If you’re a potential home buyer, you need to distinguish between two very different things. Ask yourself, “should I invest in real estate or buy a home?” We often justify the purchase of a home by calling it an investment. But is it? While I don’t suggest getting too caught up in semantics, it is important to understand the difference. At minimum, it’s critical to have the right expectations.
Considerations when you invest in real estate:
- Expected rent and assumed increase each year
- Expected price appreciation
- Estimated costs including taxes, insurance, and maintenance
Considerations when you buy a home:
- Where your kids will go to school
- Safety and crime rates for your neighborhood
- Quality of your daily life and time with family
*Special Note: These considerations may also apply to a decision to rent instead of buying. Read the article Home Ownership: Should I Buy A House Or Rent?
While the above is not a comprehensive list, it can be helpful to distinguish between the two. It should also be noted that either of these can be morphed into each other. You could buy a home and years later turn it into an investment. Or, you could invest in real estate and turn it into a home later.
Turning your home into an investment:
While never guaranteed, rents and values tend to rise over time. That means you can have the potential to turn your current residence into a rental down the road and be cash flow positive. This is due, in part, to the low rates. However, you must resist the temptation to refinance and tap into the equity.
Turning your investment into a home:
Consider you invest in real estate and the property is in a desirable location. Fast forward several years and there might be some scenarios where that property becomes your primary residence. It is said that “the only constant is change” and that can certainly be true of our personal lives. Maybe you become an empty nester and you have an investment property that would be a perfect home to downsize.
Putting current interest rates into perspective when you invest in real estate:
Mortgage rates are still historically low and that’s great news for people with a long term time horizon. Granted, home prices have increased significantly over the past few years. This has made it difficult for some first time home buyers despite the low interest rates.
Most people focus on the monthly mortgage payment as it relates to their current budget. While this is important, it shouldn’t be the only consideration. Some loans offer a lower payment but that is usually for a short period of time. Assuming you get a 30 year fixed loan, your principal and interest payment will remain the same, for 30 years. While it may not be the lowest payment available, it offers consistency and the ability to plan further into the future.
Also, there is a huge interest savings over the life of a loan that most folks rarely consider. A $300,000 loan at 4% will cost $215,607 in interest. At 5%, the interest cost is $279,769. That 1% increase in rate equals an additional $64,000 in interest. That is money that could have been saved and invested. For more on the importance of understanding interest rate concepts, read this article Compound Interest: Make It Work For You.
If you have bought a home, it is possible you did so without putting 20% down for the purchase. If so, you likely have Private Mortgage Insurance, or PMI. This is an added cost to your mortgage to protect the lender in case you default. Knowing when and how to cancel this added cost can put some serious money back into your pocket. This article goes into more detail on this subject: Canceling PMI Can Save You Thousands!
If you get a low rate on a 30 year mortgage, think long term. Don’t tap into your home equity like everyone did prior to the crisis of the last decade. Using a home as an ATM machine is one of the behaviors that led many to lose their homes during the mortgage meltdown and subsequent financial crisis. Think of home equity as a buffer against periodic declines in market value. Home equity is a good thing and the more of it you have, the better.
I was quoted in this U.S. News & World Report article titled When Is Buying A Home A Good Investment and said:
“The problem with real estate is that the real money is made over long periods of time and most of us aren’t that patient. If you buy a home and are counting on selling it in 5 years to turn a profit, you might be disappointed.”
Whether you invest in real estate or buy a home, time is on your side. Giving yourself a long time horizon will increase your chances of turning a good investment decision into a great one.