Here is the worst financial advice I have ever heard:
“It’s better to rent instead of buying a house and then you can invest the difference in the stock market.”
Logic Behind the Advice
Often, this advice comes from someone who has “Run the Numbers” and determined mathematically that you will be ahead if you invest the difference between renting and owning in the stock market, instead of investing in real estate. This advice is even more popular in a dropping real estate market, like we have right now. On the surface, this argument may sound convincing. If the historic returns of the stock market exceed the historic return of real estate in your area, then why wouldn’t you be ahead?
Errors & Omissions
Invariably, this bad advice is based on a number of important factors, which have been naively or conveniently omitted. Factors such as leverage, taxation, inflation, appreciation and local market conditions all play a huge factor in long-term investments and they usually benefit the investment in real assets over financial assets.
It’s easy to point out housing markets like Detroit or Philadelphia and argue that real estate is a bad long-term investment. The same could be said for the people who recently bought in market bubble areas, such as Florida, California and Nevada. But, if you look beyond these special circumstances and consider the overall market from a long-term perspective, real estate has consistently outpaced inflation and will likely continue to do so well into the future. Barring some spectacular catastrophe in the economy or the population, there will definitely be a future demand for prime American property.
Death by Taxes
Everyone’s tax situation is different and the interest deduction from a house will vary greatly, based on your income and deductions. One thing is fairly certain; your tax benefit from purchasing a property will greatly exceed your renter’s credits. And, since you pay for housing in post-tax dollars, you will have to earn $1.30-$1.50 of income for every dollar of housing costs. So, why pay extra taxes to the Government, when you can invest it in your house or some other worthy goal.
Interest & Inflation
Interest and inflation may seem like a small percentage, which doesn’t add up to much. But, over the course of an adult lifetime, they can compound into a significant factor. It’s been my experience that rent and housing costs seem to double every 10-15 years.
Soon after you buy a house, a couple of magical things start to happen. First, your mortgage payment stays roughly the same, while everybody else’s rent keeps going up. Second, your interest expense keeps going down, and more of your mortgage payment goes back into the principal. This assumes that you get a good fixed mortgage and you don’t keep refinancing your house. As time goes by, inflation and interest start to work in your favor, because your house is gaining value at the same time your loan is shrinking.
Retiring in Style
Nothing in the financial realm terrifies me as much as paying rent or a mortgage from a fixed income, when I retire. The real goal of buying a house should be to pay it off completely before you reach retirement age. Then, you can retire in style and spend your housing money for recreation. You may still have to worry about your property taxes and insurance going up, but that’s nothing compared to the future price of rent.
I can almost guarantee you that anyone who has supposedly “Run the Numbers” hasn’t calculated how big of a nest egg it will take to pay rent fifty years from now after getting taxed on the proceeds from their IRA account or 401K plan. And if they have, I would be very curious how they calculated the future cost of rent.
I’ll make it easy and “Run the Numbers” for you. I’m 43 years old and live in California. My retirement age is 67, which happens in the year 2032. Estimating that rents will almost double twice in the next 24 years, rent will cost around $6000 per month for a small apartment. That means rent will cost $72,000 per year after taxes, so it will take $100K in income, just to pay the rent. And then, the cost will almost quadruple again, during my life expectancy. If you are younger than me, then it will cost you even more.
The Bottom Line
The bottom line is that bad financial advice is everywhere. Many people weren’t taught sound financial principles nor do they have the discipline to stick with a financial plan that makes sense. People working in the mortgage, real estate or financial services industries, may have an incentive to recommend products or investments that benefit themselves and their employers, instead of you.
Any financial advice that is based on convenience, risk or gratification probably isn’t going to work out too well. Stick to the proven methods of building wealth and you will be rewarded in the future.