NEW YORK (BankingMyWay) — The spring home-buying season is limping along, suffering from a sluggish economic recovery, a shortage of inventory and tight lending standards. To pour salt in the wounds, in many markets buying is now a better financial option than renting.
But if you’d like to buy and can’t, don’t feel too bad — homeownership isn’t always the path to prosperity that many make it out to be. We’ve often noted that, on average, home values don’t rise as fast as stock prices, making stocks and stock funds a more profitable choice for long-term investors. Last year homes gained an impressive 12%, while the Standard & Poor’s 500 returned a stunning 32%.
But poor investment returns are just one of several reasons to avoid sinking every cent into a home.
New York Times columnist Josh Barro noted Monday that the homeowner, instead of seeing the home as an investment, should view it as “consumption good” like a lifetime supply of chicken breasts. But people resist thinking of homes this way.
“[Because] housing consumers tend to take long-range equity interests in housing, they come to view housing as an investment, which distorts the housing market in the directions of restricted supply, inflated prices and speculation,” he said.
The investment illusion is easy to understand because so many of us have known people, like our parents, who bought homes for what now seems a pittance, and later sold them for hundreds of thousands of dollars. The truth is, the same sum invested in stocks over a 30- or 40-year period probably would have grown much more.
Many people, Barro notes, argue that home prices are less volatile than stocks, making the home a safer investment. A long-term stock investor, for instance, should expect to live through several bear markets with stock drops of 20% or more, while it’s rare for home prices to fall that much. But in fact home equity can be quite volatile for anyone with a large mortgage.
If you carried a mortgage for 80% of the home’s value, the value of your investment would actually be just 20% of the home’s value. That would be your equity, the difference between the value and your debt. In that case, a modest-looking 4% drop in the home’s price would wipe out 20% of your equity. On a $100,000 home, for instance, you’d have $20,000 in equity, and a loss of 4%, or $4,000, would reduce your equity by 20%. So a 4% home-price decline could hurt you just as much as a 20% stock drop. Seen in this light, a home “investment” can indeed be risky.
It does work the other way, of course. If you had 20% equity, a 4% rise in home prices would increase your equity by 20%. Unfortunately, this gain can be more than offset because a home, unlike stocks, comes with lots of carrying costs — mortgage interest, insurance, property taxes, maintenance expenses. Though profit on most home sales is tax free, a rigorous accounting of all these expenses could well show there is no real profit even if the sales price far exceeds the purchase price.
Also, as an investment, the home is “illiquid,” meaning it can be difficult and time consuming to sell. Other investments can be converted to cash with the click of a mouse.
“I will grant that there are some advantages of homeownership,” Barro writes. “Owning offers people a sense of security, as well as the freedom to customize their residences as they see fit. Those are perfectly good reasons to buy a home as a consumption good; it is not a justification for homes (or chicken breasts) as investments.”
Over the long haul, owning may be more economical than renting. But “more economical” is not the same as “profitable” — owning is merely less expensive. With anything that’s an expense rather than an investment, the goal should be to keep the cost as small as possible.
So when it does come time to buy, get the least expensive home that suits your needs, not the most expensive you can afford. Then invest the savings in something more promising.
—For more ways to save, spend, invest and borrow, visit MainStreet.com.