Off the top of my head the other four are probably
- Stay out of high-interest debt
- Automate your savings and investments
- Invest in risky, not safe, things
- Invest for the long term, greater than 5 years.
As a top five action, why and how is homeownership important? And can it go wrong? Oh yes, it can go wrong. It’s been less than a decade since homeownership went terribly, horribly wrong for many, so even while I want to extol ownership, it’s worth reviewing painful lessons too.
In 2014, the last time the Federal Reserve published their Survey of Consumer Finances, reporting median homeowners’ net worth of $195 thousand compared to renters $5 thousand net worth. Homeowners have nearly 40 times as much net worth as renters.
Of course you scientists will point out that correlation does not imply causation, and also that causation goes both ways. People own a house because they have wealth, AND people have wealth because they own a house. Even so, the mechanism by which home ownership builds wealth matters.
Homeownership works to build wealth because of automation, tax advantages, and leverage.
By automation, I really mean to highlight the way in which paying a mortgage over 30 (or even better, 15) years steadily builds, month after month, year after year, your ownership in a valuable asset, and in a way that matches your monthly budget. Your monthly mortgage payment is a combination of interest and principal, and every bit of principal you pay adds a steady drip into your bucket of positive net worth. Sleep like Rip Van Winkle and then wake up 30 (or even better, 15) years later and boom! You own a valuable asset free and clear of debt.
By taxation, I really don’t want to highlight the mortgage interest tax deduction that everyone seems to know about already, and that quite frankly I’d be happy to see disappear.
Instead, the tax-reducing key to wealth building through a lifetime of home ownership is the capital gains tax exclusion of $250 thousand, or $500 thousand for a married couple. Home ownership doesn’t work like other investments. It works better. If you buy a house for $200,000, and then manage to net $450,000 when you sell it many years later, you have a $250,000 capital gain. Normally, Uncle Sam takes a cut of a wealth-gain like that, like 20 percent, or $50 thousand. But as long as certain conditions are met – you lived there 2 out of the last 5 years – then that entire $250 thousand gain is yours to keep, tax free.
In the bad old days – before 1997 – Congress only let you do this tax trick once in a lifetime. Since then, however, you can do it over and over as much as you like. Now doesn’t that make you love Congress more? Congress is WAY better than cockroaches, traffic jams, and Nickelback, even if it consistently polls worse.
By leverage, I mean that middle class people can’t normally borrow four times their money to buy a valuable asset. If you experience home inflation, that borrowing juices your return on investment in an extraordinary way.
Please forgive the oversimplified math I’ll use as an illustration of leverage: If you invest $50 thousand as a down payment and borrow $200 thousand for a home, and then the home goes up in value by 10 percent, what’s the immediate return on your investment? Hint: The answer isn’t 10%.
If you managed to sell your house with a 10% gain in value, you’d clear $75 thousand after repaying your loan. If you invest $50 thousand in a thing and net $25 thousand on that thing, you have a 50% return on investment. That’s the power of leverage.
When you combine automation, tax advantage, and leverage, you have a powerful wealth-building cocktail from home ownership.
Ready for the cold water to spoil your mojito? Home ownership as an investment can also go terribly wrong.
I was thinking of this recently because I checked a personal finance book out the library that has aged very badly, David Bach’s The Automatic Millionaire Homeowner.
Published in 2005, a few years before the 2008 Crisis, Bach’s book is a combination of good advice, like I reviewed above, and terrible advice.
Bach urges people with weak credit scores to check with their banks about alternative mortgages specifically tailored to them. Bach also describes in detail the opportunities for prospective homeowners to purchase with just 5 percent or 10 percent down, or even “no money down,” rather than seek the conventional 20 percent down-payment mortgage. Bach describes without apology the idea that your house could increase in value by 6 percent per year, every year for 30 years, turning your $200,000 starter home into something worth $1.1 million. In fact much of the book reads, in retrospect, like an excited exhortation to flip one’s way from a starter home to a millionaire mansion through risky mortgages, low money down, and price appreciation as far as the eye can see. Needless to say, that isn’t the way to do it.
I’m not saying low down payments, or buying with weak credit will always go wrong and should be forbidden. I’m just saying that, given what we experienced a few years later, we know it will lead to tears for many. And I’m not saying your house won’t appreciate, I’m just saying that a more normal annual price increase like 2 percent – in line with inflation – is a much better bet.
Good personal finance books are evergreen, and that one isn’t. If you want a good one however, may I suggest Bach’s excellently readable and important The Automatic Millionaire, in which he extols the concept of automating savings and investments, a key for most middle-class people to build wealth over a lifetime.
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