Purchasing a house is one of largest and most important transitions in your lifetime. It can also be one of the best investments you ever make. Peter Lynch is famous for saying: "Before you do invest anything in stocks, you ought to consider buying a house… in 99 cases out of 100, a house will be a money-maker".
Before you stop reading, citing the sub-prime mortgage crisis as the greatest financial crisis since the Great Depression, take a moment to review these figures.
- You get to leverage yourself 500% by putting only 20% down on a mortgage.
- No margin call on your levered bet.
- Interest payments on your mortgage are tax deductible.
- Local tax payments are deductible from federal income tax.
- Tax credit programs for households under certain income levels (surprisingly generous levels, up to $90,000 in many areas).
- Non-taxable capital gains on your investment (certain rules apply).
- The price of your house will NEVER go down!!!
Yes, number 7 was said in jest, but all other reasons are very real, very beneficial reasons to purchase a home. The federal government is practically begging you to buy a house with the gigantic tax loopholes that they parading around your feet for you to jump through. Let's do a quick hypothetical:
Let's assume your household makes $65,000 a year and assume a worst case scenario, meaning you live in California and have to pay a 12.3% state income tax. After all taxes, federal withholding, social security tax, Medicare tax, SDI (don't ask), your monthly take home pay is $3,710.32.
With this income, given a 30-year fixed rate mortgage at 3.92%, you can afford a $300,000 house/condo making monthly payments at 40% rate of your monthly take-home pay. Your down payment (initial investment) of 20% would be $60,000.
For the first year, if housing prices increase 2.6% (National US Zillow Home Value Forecast, California is expected to be even higher), your return on investment is:
Home Appreciation: ($300,000*.026) = $7,800
Tax Deduction on Mortgage Interest (25% tax bracket) = $9,408*.25 = $2,352
Tax Deduction on Property Tax (25% tax bracket) = $3000*.25 = $750
Mortgage Tax Credit: $2,000
Mortgage Interest: $240,000*.0392 = $9,408
Property Tax: $300,000*.01 = $3,000
Return: $494/$60,000 = 0.823%
You have essentially broken even. You get a 1% annual return and have the prospect of appreciation in your house, but you have locked in an investment of $60,000 for 30 years and have significant opportunity cost. However, we still need to add another element to the equation. You just lived in your house rent free for the entire year! If we assume that rent is 40% of your take-home pay, that would come out to $17,819.14 per year. Plug that into your return figure:
Total (with cost savings): $494 + $17,819.14 = $18,313.14
Return (with cost savings): $18,313.14/$60,000 = 30.52%
Of course, this return figure isn't a true 30.52% return on your investment because you aren't earning $17,819.14, per se. But the money that you sink into rent is an unavoidable cost unless you want to be homeless, or live in your parent's basement.
Housing prices have never decreased since 1969 with the exception of the great recession and financial crisis which was triggered in early 2007. However, starting in early 2000, we can see a point where the linear relationship between housing prices and time begins to break down and a classic hockey puck begins to form. This can be attributed to the easy monetary policies put in place by Greenspan (low interest rates) after the tech bubble burst, which eventually developed into overly lax lending policies, and subsequently, over-securitization and under-collateralization of the mortgage-backed securities and its respective derivatives markets.
This eventually led to the financial crisis. What followed was an unprecedented drop in housing prices and accompanied by a steep incline in unemployment rate.
From the chart, it is evident that past unemployment spikes did not have a large impact on housing prices. The inverse relationship between housing prices and unemployment can be attributed to a financial crisis that was driven by a meltdown specifically in the mortgage and housing industries, not a general economic downturn.
It is worrying that historical prices are once again approaching pre-housing crisis levels. However, if we take a look at housing prices relative to household income and rental prices (ratios are plotted below), we will see that relative prices are still at a healthy level. The charts are encouraging as they show that home prices relative to income and rent are well below what they were right before the financial crisis.
Income can be used as a proxy to gauge housing prices since it is a person's primary means of paying a mortgage. However, income can be a poor indicator of relative risk in purchasing a house since incomes can still stay relatively high in periods of unemployment, and if you are unemployed, then the current income of employed people has no relevance in your ability to pay your mortgage.
By the same thinking, comparing housing prices to rental prices may also be a poor indicator of true risk because rental prices, like mortgage payments (and therefore housing prices) are also set by incomes, and as stated previously, incomes can still remain relatively high during periods of high unemployment. While income and rental prices are not direct relationships, these comparisons are useful in assessing price risk given an individual's employment status.
The following chart shows the decrease in home foreclosures, an encouraging sign of health and sustained prices in the housing market.
As long as asset prices remain high, housing prices should also stay high. Low interest rates and high equity prices force investors to diversify and find other sources of return, fueling capital into alternatives assets such as real estate.
Although interest rates are expected to rise, they are still expected to remain low relative to historical levels. This can be seen from the flattening yield curve and low rates near the longer end of the curve, 3.01% yield on a 30-year T-Bond as of 12/31/15 (US Treasury Department).
The low interest rate environment has the added effect of a lower mortgage interest rate and also lowering the return and increasing the interest rate risk on fixed income investments. Both of these factors make purchasing a home an even more compelling investment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.