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What’s so great about buying a home?

An article I read recently on Yahoo!Finance debunked several “Money Myths.” Among these myths were several related to owning a home.  (I recommend reading the whole list, though, as there was much good advice contained therein.)  Also, another really excellent article by Jack Hough at SmartMoney.com gives further detail about why owning a home, at least from a financial perspective, is not such a great thing.

I think home ownership is an important issue to discuss with respect to how it relates to personal finance and growing one’s wealth.  There’s a lot of glib talk about how “renting is like throwing away money” or that buying a home is good for your financial well-being because “you can deduct your mortgage interest” or “your home is an investment.”  However, I believe that more often than not (especially for singles and couples without kids or other dependants living with them), renting is preferable to owning.

Let’s start by addressing the three home-ownership/renting myths discussed in the first article (all italics mine):

Myth #1 – “Renting is like throwing away money.

Do you consider the money you spend on food to be thrown away? What about the money you spend on gas? Both of these expenses are for items you purchase regularly that get used up and appear to have no lasting value, but which are necessary to carry about daily activities. Rent money falls into the same category.

Even if you own a home, you still have to “throw away” money on expenses like property taxes and mortgage interest (and likely more than you were throwing away in rent). In fact, for the first five years, you are basically paying all interest on your mortgage. For example, on a 30-year, $250,000 mortgage at 7% interest, your first 60 payments would total about $100,000. Of that you “throw away” about $85,000 on interest payments.”

This latter point about the “throw away” costs of owning a home is very important in doing a fair comparison between renting and owning.  Such costs are often overlooked by people who mistakenly assume that every dollar they put into their home will be reflected in the house’s dollar value.  I would add to this list homeowner’s insurance (or at least the amount that exceeds any renter’s insurance you might have), home improvements that don’t permanently increase the value of your home (painting the outside, fixing the roof, replacing major appliances, cleaning the carpets, etc), and also the opportunity cost of the free time you are forced to spend (or the money you would pay someone) to make repairs that a landlord would make if you were renting.

Myth #2 – “Home ownership is a surefire investment strategy.

Just like all other investments, home ownership involves the risk that your investment may decrease in value. While commonly cited statistics say that housing appreciates at somewhere between the rate of inflation [~3%] and 5% per year, if not more, not all housing will appreciate at this rate.

[…] And if your house appreciates wildly, that’s great, but if you don’t want to move to a completely different real estate market (another city), the profit won’t do you much good unless you downsize because you’ll have to spend it all to get into another house. Owning a home is a major responsibility and there are easier ways to invest your money, so don’t buy a home unless you are attracted to its other benefits.”

This myth is particularly dangerous.  I think many people have been misled (perhaps willfully) into purchasing a larger, more expensive house than they otherwise would under the faulty justification that “it’s an investment.”  While this is sort of true in that a house generally appreciates with at least inflation over the long term, this doesn’t mean a house is a good investment.  In fact, over the long term, a house is a terrible investment, with average real returns (adjusted downward by 3% for inflation) of 0-2% per year versus 6-7% for stocks.  That means that if you invested $50,000 as a down payment for a home (assuming 0-2% in real returns), that investment would be worth somewhere between $50K and $75K in 20 years.  If you put that same amount in stocks (6-7% assumed), you would have $160K to $195K, a difference of over $100,000.

Another feature that makes a home a poor investment is liquidity, or, the ability to turn your asset into cash.  With stocks, bond funds, and savings accounts, you can liquidate your assets immediately and receive the cash in a matter of days.  With a house, it takes time and effort to sell it, a process which could take months.  As Jack Hough notes: “[h]ome buyers pay around 1% in closing costs when they buy and 6% in broker commissions when they sell.  Share buyers pay $10 trading commissions, which are negligible for buy-and-hold investors.”

Also, the sentence that I italicized in the Myth #2 quote points out that you only realize the gain on a house when you sell it AND move into something cheaper.  My experience is that people are rarely willing to do this, and, if anything, often purchase larger, more expensive residencies as they age (although some retirees may sell their more expensive homes and move into cheaper ones.)

Myth #3 – “One of the major advantages of home ownership is being able to deduct your mortgage interest.

It doesn’t really make sense to call this an advantage of home ownership because there is nothing advantageous about paying thousands of dollars in interest every year. The home mortgage interest tax deduction should only be looked at as a minor way to ease the sting of paying all that interest. You are not saving as much money as you think, and even the money you do save is just a reduction in the costs that you pay. Interest tax deductions should always be considered when filing your taxes and calculating whether you can afford the mortgage payments, but they should not be considered a reason to buy a home.”

Amen.  Now let’s transition to the SmartMoney article.  In it, Mr. Hough makes the case that the driving force behind the increase above inflation (of about 2% annually) in housing prices since WWII has been favorable legislation:

“…while stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents… In 1940 the median single-family house price was $2,938, … while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000 the ratio had swelled to 17. In 2005 it hit 20.  […]

Two main events have caused house valuations to inflate since World War II… [T]he government subsidized housing by relaxing borrowing standards. Prior to…1934 house buyers who borrowed typically put up 40% of the purchase price in cash for a five- to 15-year loan. By insuring mortgages, the [government] permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today down payments for FHA loans are as low as 3%.  …The ratio of house values to incomes has risen 260% in just under four decades.  […]

For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to “up the ante” by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely.  I suspect real returns will turn negative over most of the next two decades … According to calculations made by The Economist in the summer of 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975 to 2000 average.

So to sum up why I rent: Shares…over long time periods return 7% a year after inflation. Houses…over long time periods return zero after inflation. And they look likely to return less than that for a while.”

Hough gives strong evidence for the reasons behind housing’s historic gains since WWII, and why he thinks such gains will not continue.  From a financial perspective, I therefore must agree with Hough that the proper place for the majority of a person’s long-term assets is in stocks (like low-fee index funds.)  This means that it is generally better to rent an affordable home while stashing your savings in tax-advantaged retirement accounts or elsewhere in equities.

All this doesn’t mean that there aren’t any good, non-financial reasons for buying a home instead of renting one.  Perhaps you want to be assured that no landlord can kick you and your family out, or keep you from painting your bedroom wall like a Jackson Pollack.  Maybe that darned American Dream of marriage, kids and property ownership is just too hard to shake off.  After considering everything above and combining your newfound knowledge with that of your personal situation, maybe you’ll still decide that home ownership is preferable to renting.  Just make sure that you don’t try to justify the purchase of a home on faulty financial logic.

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Here’s another great article on J.D. Roth’s ‘Get Rich Slowly’ blog from guest contributor Tim Ellis.

More good ideas for charitable giving

It’s estimated that worms treatment has a benefit-to-cost ratio of 20:1! Also, it affects 2 billion people (400 million children) and costs only ~0.25 cents per kid to treat. Sounds like a fantastic use of charitable dollars.

– Give to “Room to Read” to fund education around the world.  ($250 for 1-yr of schooling for a girl who wouldn’t otherwise have the opportunity.)  http://www.roomtoread.org/involvement/adopt.html

– Below is a good post by Tim Ferris (author of the ‘lifestyle design’ book “4-Hour Work Week”.)  He gives convincing rationale for why you should give NOW (and not wait until you are older/have more money):

http://www.fourhourworkweek.com/blog/2007/10/04/karmic-capitalist-should-i-wait-until-im-rich-to-give/

Disturbing (but not altogether surprising) news about the financial bailout

No one seems to know where the $700 billion financial bailout went, what’s being done with it, and how much is still in the bank’s coffers to be used for who know’s what. Read about this below:

http://news.yahoo.com/s/ap/20081222/ap_on_go_ca_st_pe/meltdown_secrets

Now I can understand how normally, banks wouldn’t track dollars that came from one source versus dollars from another. However, in THIS case, the government fronted billions in taxpayer money (not private investment.) Therefore, I can’t imagine congress requiring anything less than full disclosure of how the money was going to be allocated and spent.

It appears that the rush to get money to the banks has succeeded in giving banks no incentives whatsoever to transparently disclose what’s being done with the money, or ‘where’ it’s at within each bank. If one made the assumption that these banks were all going to use this money for the best possible long-term usages for their firms, this lack of disclose might be okay. BUT, the fact that banks are in this mess due to poor financial decisions (and NOT “bad luck” due to the economic downturn, despite the fact that it exacerbated the situation), destroys that assumption.

While I do strongly believe that private firms generally perform better than government-owned ones (been to your local post office lately?), one thing that political trumpeters of the “free market” like to neglect are the conflicts of interest between firms and their management teams. Unfortunately, CEOs are often rewarded with compensation that focuses on the short term stock price (stock options and bonuses dependant on share price) rather than being aligned with the company’s long term future.

Warren Buffet, CEO of Berkshire Hathaway and arguably the greatest investor of all time, is a notable exception. His substantial net worth of many billions is almost completely investing in the company he leads. This long term ownership, combined with the fact that Buffett’s salary is a meager (for CEOs) $100,000 per year, with no fancy options deals, means that Buffett’s incentives are aligned with those of his long term shareholders.

Also, CEOs are generally paid more relative to the size of the company they control***. This creates the incentives to make fiscally irresponsible mergers just to “grow the empire.” And now, with the precedent being set of companies designated “too big to fail,” managements have even more incentives to grow the size of their firms. These incentives by themselves do not encourage firms to pursue social gains (either for consumers or shareholders) and therefore are undesireable.

Coming back to the financial bailout, it is very troubling that in an effort to quickly sustain failing companies within the financial services industry (without discussing whether that was the right thing to do or not), congress and the administration may have not addressed the threat of those firms failing in the future, throught poor use of the bailout money in the present. This lack of oversight may result in these same companies returning years later in similar predicaments. (Of course, that may have resulted anyway, even with oversight, calling into question the wisdom of the bailout, of which I’m not knowledeable enough to discuss.)

Hopefully failure of many of these companies down the road does not turn out to be the case. But, when one has no idea of what’s happening with the bailout money those firms received, how can we know one way or the other?

 

*** From nobel prize-winning economist Gary Becker (on the Becker-Posner-Blog.com): “For every 10 per cent increase in firm size, measured by the market value of assets, by sales, or by related variables, compensation increases by about 3 per cent. This “30 per cent” law held during the 1930’s, and has held for every succeeding decade, including right up to the present.”

What to do (and what NOT do to) in today’s turbulent financial markets

Unless you’ve been living in a cave that’s under the ocean AND on another planet, you have likely heard about a bit of trouble going on throughout the US’s financial system.  First, house prices dropped, then stocks prices, now entire banks like WaMu and Lehman Brothers have gone under (taking the markets further down with them.)

While Congress and the United States Treasury Department try to figure out what to do about the mess that Wall Street (and, let’s be fair, Main Street) got us into, most investors are left trying to figure out what actions to take in their personal lives.  Although I certainly don’t pretend to be an expert on the macro economy (and you don’t need to be to make good decisions when that same economy is acting crazy), I will offer some advice.  The first step is absolutely essential; fortunately, it’s pretty straightforward:

DON’T PANIC!

This is a pretty standard rule in any scenario of perceived crisis.  If you’re panicked, you can’t think straight.  If you can’t think straight, you can’t make good decisions, SO RELAX!  Take a deep breath, remind yourself of all the things that are going fine in your life (or at least pretend if things aren’t), and try not to think about that tanking retirement fund.

Really though, after you’ve calmed down, stop and reflect on your personal financial situation.  (Stop worrying about the rest of the country for a minute, and do Ayn Rand proud by thinking only of yourself, and your immediate financially dependent family, if applicable.)  If you’ve followed the rules I’ve recommended, you are hopefully already in solid financial shape.  If you’re not, you need to apply the next step.  (Even if you don’t think you need it, read over it anyway, just in case there are some things you’ve missed.)

Get fit financially

No course changes here folks, continue to pay off your high-interest debt, establish a short-term “emergency fund” (you could put it into a Money Market Fund like Vanguard’s VMMXX.  Don’t worry, the government has said it will guarantee Money Market Funds for a while.)  Get yourself the necessary insurance for your health, life (I believe term is best for most people), disability, car and house, and whatever else you need insured.  (Keeping in mind that many of those types of insurance may be provided by your employer at a good price.  Check into the details with your Benefits department at work.)

Note that we haven’t decided to take any different course of action yet due to the fiscal crisis that we’re facing.  “But, surely” you might be saying, “our plan of action has to change when it comes to our investments, right?  The stock market just isn’t safe any more!  Our retirement and kid’s college funds are in there!”  Well, sorry to disappoint, but the next vitally important step in our plan to deal with these troubling times is…

DO NOTHING!

Well, almost nothing at least.  DON’T rush to cash out your stocks and bonds.  DON’T take all the money out of your savings and checking accounts to stuff it under your mattress (the FDIC insures those deposits at up to $100,000 per account.)  DON’T lose faith in the stocks, the number one wealth-creating opportunity available to all Americans.  In fact, the only “change” I might recommend is to strongly consider starting to invest in stocks (and to continue your regular investing if you’ve already started.)  Over long time periods, stocks are by far the best investment you can make with your money.

Unless you plan on needing the money in less than 3-5 years, the majority, if not ALL, of your long-term savings should be in stocks.  That especially includes your retirement, young children’s college funds, etc (assuming, of course, those events are still several years away.)

With the market in turmoil, it can be very difficult to maintain your disciplined investing strategy.  Stick to it!  Keep investing regularly, DON’T try to time the market, and avoid trading in and out of stocks.  The market has been hit hard recently, but as history shows, the biggest upturns in the economy generally follow the biggest downturns.  Don’t miss out on a huge rally by setting your long-term money on the sidelines. 

Remember that volatility (referred to as “risk” by some folks) is your friend.  Steady investments like bonds and CDs generally pay low to middling returns.  When you buy (and more importantly HOLD) those broad index funds (like the total stock market index fund VGTSX from Vanguard), those short-term ups and downs historically translate into huge gains after many years.

Conclusion

So, to summarize, DON’T PANIC, get yourself financially fit enough to weather any financial storm and keep investing regularly in a diversified collection of stocks, like low-fee index funds (that way, if one of them blows up, you’ll have plenty of other quality business to fall back on.)  Your own financial security is in your hands!  This is just a broad overview of how to handle this adversity, if you have specific questions, please leave a comment or email me.

Hang in there!