Housing prices are dropping.
After a prolonged increase in housing prices, signals are now pointing to a cooling-off period. Instead of home buyers getting excited about this possibility, many wonder if buying a house during a recession is still a wise investment.
While there are some exceptions, owning a home is still a smart financial move for most people. This is especially true if you plan to own the property for at least five years. Here are the most significant reasons you should still make it a priority to purchase a home.
Historically, appreciation in real estate has outpaced the rate of inflation. According to Robert Shiller, an economics professor at Yale University, annualized return on this asset class from 1928-2021 is 4.2%. Compare this with the annualized inflation rate during this same period of 3.08%.
There are years, including 2022, where inflation outpaces real estate appreciation. But when you look at trends over a longer timeframe, the return you earn from real estate tends to be higher.
Another way to look at this investment is in terms of your mortgage rate. If you buy a house and take out a 30-year, fixed-rate mortgage for 5.25%, you will pay this same rate for the entire 30 years. With interest rates expected to remain high for the short term, you are coming out ahead because the interest you are paying is less than the inflation rate.
When the inflation rate falls, interest rates will fall along with it. At this time, you can choose to refinance to a lower interest rate, and still save money.
If you choose to rent instead, the rent you pay may change when your lease is up. For most renters, the lease only covers a 12-month period. According to Redfin
By renting instead of buying, you risk potentially paying more for housing every year instead of keeping your payment stable if you purchase a home.
One important thing to remember when you make your monthly mortgage payment is that a portion of your bill pays down the loan’s principal. In other words, you are building equity. When you go to sell the home, you will get this money back.
Renting, on the other hand, does not build equity. Every month when you pay your rent, you have nothing to show for it other than a roof over your head. If you take out a $200,000 mortgage for 30 years at 6% and sell after ten years, you have accrued more $32,000 in equity.
A major benefit of owning a home are the tax breaks. The two most significant are the mortgage interest deduction and the capital gains exemption. With the mortgage interest deduction, you can write off the interest you pay as it relates to your tax bracket.
For example, if you are in the 25% tax bracket, you realize a tax savings on 25% of the interest you paid. So if you paid $10,000 in mortgage interest for the year, you could write off $2,500 on your taxes if you itemize.
With the capital gains exemption, single filers can qualify to exclude up to $250,000 of the gain from the sale of a primary residence from their taxable income. If you file a joint return with your spouse, you can exclude up to $500,000. This is a massive tax break, and it is one way that people build wealth with real estate.
If you rent, there is no tax deduction for you to claim. There are no tax breaks at all.
In addition to building equity in your home, you also gain price appreciation. As stated before, the average annual increase in real estate values is roughly 4%. Using the rule of 72, you can expect the value of your house to double in 18 years. If you made a down payment of $50,000 and took out a loan of $200,000 for 30 years at 6%, after 18 years, you have built up $77,123 in equity. The overall value of your $250,000 home when purchased has increased in value to $500,000. You now have an investment balance of $377,123 ($50,000 down payment + $77,123 worth of principal payments + $250,000 appreciation) if you were to sell.
Historically, housing prices trend upwards; there have only been a few exceptions, mainly in 2008 and 2019. Therefore, chances are good you will realize an increased value in your home.
The only appreciation you experience as a renter is the annual increase in your monthly rent. There is no long-term appreciation for you to enjoy since you aren’t building any equity.
According to Consumer Affairs, 63% of people are hoping for a housing crash so they can afford to buy a home. Unfortunately, no signs point to this happening. Most experts agree that a crash like the one in 2008 is not on the table.
There are a handful of reasons for this. First, the consumer has a stronger balance sheet today than in 2008. Also, many of the mortgages underwritten in 2008 were of low quality, and not many checks and balances were in place to prevent unqualified borrowers from taking on subprime mortgages. Today, the industry is very different, and there are more restrictions on who qualifies for a mortgage.
Finally, a crash only happens when there are more sellers than buyers. When there are few buyers, sellers have to lower the price to entice someone to buy. But if 63% of people are waiting on the sidelines, a full-scale crash is unlikely. A large pool of people are ready to buy, so any drop in asking prices will result in a flood of buyers, which will actually stabilize prices.
Buying a home has always been a scary proposition. It is a major financial investment as you sign up for a monthly payment for the next 30 years. This is why you see home prices dip during economic downturns. If a person is uncertain they will have a job tomorrow, they are not likely to commit to buying a house.
If you rewind the clock to the 1950s and see that housing prices were much lower, you have to remember that back then, only one spouse was earning an income in most cases. Also, it was challenging to buy a home because of high lending standards. It wasn’t until the establishment of the Federal Housing Authority (FHA) and the Veterans Administration (VA) home loan programs that it became easier to purchase a home.
Still, it was an enormous undertaking to purchase a home. This was even more true in the 1970s when stagflation took hold and interest rates skyrocketed to nearly 20%.
Fast forward to 2008, and the government had to step in again to entice people to purchase homes with the First Time Homebuyer credit of $8,000.
No matter what period you look at, there are always reasons people are nervous about buying a home (in addition to the natural fear of committing to a monthly payment for up to 30 years).
Since real estate is an excellent long-term investment, what more can you do if you already own a home? For starters, you could consider buying an investment property. Not only do you take advantage of long-term appreciation, but as you rent the property out, your tenant pays your monthly mortgage, boosting your return.
Understandably, not everyone is interested in physically owning a rental property — or the work that comes with it. An alternative is investing in real estate through purchasing stocks in companies that correlate to the housing market. Q.ai offers Investment Kits with REITs and other real estate positions built in.
Some people might consider paying extra on their mortgage principal. However, if your interest rate is under 4%, investing the money instead of paying down your mortgage is more intelligent. This is because you can earn a higher return on your money.
The average annual return of the stock market is 8%. If you invest $6,000 a year for 10 years, you end up with $93,872. If you were to pay an extra $6,000 annually on your 4% mortgage, in 10 years you would have saved $69,655 interest. Because your stocks will earn $24,217 more than your interest savings, you are better off investing your money in the market.
There are a few cases when it makes more sense to rent than buy. These all come back to timing. If you are just starting your career and unsure of where you want to live, it doesn’t make sense to commit to a home.
Additionally, if you just took a job in a new city, it is smarter financially to rent for the short term as you figure out where you would want to live over time. At the end of the day, if you don’t see yourself owning a home for at least five years before you sell, you are better off renting and not buying. This is due to the risk of housing prices not appreciating in the short term and all the closing costs you pay when you purchase a home. Your equity, appreciation, and tax breaks take time to get you over the initial hump of closing costs to realizing the benefits of purchasing.
Overall, housing is still a good investment — even with housing sales slowing down. While there is a risk of prices flattening or falling in the short term, do not expect a severe decline like in 2008. And if investing in the stock market is any guide, you know that time in the market is much more important than timing the market. In other words, it is better to invest in the real estate market — even during downturns — than to try to pick and choose the best time to buy or sell.
No one knows when the bottom will occur or when prices will start to rise again. If you don’t want to miss the action, you are better off getting in than waiting.
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