word; it is still a better idea than renting, if you meet certain criteria.

Homeownership is the better idea for people who want to stay in the same place for several years, don't anticipate a major change in income or their employment situation, and don't mind the uncertainty and effort that comes with maintaining a property.

For example, if you rent a three-bedroom apartment for $1,000 per month and your rent increases by 3% every year, you'll have paid more than $344,000 for your housing over a 20-year period without having anything to show for it.

On the other hand, if you buy a home for $200,000 with 20% down, it would roughly correspond to a $1,000 monthly housing payment at today's rates, depending on property taxes and insurance in your particular area of the country. Over 20 years, your mortgage payments would add up to about $240,000 because, unlike with renting, your payments would stay constant over time. Taxes may go up a little, but the total should still be much less than you'd pay in rent.

And, after 20 years, you would owe just over $77,000 on the house. Assuming 3% annual average appreciation, this would give you more than $280,000 in equity. Not quite enough to retire with, but much better than the zero equity you'd have from your rental.

The key takeaway
In a nutshell, buying a home can be a good financial decision, but don't look at it as an investment.

Don't buy more house than you need just because you think it'll make you more money. The extra money will be better off invested elsewhere.

However, buying a house is generally a better idea than renting, as long as you're going to live there for a long time. Building equity in a home is a great way to create some wealth over the long term while also putting a roof over your head, but it by no means substitutes for a well-constructed portfolio of real investments like high-quality stocks.

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