The Math – Why Buying a House is Actually a Terrible Investment – Part Two of Three

As promised I am following up on my last post on why I think purchasing a home is a bad investment, and can derail your retirement dreams. First, I think it needs to be clarified how I think about housing. Housing is a lifestyle choice. It is really not that different than choosing what kind of car you drive, what kind of clothes you purchase, or how you obtain and consume food.

That is to say, when you buy a home, you are making a decision on what location you live in, how many square feet the home is, how new the house is, and what features you decide you must have. As I covered in my last post, you can go totally nutso on options, lot premiums and size of the home and push the price of a new home into the stratosphere. This is really all about choices.

The homebuilders, mortgage lenders, and real estate companies have done a magical job on convincing consumers that you should buy “as much house as you can afford“. There is constant talk in the media about using different formulas to figure out how much you can afford, be it 33% of you salary or some other made up figure the industry uses. There are home affordability calculators designed specifically to ferret out the maximum amount of money you can borrow to plunk down on a house. All of this marketing leads people to believe that it is actually a good decision to borrow as much as they can in order to buy the best house they can in the best neighborhood they can afford! Makes logical sense right? Not so fast!

Do you buy anything else the way that people buy houses? For example, would you go out and buy the most expensive pair of shoes you can afford based on your credit card maximum limit? Or would you buy your food this way, go to the most expensive restaurant in town based on your ability to pay for it with credit? Of course you wouldn’t. So why on earth would you buy a house this way. For many, the answer has been because they believe that housing is a good investment. I want to help open your eyes up to the idea that this is really not true. For others, the rationale is that this is where I live, and I want to be in a nice place. Fine answer, just realize that you are making a lifestyle choice, not an investment decision.

So lets now look at the first reason why I hate it when people think that buying as much house as they can afford is a great investment. Leverage! For those not familiar with the term or exactly what it means. The Wikipedia definition of leverage is: In financeleverage (sometimes referred to as gearing in the United Kingdom and Australia) is any technique involving the use of borrowed funds in the purchase of an asset, with the expectation that the after-tax income from the asset and asset price appreciation will exceed the borrowing cost.

When you buy a house, you are using leverage in a very extreme way. For many people it means borrowing 95% of the price of the “asset” (Your House) you are purchasing. Let that sink in a little bit. When you buy a house with just 5% down, you are borrowing 95% of the funds to purchase that asset. There is no other asset that any bank in the world will let you buy with that kind of leverage. Well maybe one – your car – which I will touch on in a later post – but a car is almost always a depreciating asset so it really does not count.

Ms Leverage – The Crazy Hot Girlfriend

Think of leverage like a crazy hot girlfriend. It can be really great or really terrible depending on the circumstances. And it can be risky as hell. First lets look at the positive side. Say you buy a house for $500,000 dollars, and you put down only 5% money on the home. So your down payment would be $25,000. And lets say you do really well and that house goes up 20% in value in the time that you own it. So in simple terms, that would be an increase of $100,000 dollars from your $25,000 dollar initial investment. That is a fantastic return of 400% or 4 times your initial investment. <<Now I am purposely keeping this example very simple here. There are a lot of other factors I will get into later that include things like the time value of money, compound returns, expenses etc. But for now lets stick to the simple math just on leverage.>>

Now let’s look at how that crazy hot girlfriend Ms. Leverage can really hurt you… Taking the same example of a $500,000 purchase price and 5% or $25,000 down. In this example, let’s say that you get caught in a situation where you have to sell and the housing market has gone down 20%. Don’t think that can happen? Check out the prices falling in the once red hot Seattle Realestatemarket. In fact, 20% declines in any asset class is not at all uncommon. A 20% fall of your $500,000 purchase would mean that you would lose $100,000 on that asset. So now your asset (your home) is only worth $400,000 dollars. In this case, your $25,000 of hard earned money is totally wiped out. But it gets worse. If for some new life reason you are forced to sell your house in the down market, you still owe the $475,000 mortgage agreement you signed up for! Meaning, you are now what is called underwater, by about $75,000 dollars. Yep, that’s right you would now have to pay the bank the difference between what you borrowed and what the house is now worth. If it were only that simple. Nope, it gets worse, because when you sell your house, you will also incur 10% selling fees on your home. So if you had to get out of that house in this down market scenario you are looking at paying up $40,000 to sell the house, plus the $75,000 you owe above what the house is now worth. Meaning your $25,000 dollar initial investment in your dream home just became your $115,000 dollar loss nightmare. That is when you decide it is time to leave Ms. Leverage for good!

OK – now you can see how fast things can go really bad with what you hoped would be a smart decision to buy as much house as you possible could with leverage. Now lets get real about the true cost of home ownership. I mean lets get really real and look at what nobody wants you to see when you are stepping up to the American Dream!

In this case, I am going to use a $1 Million Dollar price point. I know in some markets a Million dollar house is insane to think about, but on the West Coast, there are several markets where a Million dollar price point is nothing fancy or it is just getting started. I am going to use a neighborhood I am familiar with but pick a house at random from Zillow to illustrate the true cost of ownership of a home. Here’s a house that recently sold for $1,030,000 near my old neighborhood I lived in before I geo arbitraged my wait out of the Seattle area.

Example house pulled at random.

I love the example of this house, because the silly size of it, the rapidly increasing taxes, and built in 1988 it is one of worst possible ages of a house to buy. BTW- if you own this house, I am sorry, I mean no disrespect to you, and the home could make perfect sense for your lifestyle.

Now lets really dig into the math of owning an asset like this house. How much a year does it really cost to have a house like this? For this, I am going to do a complete look at the cost of ownership on this house on a monthly basis. I am going to try and be fair in the values I assign to the various costs, and because this is very near the neighborhood I once owned a home, I think I will be reasonably close in my estimates.

The first thing to look at is the cost of the down payment. For a 1 Million dollar home, let’s assume you were going to put down 10% or $100,000 dollars. Some people do more or less. But we will use $100K. When you write that check for $100K – that money is essentially gone, locked up into the house. I am going to use a conservative figure on the cost of losing that money and put it at a simple 5%. That is well below what the market can return to investors over the long hall, but I am going to use that to be very conservative. What that means is that if you had rented instead of bought this house, you could invest the $100K and receive $5,000 a year. Call that $416 a month money cost here. That is the cost of locking up your 100K downpayment.

Next we have to look at the monthly payment you will make each and every month. This typically includes the principal and interest on your own, the taxes, homeowners association dues and insurance. Sites like Zillow do a good job of estimating these things, and for this particular home, using a 10% down payment, Zillow works this out to be $5010 dollars a month at Today’s interest rates.

This looks like a fair accounting of monthly payment – too bad it is just the beginning of the cost!

Now this is where you are hoping the pain will end. It actually gets slightly worse. This house is 4010 SQFT on a .71 acre lot. As I mentioned earlier, the house was built in 1988. Like a car, the older the house is, the more maintenance it will require. This particular house says it has been remodeled, so some stuff is likely already done. But what likely has not been replaced is a lot of the mechanicals. For those who have not been exposed to homeownership. Mechanical is stuff like HVAC systems, plumbing, water heaters, garage door openers etc. When this stuff breaks, it is expensive. With houses this age, mechanicals break and need replacing often. A fair estimate is about 1-3% of the purchase price of your home should be allocated yearly to cover the basic upkeep of these kinds of things. This can also include things like maintaining your driveway, roof repairs, windows that age out (I was surprised how often that happens), painting the exterior, cleaning gutters (this was a job I really hated!). Power washing your hard exterior surfaces. This list goes on and on and on. I am going to be conservative here and put that cost at 2% of the value of the home per year. So that is $20,000 a year on a $1 Million dollar home. Call it $1,666 every month. If that sounds like a lot, it is because it is a LOT! But I am telling you, that is a very reasonable estimate having owned a similar but smaller home in this area. This one is really important for people to think about, because, when you own a home, 100% of the responsibility of keeping it up is yours. If you don’t do the proactive stuff, it will cost you even more later, and if you don’t take care of problems as they come up, it just gets way more expensive.

Next up, you have to add in all the costs associated with running a large house like this. Some of this expenses are the same as when you live in a rental, some are much more. Here’s an estimate I would give on this house.

Lawn Maintenance – this yard is big, and you won’t have time to do it yourself in all likelihood. Monthly cost $400 for Mowing and Trimming. Additional water bill in the summer and shoulder months $200 average for 6 months a year. Call it $500 a month.

Power gas and electric – a house this large will take $400 month to heat and cool.

Waterestimate $100 Monthly – not including irrigation mentioned above.

Garbage$75 Monthly . Oddly you will produce more garbage in a huge house. It just happens!

Internet and Cable –  $150 Monthly – you might be able to get buy on less than this, but being a chord cutter is hard in a huge house, most people don’t do it, this is a conservative estimate IMO.

I could go even more crazy here and explain how you will spend more on furnishings, artwork, rugs, stupid throw pillows, yard decorations and furniture. When you buy a big nice house, and all your neighbors have all this crap, you won’t be able to resist keeping up with the Jones. It just happens. But I will keep that out of my estimate because what you will see is the total form what I have is bad enough.

Here is what your monthly Total Cost of Ownership will look like.

Ouch!! That is a BIG number!!

$8317 a month is a pretty big number. That is just shy of $100K a year! To be exact – it would be it is $99,804 a year!

In my next post, I will talk about home price appreciation and if the gamble of betting on the price of your home going up while you are living there – justifies the cost of owning a home at these lofty prices. Spoiler alert! I don’t think it even comes close to being worth it. I will also cover the tax advantages of home ownership, and how that advantage has been significantly reduced by the last set of tax law changes from the Trump administration.

For now, I ask you to think about how much money the true cost of home ownership will cost you, factoring in everything, not just the monthly payment to the bank. And also think about if you really want to date Ms. Leverage, and if she is really that hot?