Have you ever heard somebody -- a real estate agent, maybe -- say that buying a home is the best investment you'll ever make? Not to spoil the discussion to come, but they're wrong. I can think of a dozen investments that are likely to produce better returns than buying a home to live in. But that's not to say that buying a home isn't a sound financial decision.
With that in mind, here's a deep dive into one of the most common questions homebuyers and homeowners ask: Is buying a home a good investment? First, we'll take a step back and look at what an investment is and where a home fits into the definition, why a rental property is a different type of investment than a home you live in, and why even though it isn't a good investment from a long-term return perspective, owning a home can still be a great financial decision. Finally, we'll discuss why looking at your home as a form of real estate investing entirely misses the point of homeownership.
A home is an investment -- sort of
The term investment can be loosely defined as an asset you buy with the goal of either earning income or selling for a profit. For example, if you put money into a CD, you'll earn income on your money. If you buy a gold bar, it could be worth more today than tomorrow. And if you buy a stock, it could do both -- give you income by paying dividends and eventually increase in value.
By this definition, buying a home is an investment. But I don't think anyone would argue that if you buy a home in today’s housing market, it's reasonable to expect that someday it will be worth substantially more than it is now.
While home values certainly go up and down in the short term, homes in the United States have historically appreciated by about 3% per year over the long term. Home values have barely outpaced inflation, but their nominal value will almost certainly be higher in the future, and to be fair, there are many forms of investments (CDs, for example) that typically don't keep pace with inflation.
But is a home a good investment?
Having said all that, it's important to make the distinction that not every investment is a good one. There are great investments, there are good investments, and then there are mediocre investments. I'd argue that owning a home falls into the latter category.
For starters, although the value of the home itself will almost certainly rise over time, a home you live in costs quite a bit of money on an ongoing basis. Just to name the most common expenses, here's what you'll have to pay for while you own a home:
- Mortgage interest: Unless you pay for your home in cash, which isn't common, you'll have to obtain a mortgage to buy your home. A portion of your monthly mortgage payment will be interest that is paid to a bank.
- Property taxes: The national average cost of property tax is about 1% of the home's value, but this can vary significantly. In high-cost states, property taxes can be two to three times the average.
- Insurance: In most places, you'll need basic homeowners insurance, which protects you (and your lender) from things like fires, vandalism, and other common hazards. However, depending on where you are, you might need special types of insurance. For example, if you live in a hurricane-prone area, you'll probably need windstorm insurance. If you live in a low-lying area, you'll probably need flood insurance. And I can tell you firsthand that neither of these is cheap.
- Maintenance: Houses require significant upkeep. Over the past year, I've had to pay to have the exterior of my home pressure washed, my gutters cleaned, a toilet replaced, and two electrical outlets redone -- and this was a pretty mild year as far as maintenance is concerned. A good rule of thumb is to expect maintenance to cost at least 1% of your home's value each year, and more if the home is a bit on the older side.
To be perfectly clear, homeownership can still be worthwhile, even with these expenses. In full disclosure, I've been a homeowner for about a decade now and couldn't imagine going back to renting. However, the point is that good investments don't have high ongoing out-of-pocket costs like owning a home does.
Productive vs. unproductive assets
When it comes to investments, there are three main varieties. First, there are currency-based investments (think savings accounts and CDs). These are generally used more for safety than to generate returns. The other two types of investments are the assets that are most commonly associated with the term:
- Productive assets: A productive asset is one that either generates income or produces assets or services. A business you own is an example of a productive asset. Stocks (or more specifically, the companies they represent) are another common form of productive assets.
- Unproductive assets: These are investments that have the potential to increase in value over time but don't generate any income or produce any goods or services. Gold and other precious metals are a good example of unproductive assets. Sure, they could be worth more someday, but in the meantime, they aren't really doing much.
Here's the point: Productive assets are almost always better investment options than unproductive ones. A productive asset can create an income stream, and its value is generally based on something more concrete than "someone else will pay more for it someday."
A house that you live in is definitely an unproductive asset. It doesn't generate income, and it actually costs you money on an ongoing basis, as we discussed in the last section.
An investment property can be an excellent investment
Before we go any further, I'm not saying that real estate isn't a great investment. I'm saying that a home that you live in isn't.
A home that you buy as a rental property can certainly be a fantastic investment. In full disclosure, I own a few rental properties myself and actually prefer investing in real estate to stocks and bonds in many cases.
The difference is that an investment property becomes a productive asset. You'll be earning rental income that should cover the ongoing expenses of property ownership (mortgage payment, taxes, insurance, and maintenance) and hopefully generate some cash flow for you.
And after years have gone by, you'll have built up equity in a property that someone else paid for. The stock market has historically generated total returns (income plus appreciation) of about 10% per year, on average, and it's not uncommon for rental properties to generate even more when selected and managed properly.
What's better: Renting or owning your home?
The only way I would consider a home you live in to be a sound investment is if you plan to live there for a long time. Simply put, the long-term costs of owning a home are typically less than the long-term costs of renting. Let's take a look at an example of this.
The costs of owning a home
Consider this simplified scenario: Let's say that you buy a house for $200,000. You put 20% down ($40,000) and use a 30-year fixed-rate mortgage to finance the rest, with a 4% APR. Over the course of 30 years, you'll have paid $274,991 toward your mortgage payments (principal and interest). And we'll say that property taxes, insurance, and maintenance expenses are about 3% of the home's value per year, increasing by 3% per year, on average, which over a 30-year period comes to a total of $285,453. Here's your total cost of owning the home for 30 years: