The single biggest purchase most families will make is their house. There’s a lot of mythology about the economic benefits of homeownership, and I’d like to break through that so that you can make the best decision for you and your family.
To start off, my parents paid about $5,000 54 years ago for a house that’s now worth about $5,000 today. There’s no typo there. The house is in Youngstown, Ohio. The house lost value in real terms, and yet, it made perfect financial sense for my parents.
The economic benefits of home ownership are grossly oversold, but they do exist. Some of the benefit is in the mortgage interest deduction, for those who still qualify, although this has never been as big as people like to believe, especially not now when interest rates are so low.
A house is a package of things, with different economic values. First, you have the building and its fixtures, and these are depreciating assets. You will constantly have to repair, replace, and update a house and all the things that are in it. You will not get your money back for most improvements – they often reflect your taste. My husband is a geologist, so we have fancy fossil tiles in one bathroom and mixed stone countertops in our kitchen, and the number of people who appreciate these features is pretty small. Also, the improvements get old. No one will pay up for a 10-year-old refrigerator, even if it is a SubZero. This isn’t necessarily a bad thing. Many people want are willing to spend money on items that reflect their personal and make their lives easier, but they are not investments. A purse is not an investment, and neither is an appliance.
Next, you have the land, which in economic terms is a store of value. The land value of a house should, on average, increase by the rate of inflation, no more and no less. This isn’t an amazing return, but it’s okay.
Finally, a house comes with the opportunity costs and benefits of the location: schools, parks, public transit, proximity to work, etc. The advantages and disadvantages of the location are ultimately the greatest driver in changing housing values. My house and my mother’s house are at the extremes. I live in a Chicago neighborhood with excellent public transportation, trendy restaurants, and a top-rated public elementary school. It’s close to Wrigley Field, and a lot of current and retired athletes live nearby. My house is worth nothing; it’s a tear-down. People want land in this location more than they want they building that sits on it. My mother’s house, meanwhile, is valued only for the building. Youngstown, Ohio is a high poverty city, and one of the city’s largest employers, a General Motors plant, just closed. There’s no economic value in her location.
You only benefit from a price change when you sell your house. Until then, the big economic advantage of home ownership is that you are capitalizing the cost of housing. Essentially, you are pre-paying your rent now so that you can live in your house rent-free after the mortgage is paid. My mother doesn’t have to worry about paying rent. Many people undermine the advantage of rent capitalization because they keep trading up and carrying a mortgage because they think they are getting some huge tax advantage. Meanwhile, many retirees in rental apartments are living in fear that the landlord will raise their rent.
My top tip is this: if you buy a house, get a mortgage you can afford and have a plan for paying it off. Even very small additional payments to principal will let you pay it off faster by reducing your total interest expense. In our case, our plan was to pay off the mortgage before our kid started college so that we would just roll the money over into tuition, because as an only child with two parents with decent jobs, he wasn’t going to get any financial aid. I know, I know, carrying a mortgage will help you get more financial aid, but? Be realistic about you’re talking about here. Carrying a big mortgage so that your kid qualifies for a larger student loan – the only aid on offer at many public universities – isn’t exactly smart financial planning. My parents paid off the mortgage on their house before I went to college, but ended up taking out home equity to help cover tuition for my two youngest siblings, a cheaper option than many student loans.
Also, if you are in a two-income family, avoid getting a mortgage that requires both incomes for the full payment. That gives you no wiggle room if one of you becomes unemployed or disabled. (See also: Elizabeth Warren’s book “The Two-Income Trap”). We made a large down payment so that we could get a mortgage payment that we could meet on my husband’s salary alone. He was unemployed for a while and I had to make the mortgage on my freelance income. It was not fun, but it was possible.
That’s related to my second tip: be careful about trading up. Everything will cost just a little bit more. Your bigger house will need just a little bit more furniture, your new neighbors will dress just a little bit better, the school fundraisers will be just a bit pricier. Moving to bigger house in a fancier community will increase your total living expenses by more than you may realize. It’s perfectly fine if you still choose to move, but be aware of the potential costs going in.
The third thing: given the role of location to real estate value, the best thing economically for the vast majority of people is to buy a relatively inexpensive house in a neighborhood that is likely to improve. Then, get involved in neighborhood organizations or the Local School Council to improve the value of your house. A nicer park, a better climate for local merchants, and a stronger school will give you a bigger payoff than new appliances. (Of course, this raises all sorts of issues related to gentrification, which is an entirely different discussion.)
Neighborhood improvement worked a little too well where I lived, and now my house is worthless. Now, as for the investment piece, a house has two components, the building and the land. The building is a depreciating asset. It needs constant upkeep, and you will not get your money back for most improvements – they often reflect your taste (not everyone will like the fancy fossil tiles in our bathroom or the mixed stone countertops in our kitchen, because not everyone has a geologist in the family) and they age. No one will pay up for a 10-year-old refrigerator, even if it is a SubZero.
Finally, renting is often a cheaper option, depending on where and how you live. You do not have to buy a house to get ahead financially. However, you lose the advantage of a pre-paid place to live in retirement. Even though my mother’s house is practically worthless, it’s cheaper for her to live where she does than in an apartment. Renters should be diligent about saving money, whether for a future down payment or for a larger retirement fund.
There’s no right answer here. The wrong one is to take a mortgage that you cannot afford under the misguided notion that real estate is the best investment that will pay for itself through tax deductions. That got a lot of people in trouble back in 2008. You don’t want to be a party to that.
