Many people refer to their home as their “best investment.” Others argue that a home isn’t an investment at all because it may not go up in price or because you may never sell it.
In my opinion, anything that has a calculable (usually positive) rate of return is an investment. And it’s worth noting that buying a home can yield a positive rate of return even if the home never increases in value. (Conversely, it can have a negative rate of return even if the home does increase in value.)
Rate of Return Involves More than Home Value
The rate of return on a home purchase involves more than just the home’s market value. If you only consider the change in home value, you’re leaving out:
- Part of the price of the investment — maintenance costs and property taxes,
- The biggest part of the payoff — the fact that it replaces your rent, and
- The fact that the investment was probably leveraged (i.e., paid for using a loan).
I think it’s easier to first look at the purchase as if you were buying the home with cash. That way, it’s easy to calculate the expected return on the purchase:
Expected Real Return = D + G – C, where
D = imputed rental dividend (calculated as the size of the annual rent bill that you’d eliminate by owning instead of renting, divided by the purchase price of the home),
G = inflation-adjusted growth in home value, and
C = costs (insurance, property taxes, and maintenance), expressed as a percentage of the purchase price.
For example, if you’re currently paying $1,000 in rent per month, and you buy a home for $180,000, your imputed rental dividend would be 6.67% ($12,000 ÷ $180,000). From that, add the inflation-adjusted rate at which you expect the home to appreciate, and subtract any non-mortgage costs of owning the home.
Then you can determine how your return would be affected by using borrowed money for the purchase. (In short: It only makes sense to borrow if you expect a return greater than the interest rate you’d have to pay on the loan.)
Rate of Return When Prepaying a Mortgage
A recent Get Rich Slowly post asked whether it’s better to prepay a mortgage or invest elsewhere. In the comments, several people asked questions to this effect:
“Isn’t it risky to put a bunch of money into prepaying your mortgage? After all, we’ve seen in the last few years that home prices don’t always go up.”
It’s true that home prices don’t always go up. But if you own a home, you’re already exposed to that risk — whether you decide to prepay your mortgage or not. The rate of return you get when you prepay your mortgage is simply equal to the interest rate on the mortgage. It’s got nothing to do with changes in the market value of the home.
Why I’m Not Buying a House (and Likely Never Will)
For many people, owning a home provides an emotional benefit, so they’re happy to buy a home even with an expected return that’s somewhat less than the return they could get with other investments.
I find myself in the opposite boat. From where I’m standing, owning a home looks to be:
- A huge pain in the butt,
- Illiquid, and
- Extremely undiversified.
…whereas putting money into an ETF portfolio is the opposite. It’s easy. It’s liquid. And it’s diversified. As a result, I’m only going to be interested in buying a home if it appears that the expected return is significantly greater than that of other investments.
Of course, given that there are so many people willing to accept a lower return (i.e., pay more for the home), that may never happen.