tibchris via flickrAs I wrote before, housing is a combination of necessity, consumption, and investment. To the extent a house is also an investment, we should be clear-eyed about the risks.
Despite the numerous risks of investing through home ownership – and acknowledging that it’s neither a slam dunk nor appropriate for everyone – I advocate long-term home ownership as an investment for a host of important reasons. No other investment offers such an array of factors stacked in its favour. The forced savings, tax-advantages, inflation-hedge characteristics, local specificity, and responsiveness to improvement all make home ownership the most important wealth creating vehicle widely available to the middle class.
I’ve listed in this post the 7 most important advantages of home ownership for personal wealth creation, in order of importance.
1. Forced savings – It turns out that for most people, voluntary savings is tough-to-impossible on a monthly basis. What seems to effectively generate a personal financial surplus each year are programs that ‘force’ savings — such as excessive income-tax withholding or automatic paycheck deductions for a 401K.
Monthly mortgage payments, which include a portion for paying down principal and therefore purchase small increments of home equity on a monthly basis, work in a similar fashion. Most of us have a hard time accumulating a few hundred thousand dollars in investment equity. But through the forced-savings method of paying down a mortgage every month for a period of 15 or 30 years, millions of people do manage it.
I can’t prove this, but I’d bet much of the ‘magic’ of wealth accumulation through home ownership can be attributed to this forced savings program. The psychology of forced savings matters tremendously, probably more than any other factor.
2. Capital gains tax exemption – The mortgage interest tax deduction is what we think of when we think of tax-advantaged investing in our home, but I’d argue that the capital gains tax exemption for home owners overwhelms the mortgage interest tax deduction – when it comes to wealth creation.
An example here can illustrate my point.
Let’s say you bought your house for $200,000 15 years ago and just sold it for a gain.
Inflation on your home ran at 5% annually. Using the compound interest formula we can calculate that your home sold for $415,785 today.
(This is because $415,785 = $200,000 * (1+5%)^ 15 )
As an investment, you now have a ‘capital gain’ of $215,785, the difference between your $200,000 purchase and your $415,785 sale.
Now let’s compare the $215,785 capital gain to other ways of making money through investments.
If you made $215,785 in capital gains, for example, by purchasing an IPO and flipping it soon after, you would owe taxes at your ordinary marginal income tax rate. If you are the kind of highly compensated person who can access an IPO, with enough capital to make that kind of gain, you’re probably up at the 39.6% income tax rate and you might pay as much as $85,451 on your capital gains (39.6% of $215,785).
To take a more comparable investment scenario – if you held a stock investment for over a year – your capital gains tax rate drops to 20% in this scenario, and you would only owe $43,157 (because $43,157 = 20% of $215,785) on your stock investment, upon selling it.
Capital gains from your house in the example above, however, are completely exempt. Meaning, zero taxes on your $215,785 gain.
Not only that, but as you roll your gains into a larger house, in many scenarios the gains on your next house also remain completely exempt from taxation. Most homeowners can continue to build home equity over a lifetime and a series of houses and never pay taxes on their capital gains.
No taxes. This is amazing and awesome and a huge part of how middle class people accumulate tax-free wealth through home ownership.
The capital gains tax exemption gains on your house as an investment is a real cool money saver.
3. Mortgage interest deductibility – The tax deductibility of mortgage interest gets a lot of attention, and it’s worth acknowledging this important advantage of home ownership as an investment. I write this semi-grudgingly because my own opinion is that it’s an unfair tax break and that it’s also overvalued in the popular consciousness.
But I’ll review the tax advantage anyway, using the same home mortgage example, as it’s still quite important.
Let’s assume you originally made a $40,000 down-payment on your $200,000 house 15 years ago, and took out a $160,000 mortgage at 6%. Over the course of the next 15 years – until sale – you would pay a total of $126,242 in mortgage interest. Interest as a portion of mortgage payments declines annually from $9,546 the first year to $6,953 in the 15th year, with average annual mortgage interest payments of $8,416.
If you itemize your home mortgage interest on your taxes, at the highest 39.6% income tax rate, you’d save $49,992 (because $49,992 = 39.6% of $126,242 interest paid) in income taxes spread out over 15 years. That’s probably the highest tax savings available under the scenario I created.
If you own your house for less time – let’s say 5 years, and you have a lower marginal income tax rate – let’s say 28% – you’d enjoy total tax savings over those 5 years of $13,001 on a total of $46,434 in mortgage interest.
In my example, a total of somewhere between $13K and $50K in tax savings on your investment sure helps. If you have a mortgage larger than $160,000 and/or a higher interest rate and/or you own the home for a long period of time, the total tax savings will be even more significant than the example I give, which is also nice. You can’t expect to save anything on any other investment loans – like a stock margin loan, so this mortgage interest tax break matters quite a bit.
4. Inflation-hedge – Gold bug investors think their shiny metal offers an appropriate inflation hedge for troubled financial times. Less well known is the fact that owning a home is a much better overall strategy, for a middle class person, to hedge against future inflation.
How does home ownership, with a mortgage, hedge against inflation?
In investment terms, the 20% down-payment on your home is equity, which you finance with ‘debt,’ in the form of a mortgage.
There are two ways to use a little bit of compound interest maths to see the advantage of a home and mortgage combination as an inflation hedge. First I’ll focus on the nominal increase in home equity, and second I’ll focus on the real decrease in debt value.
Nominal increase in home equity
The value of your home – $200,000 in our example – should at least keep pace with inflation in the medium and long term. If inflation ticks up from an ordinary 2% per year to a less comfortable 9% per year or worse, for example, you can reasonably expect your home, like other hard assets will increase in price at a comparable rate. If we suffered 10 years of regrettable 9% annual inflation – all else being equal – the price of your home will likely ‘appreciate’ in nominal terms at that rate, leading to an expected value at the end of 10 years – calculated via the compound interest formula of course! – of $473,472.
(I got here because Future Value $473,472 = Present Value $200,000 * (1+inflation 9%) ^ 10yrs.)
But – and here’s the great thing about home ownership with a mortgage as an inflation hedge – your mortgage has a fixed value, starting at $160,000 and amortizing downward over the 10 years. Assuming you paid the mortgage on time, your mortgage balance at the end of 10 years would be $134,030.
Your nominal ‘home equity’ under the inflationary scenario of 10 years at 9% has increased to $339,442, which is the difference between $473,472 market value and $134,030 in remaining mortgage debt.
Under more moderate inflation – say 2% for 10 years – your nominal home equity would be only $109,768. So in way, you have a $229,673 higher ‘net worth’ after the higher inflationary period.
Of course the $229,673 higher net worth in nominal terms has less purchasing power in real terms than it did before inflation, but at least it has kept pace with inflation. As a hedge, the increased net worth balances out the decreased purchasing power.
But, you may ask, aren’t there instances in which high rates of inflation cause such turmoil and chaos that the Peter Schiff and Ron Paul apocalyptic scenarios come true and my home price declines in value? Shouldn’t I be buying guns, ammo, and canned goods as they seem to suggest, rather than depending on this ex-banker’s optimistic view of “house + mortgage = inflation hedge?”
Nope. They’re wrong. Houses can always go down in price for many reasons, but inflation isn’t one of them. High inflation makes at least the nominal price of your house go up, kind of just by definition. There is no reasonably probable alternative scenario in which anything but house price appreciation happens if we experience high inflation.
Real decrease in debt value
You can also conceive of your home-and-mortgage combination as an inflation hedge by flipping around the perspective and focusing on the decreased cost of your mortgage, in real terms, over the course of 10 years, under an inflationary scenario.
Using the same example of 9% compounding inflation, we can calculate the value of your future mortgage in adjusted purchasing power – also known as “Real” dollar – terms.
As I wrote above, at the end of 10 years of paying down your mortgage you can expect a remaining debt balance of $109,768. But $109,768 after 10 years of relatively high 9% inflation no longer should be considered the same amount of debt. You can apply the discounted cash flows formula to calculate how much $109,768, 10 years from now, will be worth in today’s terms.
Specifically your new mortgage balance after 10 years would be the equivalent of $46,367 in today’s dollar terms, or less than half of the nominal balance.
(I arrive at that number because Present Value $46,367 = Future Value $109,768 / (1+9% inflation) ^ 10years.)
What does it mean that your future mortgage balance of $109,768 is really worth $46,367 in today’s real dollars? It means that the price of everything has increased in the future, including ideally and most importantly, the price of your labour.
In simplest terms, you can imagine that after 10 years of 9% inflation you’ll be earning more than twice what you earn today. If your wages keep up with inflation, it will make the future $109,768 seem more like $46,367 seems today. A sizeable amount still, but less than half as scary.
If your wages do not increase commensurately with inflation, that is of course another big problem with inflation, and with earning a fixed income in general. Anticipating inflation in the future is an argument for seeking to move from fixed income compensation to equity compensation, as I wrote about in my segments On Entrepreneurship. The lifestyle of folks on a purely fixed income, like seniors on unadjusted social security and fixed pensions, would get ravaged by high inflation, making an inflation hedge like home ownership that much more important.
5. 4-to-1 Leverage – Purchasing your $200,000 home with a $40,000 down payment and a $160,000 mortgage offers you, in financial terms, 4-to-1 ‘leverage,’ also known as the ratio between equity and debt. For the average middle class person engaged in investing, banks and brokerage companies provide very little leverage.
In many ways zero leverage is appropriate for the average investor, as leverage exaggerates investment returns, both up and down. A review of financial history shows that leverage has a way of periodically punishing investors, and small-time investors are the least prepared for the catastrophic consequences of a systemic credit crunch.
For middle class folks fortunate enough to weather a few decades of home equity gains amplified by leverage, however, small nest eggs become meaningful accumulations of wealth through the magic of 4-to-1 leverage.
Yes, it increases your risk and the volatility of outcomes, especially in the short run. If you can sustain a longer holding period, however, the debt helps you accumulate wealth. And if you can use the debt responsibly – an acknowledged big ‘if’ – you can continue to access this home-equity-based leverage for other investment purposes.
6. Local knowledge is useful – Few middle class people can effectively apply local or personal knowledge to investing in securities. We are all at an extraordinary information disadvantage when purchasing stocks, and even bonds. Hundreds to tens of thousands of the smartest people in the world are – right now – following the same stocks we might buy as individuals, making moot most individual stock-picking efforts to find unrecognised value.
When buying a house as an investment, however, specific local information can make us ‘experts,’ to some degree, in what we buy. This local, personal knowledge helps even the playing field in a way not generally available in other investment areas.
Any home buyer can investigate or intuit neighbourhood trends, school quality, demographic shifts and hidden aesthetic potential in homes. As home buyers we become long-term value-investors in a way totally unavailable to most people in other investment spheres.
Who knows more about your home and neighbourhood – you or Warren Buffett? That’s right, kiddo! In that one investment comparison at least, you shine. Congratulations.
7. Home Improvement – ‘Activist Investing’ – I have what I like to call a ‘purple thumb’ when it comes to physical labour around the house – like swinging a hammer. Home improvement is not really an opportunity for me, without risking my concert pianist or surgical sub-specialty career. (I have grandiose plans for my life as an ex-banker.)
But for many, home maintenance and improvement allow us to physically enhance our investments. We can personally work on a low-value or under-valued asset and make it more valuable. I think this is great.
When activist hedge fund investors like Bill Ackman or Carl Icahn purchase shares in a target company and then agitate to make that company more valuable for shareholders, they’re acting like home improvement guys with a different set of tools. Most of us can’t bring our toolbox to a company board meeting. I appreciate that housing makes ‘activist investing’ available to the everyman, or at least anyone who can swing a hammer. Just not me and my purple thumb.
Taken in combination, these seven factors greatly stack the investment aspect of home ownership in your favour. Of course anyone can lose money owning a home – like any true investment, it’s risky – but most of us can accumulate long-term, real wealth through long-term home ownership.
Please see previous posts