There are many considerations regarding home ownership.  Some of them are financial and some are psychological.  The comments that follow deal with misconceptions about several of the financial considerations.

Misconception #1:  Home ownership is a good investment.  This is not necessarily true, as indicated by the following excerpts from an article in The Wall Street Journal (12-9-94):

Buying a home is a good idea if you want a house, but it’s shaky as an investment strategy. . . .

Home prices generally increase only at the rate of inflation over the long term. . . .

A house should never be looked upon as an investment.

Excerpts from another article in The Wall Street Journal (8-28-02) provide the following additional perspective:

Think of your home as akin to a stock, one that both generates capital gains and also delivers a dividend.  But in the case of a house, the biggest part of your gain will likely come from the dividend.

If you live in your own home, your dividend takes the form of what economists call ‘imputed rent,’ the fact that you get to live in the house rent-free.

Meanwhile, the capital gain from a house is relatively modest.  [During a 27-year study period], home prices . . . appreciated at 5.8% a year.  That is 1.2 percentage points a year faster than inflation [during that same period].

Now, consider what homeowners have to spend to garner that 1.2%. There are regular home-maintenance expenses, including costly jobs like painting the house, putting in a new furnace and replacing the roof.  These costs might come to 1% to 2% of your home’s value each year.  Subtract maintenance expenses from your home’s 1.2% price appreciation, and your house is likely lagging behind inflation.

Some clarification of this second Wall Street Journal article seems necessary.  The amount of the dividend derived from the imputed rent is cumulative (i.e., it covers the period from the time you move into the house until the time you sell the house).  And when calculating the capital gain (or loss), it is necessary to subtract each of the following amounts from the selling price of the house:

• Total original cost of the house

 

• Selling expenses (i.e., realtor’s fee, if any, plus all other expenses incurred to sell the house)

 

• Cumulative costs of maintenance (e.g., painting, upkeep of heating and/or heating and air-conditioning system, replacing roof, etc.)

 

• Cumulative aftertax costs of mortgage interest and property taxes (i.e., the net costs of these two expenses after deducting the cumulative income tax savings that result from claiming these two items as itemized deductions)

 

• Cumulative costs of insurance on the house itself (i.e., excluding its contents)

Note that the last two items were not mentioned in the Wall Street Journal article, but we believe they should have been; they certainly make a big difference in determining the amount of the gain or loss from the sale of the house.

With regard to thinking of a house as an investment, a Parade Magazine article (5-6-07) concludes,

If you’re looking for the best return, you’re often better off investing on Wall Street than Main Street.  A study by the Fidelity Research Institute found that real estate produced returns above inflation of just 1.35% a year vs. 5.95% for stocks [during the study period of more than 43 years].

Misconception #2: Home ownership is smart because it enables owners to save on their income taxes.  This also is not necessarily true.

First of all, the savings on income taxes may be less than you think.

·        Assume that a family has a combined federal and state income tax rate of about 33% on each additional dollar of taxable income.  Thus, for every three dollars they can deduct for mortgage interest and property taxes on their house, their tax bill will be reduced no more than one dollar. 

• A family that has a combined federal and state income tax rate of only about  20% on each additional dollar of taxable income will receive even less of a benefit.  For every five dollars they deduct for mortgage interest and property taxes on their house, their tax bill will be reduced a maximum of one dollar.

·       However, many families don’t benefit even to the extent indicated above.  That is because they would receive a “standard deduction” if they did not choose to itemize their deductions.  Itemized deductions reduce taxable income only to the extent that they exceed the standard deduction.  The following illustration should help to clarify this point.

Assume that a family qualifies for a standard deduction of $9,000 on their federal income tax return.  Assume also that the family can take itemized deductions totaling $12,000, including $5,000 for mortgage interest and property taxes on their house.  Their taxable income will be reduced only an additional $3,000, not $5,000, as a result of deducting the mortgage interest and property taxes on their house.  This $3,000 is the difference between the standard deduction of $9,000 that they would get anyway and the $12,000 of their total itemized deductions.  Therefore, $2,000 of the $5,000 spent for mortgage interest and property taxes on their house has no tax benefit whatever.

Secondly, even if a family is able to reduce its income taxes substantially due to itemized deductions resulting from home ownership, the tax savings don’t always make the annual cost of buying a home less than that of renting.  The cost of buying includes not only the mortgage payments and property taxes, but also the costs of insurance, maintenance, and repairs.

Misconception #3: Paying off a home mortgage early is a wise investment.  Again, this is not necessarily true. 

From a strictly dollars and cents perspective, it would be wise to decide if the money that would be used to pay off your home mortgage early is likely to earn a higher rate of return if it is invested in some other type of investment. 

The investment return you would earn by paying off your home mortgage early is the percentage of the interest rate that you are paying on your mortgage.  If the rate of interest that you are currently paying on your mortgage is 8%, then that would be the rate you would be earning by paying off your mortgage.  For interest income investments, such as bonds or certificates of deposit, to be more attractive alternatives than paying off your mortgage early, they would need to provide an annual return of more than 8%.

In contrast, over long periods of time, diversified stock investments have provided annual returns averaging roughly 10%.  Also, stocks that are owned for more than one year are taxed at a lower rate than other income, such as wages and interest income.  Thus, when comparing the expected financial benefits of paying off your mortgage early versus investing in stocks, you will need to calculate them both on an aftertax basis.