Most of you financially savvy folks out there learned early on that homeownership is an important step in achieving long-term financial security. This, generally speaking, is a truism that is pretty accurate. In the process of keeping a roof over our heads, homeowners, with each mortgage payment, are investing in our financial future. Fiscal discipline is a virtue that is often lacking in our society (just look at how our federal government has behaved for the past eight years) so this kind of automatic equity-building is a good thing.
But before you build that McMansion consider this: like aspirin and fine wine, more of a good thing will not necessarily lead to a superior outcome. Yes you should own your own home, but if you supersize it then you’ll be paying a cost.
Consider a buyer trying to decide between buying a $600k house and a $300k house (you can either double or halve these numbers depending on property values in your neighborhood). There are some that will argue that by splashing out on fancier digs that they’re investing in their future. But not so fast…buying an $600k pad is certainly better than renting a $600k pad (under most market conditions) but it doesn’t beat buying a $300k pad. Follow the numbers…
- 6.5% fixed rate mortgage
- 0.75% property tax
- 4.5% property appreciation rate
- 9% stock market return. All excess cash (from tax deductions and lower mortgage payments) are reinvested at this rate.
The more expensive house generates a big gain through property appreciation – over $330k in ten years – assuming the market behaves roughly in line with the long term historical average of 4.5% per annum gains. Adding the pay-down of the loan balance and income tax deductions from interest and property taxes (which are continuously invested in the stock market), the $600k house creates around $500k in wealth over ten years. Not too shabby.
Compare this to the option of buying the cheaper house.
The $300k house generates considerably less in terms of property appreciation over ten years vs. the more expensive home. But compare the two mortgage payments: around $46k per year for the larger house vs. $23k for the smaller one. This is an extra $23k that can be invested in other vehicles, plus savings in property taxes. When these funds are reinvested on a yearly basis then they can generate dramatic returns.
- $300k House: $590k of value created in ten years
- $600k House: $506k of value created in ten years
Extend the anaylsis out to fifteen years then the results are even wider. And if you take that extra cash and put in into income generating real estate instead of the stock market – now you’re really cookin’ with gas.
Is this an argument against the flahsier house? Well…maybe so, but maybe not. Perhaps ten years spent living in the nicer home is worth that $84k in foregone wealth. Fair enough. Just don’t convince yourself that you’re making a strategic investment by going big. The house you’re living in doesn’t generate income – it only generates expenses. Living large is nice, but there’s a cost.