Will your home be a good investment?

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 make in your life so far. 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 out security or freedom? There are a lot of articles explaining the tradeoffs 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 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 how 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. 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 of taxes and for 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.

So how is purchasing an investment property different? It is 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 you still need to live somewhere! Take a look at your life and ask yourself if 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 is only 3 years. (http://www.bls.gov/news.release/tenure.nr0.htm) 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 homeownership 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 The Ohio State University, published a research study (http://researchnews.osu.edu/archive/chldhome.htm) 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 however. 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.

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.

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.