Lots of people think buying a house is a good investment — in fact, many American households have a lot more money invested in home equity than in the stock market. But a lot of economists think people are making a mistake. George Mason University economist Alex Tabarrok is the latest to make the case that housing is overrated as an investment.
Tabarrok sees two big problems with viewing your home as an investment vehicle. First, stocks tend to go up in value and pay dividends; homes often don't. And second, buying a house "locks people to location, making it harder to move for jobs." Many people who bought homes in Detroit in the early 2000s, for example, wound up laid off and with an underwater mortgage.
But both of these arguments are weaker than they seem. And they ignore a huge psychological benefit of homeownership. Obviously, buying a home isn't for everyone. But if you have a financially stable job and expect to live in the same area for more than a decade, buying a house is usually a savvy financial move.
Houses are a pretty good investment
Tabarrok and other economists like Robert Shiller argue that houses don't have a great financial track record. And if you just look at house prices, that's true. The value of houses did go up a lot between the mid-1980s and 2007, but if you look at the past 120 years — including down periods like the Great Depression — home values haven't increased much faster than the rate of inflation.
But that doesn't mean houses aren't a good investment. The return on any financial investment comes from two factors: price appreciation and dividends. Some stocks make money for investors by quickly increasing in value. But others generate returns by paying out generous dividends.
And while it's true, as Tabarrok writes, that houses don't literally pay out dividends, they do something even better: If you own one, you can live there rent-free. That housing has real cash value, because it means you don't have to pay rent to live somewhere else.
How valuable is this de facto housing dividend? It depends on the house and the state of the market, of course. But take my personal situation as an example. If I were renting my Washington, DC, house instead of owning it, I'd be paying roughly 5 percent of its value in rent each year. So in effect, owning a house provides me with a housing "dividend" of around 5 percent of the home's value (minus maintenance costs, taxes, insurance, and other expenses, which in my case adds up to around 1 percent of the home's value). That compares favorably with the stock market, where companies pay annual dividends worth only about 2.2 percent of the stock's value.
Of course, it's true that stocks do appreciate in value more quickly than houses, so the overall rate of return on stocks is probably higher than the rate of return on housing. On the other hand, house prices are a lot less volatile than stock prices. An inflation-adjusted rate of return of around 4 percent — with very low risk — makes housing a pretty attractive investment option.
Finally, the tax code provides huge advantages to homeownership. The interest you pay on a home mortgage is tax-deductible. If you sell your house, the appreciated value of the home is exempt from capital gains taxes up to $250,000 (and twice that for married couples). And whereas you have to pay taxes on stock dividends and bond interest payments, there's no taxes due on the free housing you get as a homeowner.
The value of these tax advantages depends in part on your income, but generally speaking, the wealthier you are, the better deal it is to buy a house.
Homeownership hedges against economic instability
The second big argument against owning a house has to do with diversification, a fundamental principle of good investment. That's the idea that you shouldn't put all of your eggs in one basket; instead of putting all of your money into one hot technology stock, you should buy a broad portfolio of stocks — such as the S&P 500 index of 500 large American companies. That's because the value of any single stock fluctuates more than the market as a whole, so buying a broader portfolio allows you to get the same high returns at lower risk.
Buying a huge, illiquid asset like a house seems to fly in the face of this principle. If you have the bad luck to buy a house in a declining neighborhood — or at the peak of a housing bubble, like in 2007 — you could wind up having your home equity totally wiped out. So, the argument goes, it might be better to keep renting and put the down payment in a broad stock market portfolio.
But this ignores a crucial fact about human beings: If we don't own a house, then we have to pay rent every month. And rent is itself highly volatile. As renters living in a high-cost area will tell you, one of the biggest fears is that rents will rise faster than their incomes, pricing them out of a neighborhood they love.
In Wall Street lingo, everyone is born with a short position on housing. From this perspective, a house isn't a risky bet on the housing market. Rather, it's an insurance policy against the volatility that everyone faces if they don't buy a house.
Of course, there's some truth to Tabarrok's argument that buying a house makes it harder to move to a new city if a regional downturn hammers the local housing market and the job market simultaneously. But the significance of this factor depends a lot on your situation.
If you're an autoworker in Detroit or an oil worker in Houston or North Dakota, you should think twice before betting your family's nest egg on a house. But other jobs aren't like that. If you're a tenured schoolteacher, a doctor, or an IT professional, you can probably count on having work in any economic environment. And if you live in a diversified economy like New York or Chicago, there's less reason to worry about a decline in any single industry triggering a region-wide housing meltdown.
And once you get married and have a family, moving to a new city becomes a lot more difficult anyway. Even if you get laid off, your spouse's job, your children's education, your church, and your social life are all going to be tied to your current location. While young people often job-hop to a new city in search of opportunity, this becomes less and less practical as people get older.
And once you reach retirement, your livelihood likely won't be tied to the local economy anyway. Your Social Security checks and 401(k) earnings will be the same no matter where you live. So locking in a predictable cost of housing is far more important than preserving the option to move to a new city.
Homeownership forces you to save
Ultimately, the most important advantage of buying a home has more to do with psychology than financial considerations: Buying a home is an excellent way to force yourself to save a few hundred dollars every month.
Suppose you're paying $1,000 in rent and you calculate that buying a similar home would cost $1,400 per month (once mortgage insurance, taxes, maintenance, and other costs are factored in). In principle, it should be possible to continue renting, put the extra $400 per month into an IRA, and wind up with a substantial nest egg after a decade or two.
In practice, that rarely happens. Unless you're unusually disciplined, you're likely to spend a lot of that $400 per month, leaving you with little or no extra savings. But once you buy the home, you have no choice but to find the money to make the mortgage payment every month. And every mortgage payment is going to include a few hundred dollars that goes toward paying down the principal on the loan. After 30 years, you're going to own a house — without making a conscious effort to save.
In practice, I suspect this effect dwarfs most other considerations in the renting-versus-buying debate. It's a lot easier to make financial sacrifices for a tangible, short-term goal like owning a home than an abstract, long-term goal like accumulating enough stocks and bonds to retire in your 60s.
Not everyone should buy a house
While buying a house will eventually be a good idea for most people, it's not for everyone at all ages. The big thing to remember is that buying a house and then selling it again costs about 7 percent of the home's value, which in some areas can translate to tens of thousands of dollars. So you should only buy a house if you're confident you'll want to live in it for a long time — at least five years, and probably 10.
If you're in your 20s, single, or have a career that might require relocating to a new city, it may be too early to buy a house. You should also wait if you're expecting a big change in your income soon, or if you're in a particularly volatile job situation — like a Silicon Valley startup or the North Dakota oil fields.
But for most people — especially once they're married and have a stable career — buying a house is an excellent financial decision.