The American ideal. Owning a home, a nice pension, and social security. You were set for life.
After the 2008 housing crisis the desirability of home ownership changed. Many people lost everything because they bought too much house. Pensions are going extinct. Social security has changes on the horizon.
The American ideal isn’t the same as it once was.
Yet, owning a home is regaining its flare. Specifically, in the Madison, Wisconsin market it seems like houses are selling before they hit the market. At least based on the post cards I receive from realtors sharing their successes.
If you’re a renter you’re beginning to think… “why should I keep paying rent when I could be building equity in a house?”
If you’re already a homeowner you’re thinking… “wouldn’t it be nice if we had a 4th bedroom…private backyard… new neighbors.” You get the point. That list could go on for days!
OK, it is decision time.
How much house can I afford?
Typically, lender thresholds for the maximum amount to borrow are based on the 28% rule and 36% rule.
- 28% Rule: Monthly housing payments (principal, interest, taxes, and insurance (PITI)) should not exceed 28% of monthly gross income
- 36% Rule: Total monthly payments for all obligations include PITI, credit card payments, child support, other loan obligations, and sometimes alimony, should not exceed 36% of gross income
There are a few exceptions in terms of FHA and certain types of Fannie Mae loans, which allow the ratios to exceed 40%. Since those are special circumstances, we will not review those options here. However, to illustrate the 28/36 rule here is an example:
Ellen earns $5,000 per month and pays 36% in debt payments ($1,800). After debt and income/payroll taxes of 15% ($750), she is left with $2,450 per month to spend on everything else.
If you exceed these debt ratios then a lender perceives you as too risky for a standard loan, if as somebody they will lend money to at all. This debt ratio has absolutely nothing to do with whether or not it is a good financial decision for you.
Determining whether or not buying a new house is a good financial decision for you is up to you. Not a mortgage salesperson.
The basis for buying a house is to focus on what is “enough” to enjoy your desired lifestyle.
Although, in the back of your mind you are thinking… buying a house is an investment, isn’t it? If it is then I am increasing my savings rate! Rats, safe savings rate research doesn’t include home ownership as an asset.
Is buying a house an investment?
According to Investopedia, an investment is “an asset or item that is purchased with the hope that it will generate income or appreciate in the future.”
If your house does generate income then it is no longer a personal residence. It is either a mixed-use property or rental property.
Since your primary residence doesn’t generate income then for it to be an investment there needs to be hope for appreciation in the future.
Appreciation is defined by Investopedia as, “an increase in the value of an asset over time.” Beyond that, “the increase can occur for a number of reasons….increased demand…weakening supply…changes in inflation or interest rates.”
Ah yes. Increased demand, weakening supply happen in certain real estate markets. There is hope for your house to appreciate in the future if you find yourself in a thriving real estate market when you go to sell.
If you are not in a real estate market that drives up the price of your house, you must see growth through inflation. Robert Shiller (Yale Economist), noted that real inflation-corrected prices of homes showed almost no change.
In nonprofessional terms… yes, houses generally increase with inflation, but no further. Based on the definition, the property does appreciate in value due to inflation.
Building off the original definition an investment, if you live in a booming real estate market then your house is an investment. Since house prices generally increase with inflation then your house is an investment.
That doesn’t mean it’s a good investment
Being an investment is significantly different from being a good investment.
However, the problem with identifying a good investment is that it is product focused. Here are a few examples of what I mean by product focused:
- Is gold a good investment?
- Are utility stocks good investments?
- Will this whole life insurance policy be a good investment?
If we focus specifically on the individual products, we are overlooking the most important factor in investment decisions.
The investment process.
The most important step in the process is to understand how it relates to your goals. Your current sum of money is finite. By allocating your money to this or that, you are making a trade-off.
A few other considerations are:
- When an investment doesn’t create cash flow you’re 100% reliant on timing or appreciation.
- What are the holding costs?
- How much are selling costs?
- What happens if you can’t sell it when you’re ready?
The real question is… Does allocating my money here get me closer to my most important goal(s)?
Answering that question is personal to your situation. To start, you could create your situation in a free financial calculator to understand if a potential investment is good for you.
Should you buy a house?
We have identified that buying a house is an investment based on the broad definitions by Investopedia. Identifying whether or not it is a good investment is personal to your goals and needs to go through your investment process.
Does it matter if it is an investment?
Justifying it as an investment definitely makes it easier in your mind to buy a house.
You think, even if I can’t sell it in retirement, I can tap the equity in the house to cover living expenses. You are right. It is true. It is a reverse mortgage.
What certainly matters when you buy a house is that you lose the freedom you had while a renter. Finding a sub-leaser or paying for a few extra months of rent is way easier than finding a buyer or paying 30 years of a mortgage if you want to leave town.
If you are looking to upgrade your house then consider the impact on your monthly cash flow. As well as how this could shape your retirement if you enter retirement with a large mortgage. Understanding the trade-offs are important.
My recommendation is not to make your home buying decision based on whether or not it’s an investment. Rather, base it on whether or not the trade-off you’re making is worth it to you.
Does buying this house allow you to attain or sustain your desired lifestyle?
Do you want to understand how to make your money work for you and keep more of what you have earned?
Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Nate Byers a Madison, WI CPA Financial Advisor, and all rights are reserved. Read the full Disclaimer in the footer below.