The current world financial tsunami started with the collapse of American mortgages. Many people who over-strapped themselves, and bankrupted their families with homes they couldn’t afford believed they were doing the right thing. Their whole lives they were told that a home is a great investment, money in the bank. Now they are learning, a bit too late, that it’s not.
Money, as in money in the bank, by definition must be devisable, portable, and universally exchangeable for the purchase of goods or services. Your home is none of these things.
If you like a home and wish to live in it, by all means buy it, but don’t kid yourself into believing it is an investment. Investments, by definition, generate income or appreciate. Investments also don’t cost you all of your income to maintain or put you into years and years of debt.
The home can be an endless money pit. Your mutual funds may go down in value, but they never ask you to repaint them, furnish or repair them, and you don’t pay annual taxes or interest for the privilege of owning them. Mutual funds, stocks and bonds, all have a ready market available for them which is a mere phone-call away. Any number of external factors may make it impossible for you to sell your home.
In bad economic times, when you have lost your job, or in the face of the current world economic tsunami, you can stop paying into your mutual fund account without any negative effects. But if you stop paying your home mortgage, you lose everything.
When I was working in New York City, a friend called me from the suburbs to tell me that a heavy wind had blown down the awning on her back porch. The damage would cost $2,000 to repair. Later, when a water leak in an upstairs bathroom caused damage to the drywall, more money went out. While the drywall was being replaced, it was discovered that the wiring was also faulty….Money out, nothing in.
On the same morning I checked my investment portfolio online. The storm hadn’t affected it.
For most Americans, their home is the largest investment they will ever make. And people are proud to tell you how much they “made” on their home. But actually, the gains are only on paper unless you sell the home, which they don’t usually do, because they want to live in it. So, it is arguable whether your home is an investment at all. For financial planning purposes, it is not. Now in the face of this new financial crunch, as home prices plummet, do people who haven’t moved out of their homes say they “lost” on their investment?
Buying a home gives people the illusion of an investment.
Once, we went out on a financial planning call to a man, call him Mr. Smith, who believed he was financially ready to retire, at age 51. The minute we walked in the door, his wife begged us, “please tell him not to quit his job.” Obviously this was an argument they had been having for some time, but the mood between them was extremely hostile, particularly since the man had already turned in his two week notice at his job.
“I don’t have to work,” boasted the man. “I am a millionaire.”
We looked at his portfolio and it was only valued at $900,000.
“Close enough for government work,” he said.
At closer examination nearly half of his $900,000 was the estimated value of his home.
“So, where are you planning to live after retirement?” asked my partner, Steve.
“Here, of course,” answered Mr. Smith. “The kids are close by. We love the neighborhood, and we are very attached to the house.”
“So, how will you use the value of your house to finance your retirement?” asked Steve.
Mr. Smith didn’t have an answer. That meant his total net-worth was about $450,000. Half of that was tied up in his wife’s 401K, which they couldn’t draw on until she reached the age of fifty-nine and a half.
Not only would Mr. Smith not listen to our arguments that he was in no position to retire, he actually got angry and threw us out.
Denial is a common emotion when people’s financial beliefs are challenged by experts or when undeniable reality steps in and crushes people’s dreams.
Another form of denial is the profit people claim to make on their house sale, during good markets. “I bought my house for $150,000 and sold it for $220,000, so I earned $70,000 profit.” This is what a proud Mr. Jones told me at a pool party on Long Island. Apart from the fact that he now needed to buy a comparable home in a comparable neighborhood, which would cost him the same money, he had actually lost on his home purchase. When he bought the home there were loan origination fees, closing fees, and other sundries. During the length of time that he was living in the home he was paying interest. And of course, he bought furniture and did maintenance and renovations on his home.
People will go into debt to buy a living room suite or a widescreen TV, kidding themselves into believing that anything they buy for their home is an investment because it increases the resale value of the home. But in reality, resale value is not affected by the presence or absence of a home entertainment center, unless you are planning to include it with the sale of the home.
To know what the profit is, one would need to total all of these expenses and subtract them from the sale price.
Living in an apartment, I was never tempted to buy anything. With the money any of my homeowner friends paid for furniture for a single room of their home, I paid a year’s rent.
When I was doing investment advisement, one of the most common reasons people gave for not wanting to invest in the stock market was that they preferred real estate. “I want something I can see and touch,” they would tell me. If they were those rare individuals who bought rental properties and collected rents, then they were right. There can be huge advantages to owning real estate. But most people aren’t collecting rent, when they claim to be investing, they just meant they were buying a home to live in.
Some of my old-school Italian clients bought a huge house, but they lived in the basement and rented out the upstairs. That qualifies as an investment. The tenant covered the mortgage while the family lived virtually rent free. Then, someday, the family could sell the house, to collect the appreciation, or could just move upstairs, in a fully paid for house.
Sadly, these people were absolute minority of homeowners. Most families chose to live in the main house and rent out the basement. This meant they were paying the bulk of their mortgage out of pocket.
Another friend of mine, Robert, had the forethought to buy a large townhouse in an undesirable section of a major American city ten years ago, when no one wanted live there. Seven years later, the house had more than doubled in value. He sold it, and cleared more than $200,000 profit.
Probably 60% of this number was real profit, over and above what he had spent on renovations, mortgage payments, and other house related expenses. Even with those deductions, his profit was way above what he would have earned if he had invested in the stock market. So, he was one of those rare Americans who actually made real money on a real-estate investment.
But, as is always the conundrum with selling the primary residence, Robert still needed a place to live. Having already done the whole living in the crack neighborhood and waiting for it to change thing, he moved into a better neighborhood, where he bought a much nicer home, worth $1.7 million dollars. He used his entire $200,000 profit as a down payment and began paying $10,000 a month on an interest-only mortgage.
His strategy was to wait till this incredibly desirable neighborhood became even better. At that point his house would double in price, as the first one had. He would sell it at a massive profit and maybe start over again, this time buying a castle.
That was the plan. But in 2008, the US economy slipped into a serious recession. The $1.7 million dollar homes aren’t moving as fast as they did a few years ago. Depending upon how the loan agreement is written, there may be a chance that if the home (the collateral) drops in value, the loan could be called. And he would lose everything.
In the current market, where Wall Street is dropping like a stone, $200,000 would buy a lot of stock. Or, maybe better, $200,000 would buy a lot of cash, which is probably the safest thing to be invested in right now.