Buying a home is the biggest financial decision most people will ever make. There are many benefits to home ownership, but also some drawbacks. Let me share my thoughts.
One of the big benefits to home ownership, aside from the pride-of-ownership factor and having more space and a place to call your own, is the fact that capital gains on your principal residence are tax-free. If you buy a house for $500,000 and the price of it doubles to $1 million, you don’t pay tax on the $500,000 gain. This is pretty sweet. Compare this to a half a million dollar gain in a taxable investment account on a stock, in which you would pay tax on 50 percent of the gain. This tax-benefit can add up over time. And the massive gains in real estate mean that many people who’ve owned their home for many years sit on massive capital gains that are tax free.
Another major benefit of real estate is that leverage—borrowing money to buy a home—magnifies gains in value on the home. For example, if you buy a $500,000 home with a $100,000 down payment, if that home increases in value to $600,000, you don’t earn a 20 percent rate of return on your investment ($100,000 divided by $500,000) but a 100 percent rate of return ($100,000 divided by $100,0000). This is the power of leverage. And it’s what has made real estate such a great investment over time.
In addition, owning a home is a forced savings program—you’re forced to build up equity in your home, or pay down your mortgage, over time. There is no possibility for you to squander the money. It has to go to paying down the home, or you lose the home. Whereas, if you rent, there is the temptation to spend the money and forgo your savings. So home ownership instills discipline in people.
As well, you’re not at the mercy of a landlord. You own your property and control your destiny.
And you can choose to do what you want with the equity you’ve built in the home. You can use it to purchase another home. Leave it where it is and continue to live in your home. Or use it to help fund your retirement. It gives you options. And indeed, for many people, the equity they’ve built up in their homes over the years goes on to play an important role in funding their retirement.
Drawbacks
The drawbacks to home ownership include the following:
Market timing. There’s no way around it, when you purchase real estate, you’re timing the market. There’s no averaging in, like you do with stocks. When you buy real estate, you’re buying in one shot, at whatever the current price is. If it’s low, you will likely do well over time financially. If it’s not, you likely won’t.
Leverage. Leverage, as we discussed, can be a major benefit to owning real estate, as it has been historically. But it is a double-edged sword. It can also be a major drawback, if you purchase at the wrong time at too high a price. If prices drop, leverage works in reverse—magnifying losses. It also serves as a negative if prices stay flat, as you incur interest payments on the mortgage and the price goes nowhere.
Interest rates. If you have a mortgage on your property, interest rates can turn against you, as they have in the past couple of years. Home owners who bought in 2020 or 2021 at 2 percent interest rates will soon find themselves renewing their mortgages at rates much higher than this. High prices and high interest rates create a double-whammy. The result of higher interest rates and high prices is lower affordability, acting as gravity on real estate prices. Eventually they have to come back to earth.
Headache. Owning a home comes with more work than renting. There’s upkeep on the home, and inevitable costs that pop up as things wear down. As well, there are frictional costs in procuring and selling the home—including real estate fees, lawyer fees, land transfer fees, and the like.
Reduced flexibility. Owning a home limits your ability to move, to switch jobs etc. It also can inhibit your ability to save and invest your money if it consumes too much of your income.
Key Considerations
If you’re purchasing a home, some things to keep in mind:
Living in a house you can truly afford is critical to achieving your financial goals.
If a house consumes 60 percent of your income, there’s going to be little left to save or invest.
If 60 percent of your income, as well, is going to purchase a home that is fully valued, it’s likely not going to work out well financially. You’ll end up owning the home over time, but you’ll earn a low rate of return on the money that went into it—potentially negative after factoring in interest paid on the mortgage.
It’s critical to ensure a reasonable amount of your income goes towards housing costs, and that there is money leftover to save and invest outside of real estate.
The root word of mortgage is “death pledge.”
In purchasing a home you have to consider not just the cost of the mortgage, but all the other costs that go into home ownership: property tax, insurance, utilities, hydro, upkeep, time, renovations. Often, the full costs of home ownership are equal to or greater than the cost of rent. Owning isn’t always better than renting. It all depends on how much you need the extra space of a home.
In addition to the costs mentioned above, you also have the costs of furnishing the home and keeping up with the Joneses. The latter of which is a real cost. The more expensive a neighbourhood you move into the bigger the cost.
In the book The Millionaire Next Door the authors made the following suggestion:
Living in less costly areas an enable you to spend less for your home and correspondingly less for property taxes. Your neighbors will be less likely to drive expensive motor vehicles. You will find it easier to keep up, even ahead, of the Joneses and still accumulate wealth.
A good suggestion. We are pulled by an invisible peer pressure. If those around us have lots of things, we will want them too. If you live in a more modest neighbourhood with people who value things other than material possessions, you will likely find yourself valuing the same.
What is crazy is just how quickly our expectations adjust to those around us. In the 1970s the median square foot home in America was just over 1,500 square feet. This was normal. This was what most people had. And people were perfectly happy with it. What happened? In the late 1980s, it increased to almost 2,000 square feet. In the late 1990s it increased to 2,250 square feet. And today we are probably close to 2,500 square feet. People’s expectations adjusted. And the costs of homes shot up.
In 1983, just 18 percent of new homes had four or more bedrooms; nearly 50 percent do today. We’ve grown accustomed to more, which is part of the reason why homes are so expensive today, in addition to the lack of supply.
The point I’m trying to make here, is adjust your expectations down and you won’t spend as much on your home, and you may be happier. You will be less influenced to spend money on material possessions to keep up with your neighbours, possessions you may not be able to afford and that may derail your finances.
Morgan Housel, in his book The Psychology of Money, said the following:
We’ve used our greater wealth to buy bigger and better stuff. But we’ve simultaneously given up more control over our time. At best, these things cancel each other out . . . The median American home increased from 983 square feet in 1950 to 2,436 square feet in 2018.
And guess what? Happiness has not changed. People were just as happy in 1950 as they are today. Owning a 983 square foot home was completely normal. Expectations quickly adjust. Don’t let yourself go down that rabbit hole.
How Much is Enough?
Most financial experts agree that you can afford to spend one-third of your gross income on housing expenses, or 40 percent if you have no debt. This advice, which is sound, is almost impossible, sadly, today in Canada, considering how out of control housing costs are, which is an unfortunate situation. The reality is we need to make some difficult decisions to keep our housing costs under control. The math doesn’t change—if you spend 60 percent of your income on housing you will have nothing left to save and invest. And if you’re spending 60 percent of your income on an overpriced home, it likely will be a poor financial decision.
So we need to keep our housing costs under control and leave a buffer to save some money outside of real estate.
Thirty or forty percent might not be doable today for many people, but I would be loathe to let your housing costs go any higher than 50 percent of your gross income.
This means keeping your expectations in check, and for many people, making some difficult decisions.
Bottom Line
If you must buy a house, keep your housing costs to less than 50 percent of your gross income, ideally 40 percent.
Before buying a house, focus on saving up your money and investing in stocks, which you can conveniently do over time, taking advantage of buying opportunities, and diversifying your investments.
Home ownership offers many benefits, but also drawbacks. Consider both before making the leap.
And remember, less is often more.