Editor’s note: Today’s Post is from our PhREI Network founder, Daniel Shin MD, at The Darwinian Doctor.
What do think of owning a home vs paying off debt? Can you do both? What would be considered the better investment? These are tough questions to answer and today’s hot market makes the questions even harder. The answers may also be age dependent. If you entered real estate after the great recession, for example 2010-2012, then you might believe that homes only appreciate…. and that real estate is pretty easy. On the other hand, if you bought in 2007 and experienced a 50% drop in equity then you may feel that real estate is an awful investment and young physicians would be wise to just pay off their student debt. I’m in the middle. I bought right before the crash and lost…. But I also bought after the crash and did very well. I feel that owning a home can be both a liability and an asset but that the ability to generate wealth while putting a roof over your head out weighs the potential liability. In addition, I am a believer in letting student debt ride as long as the interest rate is low. Dr. Shin has implemented this strategy and highlights in detail the benefits that he has experienced via home ownership. In addition, he describes how he turned his “liability” into an asset to continue to grow his net wealth.
Is owning a home a good investment? In my last post, many were shocked that 28% of our monthly spending goes to our home. I’d become numb to this fact, but the outcry drove me to look more closely at this fact. So I analyzed our 10 years of home ownership in Los Angeles to see if it’s been a good investment. Curious? Read on!
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The American dream means living life to the fullest. For many, that involves owning a home. But there’s a running debate within the FIRE community if owning a home is a good investment. A few different camps exist:
- Own a home. Pay it off as soon as possible.
- Own a home. Keep a low interest mortgage. Invest excess capital.
- Rent a home. Invest excess capital.
Group One: Own a home. Pay it off as soon as possible.
If you’re in this group, you acknowledge that owning a home is valuable. Perhaps you like the feeling of having a piece of this world that is all yours. You want to own it outright as soon as possible. So you pay off your mortgage to free yourself of monthly mortgage payments and the cashflow drain that this represents.
While you’ll always owe real estate taxes, at least the bank will never have a claim on your home!
In 2019, Zillow reported that 37% of US homeowners owned their properties free and clear. Congratulations to this lucky cohort!
Group Two: Own a home. Keep a low interest mortgage. Invest excess capital.
If you’re in this group, you plan to pay your property off over time using a mortgage. You’ve probably got a 30 year mortgage with a nice 21st century low interest rate. This is what the majority of homeowners choose to do.
I fall into this group. I’ve made a bet that by using a low interest mortgage, I’ll come out financially ahead if I invest my excess capital, rather than using it to pay down my mortgage faster. I’m making the same bet with the $220,000 I still owe in student loans.
Group three: Rent a home. Invest excess capital.
If you’re part of this extreme group, you want to put every penny into assets like stocks or rental real estate. You rent a modest apartment or home and invest every extra dollar.
This isn’t a crazy idea. In a high cost of living area like Los Angeles, for example, a small home could run you well over $1 million. A typical down payment of $200,000 could take many years to accumulate. If you simply invest all this money as you accumulate it, is it possible that you could come out ahead in the long run? Perhaps.
How did it go for the Darwinian family?
We’ve been homeowners in Los Angeles for the last 10 years. Read below for some specifics about our two homes during this time, and an analysis of the numbers.
Home #1: 2 bedrooms, 1800 square feet.
As I wrote about previously, a large part of our net worth is due to our first home. We got help (OK, a whole lot of help) with the purchase of our first home in 2010 from the Dr-ess’ parents. We bought it close to the bottom of the real estate crash for about $850,000, and sold it about 7 years later for $1.34 million.
How does this look when we consider the return on investment from our down payment? Pretty good:
|Realtor fees (6%)||$80,000|
|Cash from sale||$730,000|
|Hold period||7 years|
|Return on investment||115%|
|Annual ROI (compounding)||11.50%|
After 7 years, the $340,000 of cash grew to $730,000. Most of this went into our next home (see below), but $300,000 was left over as cash. We invested this into the stock market.
Comment: our mortgage during this time period was an interest only mortgage, so this return doesn’t reflect any benefit from principal paydown.
Current home: 5 bedrooms, 3400 square feet.
In 2017, with a second child on the way, we decided to trade up to a larger home. A priority was to have enough room to accommodate my parents, as well as my growing family. I wrote about this here.
So 3 years ago, we bought a 3400 square feet home in the heart of Los Angeles. It cost us $1.8 million. We financed the purchase and moved $430,000 from the sale of our first home into the second home as a down payment.
In the last 3 years, our home has appreciated. It’s hard to tell by how much, because the only real way to tell is to sell the home. We got the house formally appraised about 6 months ago for a refinance, but I feel the bank’s estimate was too conservative. But I also don’t agree with most of the home value estimates on the real estate websites. The comparable homes used in some of the Zillow’s data, for example, are from a much more expensive neighborhood.
These are the current value estimates:
|Home Value estimates|
Out of these, I think the one most connected to reality and recent sales in my neighborhood is the estimate from Redfin ($2,270,000). I’ll use this estimate in the calculations below.
|Current Redfin est. value||$2,270,000|
|Potential realtor fees (6%)||$136,000|
|Current mortgage balance||$1,290,000|
|Potential cash from sale||$844,000|
|Hold period||3 years|
|Return on investment||96%|
|Annual ROI (compounding)||25.25%|
Comment: we started out with a $1.37 million mortgage, so we’ve paid off about $80,000 of this over the past few years. This ROI value is counting this principal paydown as additional gain.
Caveats and criticisms
I should acknowledge some obvious criticisms of this analysis:
- What about maintenance costs?
- What about your huge mortgage payments and taxes?
These are both valid. Every few months something fairly big seems to break or require maintenance in our home. A few months ago it was clogged and leaky gutters. This month it’s the air conditioner. Every time something happens, it seems like it’s a thousand dollars or more to fix.
Also, our mortgage payment and real estate taxes are very large. As I discussed in my breakdown on our pandemic spending, these two costs together comprise 28% of our monthly cash outflow. This large costs puts pressure on me and the Dr-ess to work hard to support our high cash flow needs.
However, it’s important to note that interest on our mortgage is tax deductible up to the first $1 million of our mortgage balance. (We were grandfathered into this limit.) So most of our mortgage interest is deducted come tax time.
And you’ve got to live somewhere. Obviously we could rent, but then I wouldn’t be able to provide housing for my parents. Also, renting a house in Los Angeles is very expensive. In desirable areas, houses rent for between $5000-7000 a month.
Finally, if I rented, I wouldn’t be benefitting from the magic of leverage, tax deductions, principal paydown, and appreciation.
So is owning a home a good investment?
My admittedly biased analysis of the numbers shows that it’s been a strong wealth builder for the Darwinian family.
For sure, we’ve disproportionately benefited from the appreciation of the real estate market in Los Angeles. Overall, big coastal markets like Los Angeles swing much more wildly on the real estate pendulum than most of the country. We caught this pendulum near the bottom (through sheer dumb luck) and rode it to the top.
If we’d been renters for the past 10 years, our monthly costs would have been lower, but our wealth would likely be less as well.
As a final comment, in “Rich Dad, Poor Dad”, Robert Kiyosaki writes that an asset is something that puts money into your pocket each month. A liability is something that instead takes money out of your pocket.
While this is a simplistic view, it did help us view our primary home in a new light. A liability that takes $7860 out of our pockets every month won’t help us reach financial freedom, unless we sell it or turn it into an asset.
So to tap our equity and turn our home into an asset, we secured a $500k home equity line of credit right before the pandemic gripped the world.
How are we going to use the HELOC to put money into our pockets? I’ll give you one guess. Stay tuned for our next edition of Anno Darwinii for the juicy details!
Home ownership generates some pretty strong feelings in the world of personal finance. What do you think about my analysis? Please leave your thoughts below, share, and subscribe for more!