By Keith Whitcomb, RMA®
When it comes to housing, should you rent or buy? An easy way to answer this question is to go online and use a financial calculator that evaluates mortgage payments, closing costs, taxes, insurance, and maintenance. Once your information is entered, a payback analysis will show you the time frames when renting or buying is the “cheapest” alternative.
But is the minimization of housing expense the best way to determine if and when to buy? One problem with this approach is the use of assumptions that can span a 30-year time frame, e.g., inflation, investment returns, tax rates, real estate valuations. Another is the assumption that any avoided up-front home purchase costs will be invested if you rent. That likely isn’t realistic based on NEFE research that found over 50% of surveyed individuals live paycheck to paycheck. And where do quality of life issues enter into the equation? Can you really put a price on the value of owning a home in a good school district when you have a growing family?
Yet beyond these quantitative and qualitative challenges is the failure of the online solutions to account for the financial fact that renting and owning are fundamentally different. Your rent payment is a monthly expense. Borrowing to purchase a home is an investment strategy that can last an entire lifetime. As a result, when answering the rent/buy question you need to understand how a home fits into your long-term accumulation and retirement income plans.
Home - A Complex Asset
A December 2019 Philadelphia Federal Reserve study called housing “a complex asset with properties different from other assets.” That means it’s important for you to understand the multi-dimensional aspects of this investment to determine how it fits in with the rest of your financial resources during your working years. Here’s a quick review:
Shelter – Owning a home means you avoid the net present value of future rent payments. BUT…you have to pay for home maintenance/repairs. Make sure your budget includes these additional expenses.
Diversification – A house is a real asset with gains (or losses) largely driven by your local housing market. This helps offset your investments in stocks and bonds where returns are likely driven by other economic factors. BUT…if the value of your home is significantly larger than the rest of your investments, you may end up being over-weighted in a single asset (your home) and asset class (real estate). If the house is a “buy and hold” long-term investment and you have flexibility on when to sell, this may not be a problem. However, if you have a short investment time horizon or could be forced to sell, e.g., job relocation, this could be a knock out factor.
Disciplined savings – Monthly mortgage payments are mandatory so you methodically increase your equity over time. BUT…this is inflexible and can be burdensome if household cash flow becomes constrained. Having backup emergency funding to ensure ongoing payment if finances get tight, e.g., loss of job, is important.
Leverage – You can buy real estate with as little as 3.5% down. As a result, your return on investment is based off a capital commitment that is likely a fraction of what you would need for other investments. BUT…there is a history of catastrophic outcomes associated with housing debt, often driven by questionable lending practices. High closing costs can also overshadow gains on your real estate if you move often. Buying a home is exciting. Don’t get caught up in the moment and shoe horn your way into too much debt. Just because you qualify for a loan doesn’t necessarily mean getting one is the best move for you.
Liquidity – A Home Equity Line of Credit (HELOC) can give you access to money once you build equity in your home. BUT…HELOC funds are exposed to real estate markets. If the value of your home declines, your credit line may be frozen, i.e., you can no longer draw on the line, or reduced, potentially at a time when you need it most. Make sure you understand terms and conditions, i.e., ongoing fees, interest rates, closing costs, balloon payments, draw period, availability limitations, before you book it.
Tax – There is no tax on proceeds from HELOC loans. BUT…ongoing real estate taxes can be onerous. High property taxes can be a significant drain on your finances and may also constrain a property’s potential for appreciation, e.g., negative impact of the Tax Cuts and Jobs Act capping of Federal deductions for real estate taxes. Locking in a major piece of your investment capital on a home with this burden could be a mistake. If after reviewing these characteristics you are confident that buying a house is in your best interest, today’s historically low mortgage rates are an additional incentive for you to buy now. If you already own a home, this may be an opportune time to re-finance your mortgage or get a HELOC.
Retirement Wealth in the Home
The Fed went on to determine that “without considering homeownership, retirees’ net worth would be 28-44 percent lower, depending on age.” Europeans have also recognized the important role a home plays in retirement. In the 2019 study Making Use of Home Equity: The Potential of Housing Wealth to Enhance Retirement Security, it was noted that, “building up housing wealth through home ownership and mortgage repayment is by far the main way European households set aside for old age. In the Euro area countries, the household's wealth (excluding pension wealth, the present value of all future expected pension benefits) is primarily held in the form of real assets, which represent 82.2% of total assets owned by households…” So how should you integrate housing into the rest of your retirement plans? It may make sense for you to harvest capital gains on real estate and move to a more economically friendly location. Let’s take a look.
Long-term tax-free gains – In general, there is no tax on the gain from the sale of your home if it doesn’t exceed $250,000 ($500,000 if married filing jointly) and you have owned it for at least two years (see IRS Publication 523 for additional details). In some ways, this is similar to a Roth account; after-tax money is invested, it grows tax free, and withdrawals are tax free. Of course, to sell your home, you usually pay a real estate agent a five or six percent commission. While technology may be reducing this expense, e.g., UpNest and Clever, this fee is like a tax on the entire proceeds from the sale. However, even with this drag on performance, your home may still perform well when compared to other taxable or tax advantaged investment opportunities.
Location, Location, Location – Like the classic real estate valuation mantra of “location, location, location,” your expenses in retirement are largely driven by where you live. This is illustrated by a table of Regional Price Parities produced by the U.S. Bureau of Economic Analysis. Hawaii is shown to have the highest relative prices in the U.S. with an index value of 118, while Arkansas was listed at 85 (the overall national price level is 100). Let’s face it, if you are using a typical income replacement ratio, e.g., 70% to 80%, based on your current location, you might be over (or under) saving for retirement by 20% or 30%.
Housing is a lifelong need and investment opportunity. Once you understand the financial details of home ownership, and how it functions as a major component of your household “capital structure,” you can proactively incorporate it into your long-term financial plans.
About the author – Keith Whitcomb, RMA®
Keith Whitcomb, RMA®, is the director of analytics at Perspective Partners and has more than 20 years of institutional investment experience.