The Financial Paradox of Owning a Home
Most people’s wealth is increasingly concentrated in their home, which is a problem
For the two-thirds of Americans that own their own home, this is both good and bad news. On the one hand, owning an asset that increases in value pushes your net worth higher. On the other hand, housing equity does little to move you towards financial freedom.
In this article, I explain the housing paradox and how to diversify your wealth away from your house and into assets that will lead to financial freedom
Owning a home is the fastest way to join the middle class
Along with starting a business and getting a college education, homeownership has historically been one of the effective means for people to lift themselves out of poverty and into the middle class.
It has become trendy for personal finance writers to stick their nose up at the idea of homeownership. While I agree that there are many downsides of homeownership (many of which I will detail in a moment,) the pendulum has swung too far on the rent vs. buy debate.
While buying a home at any price is a dangerous financial decision, buying at the right price and the right time in your life is the perfect way to begin building wealth.
Owning a home helps build wealth in three ways
1. You own an asset.
As much as I would prefer for people to want to invest in the stock market as bad as they want to own a home, that is not the reality we live in.
The fact is that when many people buy their first home, that house is their first asset outside a checking account.
We have a tendency to overthink things, so let’s keep this simple. If you want to build wealth, you’ll need to start acquiring assets, and the sooner, the better. It’s also an asset that you can pass down to your children one day. We should never underestimate how powerful that is, especially for people who come from a disadvantaged background.
2. Owning a home creates forced savings.
When most people buy a home, they do so by taking out a mortgage. When you have a mortgage, you have a monthly mortgage payment, and that creates forced savings.
While people are generally bad at saving, they are amazing at making their mortgage payments.
Unlike saving for retirement, the consequences of not paying your mortgage are immediate, severe, and often traumatizing. I’ll never forget what a painful experience it was when my parents lose the house I grew up in to forclosure.
It’s easy for us to imagine what it would feel like to lose our home. As a result, most people will do whatever it takes to make their mortgage payments every month.
Every time you make a mortgage payment, a part of that payment goes towards paying the principal of your mortgage. And every dollar of principal payments increases your net worth by a dollar.
3. Home prices have the potential to go up
As demand for housing has rapidly increased over the decades, so have the values of homes. This has made many middle-class workers who own their home wealthier.
While I never count on the price of my home increasing, when it does, it is a pleasant surprise and accelerated the wealth-building process.
There are many people who have become millionaires simply by buying a house and paying the mortgage off over a 30-year period while the value of the home continues to rise.
Three reasons you don’t want your home to be your biggest asset
1. Owning a home is expensive
If you think buying a house is expensive, try owning one.
Here are some of the annual costs you will need to budget for as part of your housing costs.
- Mortgage insurance.
- Property Taxes.
- Necessary maintenance (such as reshingling the roof or fixing a broken pipe.)
- Renovations and upgrades.
- Homeowners Association (HOA) or condo fees
- Utility bills.
- House insurance.
Three factors will determine the amount of your monthly mortgage payment.
- The total amount of your mortgage.
- The interest rate on that mortgage.
- The amortization of your mortgage.
For example, if you had a $500,000 mortgage with a 3% annual interest rate and a 30-year amortization, your mortgage payment would be $2,103 per month or $25,236 per year.
If your downpayment on a home is less than 20%, you will need to pay mortgage insurance. In the U.S, FHA loans require an upfront insurance premium of 1.75% of the value of the mortgage, which is paid at closing, and an annual premium that ranges from 0.45% to 1.05% of the mortgage.
If you had a $500,000 mortgage, you might expect to pay an $8,750 premium at closing and $2,250-$5,250 each year.
Property taxes and annual maintenance costs
As a rule of thumb, you can expect the annual property taxes and annual maintenance costs for owning a home to come in at around 1% of the value of the home.
If you bought a $500,000 house, you might budget $5,000 for property taxes and annual maintenance for a total of $10,000.
In North America, we have a cultural obsession with real estate and home renovations.
Home Advisor’s annual true cost report found that the average homeowner in the U.S spent $7,560 on home improvement projects in 2019.
Condo and Homeowner Association Fees
If you own a condo, you will almost certainly be required to pay Homeowner Association (HOA) fees. HOA fees are used to pay for amenities and mutual costs for property owners in the association.
- In the case of apartment-style condos, HOA fees pay for common areas, building maintenance, and amenities like a gym or pool.
- Detached houses in certain neighborhoods also require HOA fees for amenities like neighborhood gardening or luxury services like a tennis court.
The average HOA fees in the U.S range significantly from $2,600-$6,850 per year, depending on where you live.
In the U.S, the cost of water, heat, electricity, garbage removal, phone, and the internet is around $2,060 per year.
In the U.S, the average home insurance policy premium is $1,445, according to Value Penguin.
2. Lack of diversification
If you spend $500,000 on a house, you unknowingly made a very concentrated investment in a particular asset class (housing) with the value of that asset tied to a very small geographic area (your neighborhood.)
Having the bulk of your net worth tied up in your house is the epitome of putting all of your eggs in one basket.
As fast home prices can rise, they can fall just as quickly, and when they do, your net worth can plummet.
If market conditions change and housing as an asset class begins to lose value or the neighborhood you live in becomes undesirable to buyers, the value of your home could take an unrecoverable hit.
According to research from the St. Louis Federal Reserve, that is exactly what happened to Black and Hispanic households in the U.S during the 2008-2009 financial crisis.
Housing accounted for over 50% of black and Hispanic families' net worth compared to 30% for white families.
In the decades leading up to the financial crisis, gaining access to homeownership helped minority households gain ground in slowly closing the wealth gap.
As this chart demonstrates, two decades of progress was erased in two years when housing prices crashed.
3. Your house can become a financial trap
Home equity does not move you closer to financial freedom in the same way that owning financial assets like stocks and bonds do. The reason is that accessing the equity in your home is very difficult.
If you have a house worth $500,000 and a $100,000 mortgage, you have $400,000 in equity (wealth) in your home. The problem is that to access that $400,000 and spend it on funding your lifestyle, you have two choices.
- Sell your house.
- Take out another mortgage.
Both of these options present obvious problems.
- If you sell your home, you still have to find somewhere to live. That means buying another home or renting.
- Taking out another mortgage adds to your debt and reduces your monthly cashflow.
Both options add to your monthly expenses and eat away at your equity.
Given how difficult it can be to access the equity in your home, if your goal is to achieve financial freedom, you don’t want your house to represent too large a portion of your net worth.
Which is precisely where many people find themselves.
According to data from the Federal Reserve;
- The median value of houses was $185,000 in 2016.
- The median value of financial assets was $23,500.
The value of the average person’s house in the U.S is nearly 8 times the value of their total financial assets, including deposit accounts, retirement accounts, stocks, bonds, rental properties, and business equity.
U.S households are getting wealthier, but a disproportionate level of that wealth is tied up in their primary residence.
Here is the financial trap of having too much of your net worth tied up in your home.
When the value of your home increases so does your net worth. This makes you feel rich. But since the majority of that wealth is tied up in the place where you live, the dream of financial freedom has become nothing more than a mirage.
If you want financial freedom, focus on your “accessible” net worth
Your net worth is equal to the total value of your assets minus the total value of your debts.
As we have discussed, owning a home can help you increase your net worth, but accessing that net worth is extremely difficult. This is the housing paradox in a nutshell.
That is why my primary financial goal as a homeowner is to increase my “accessible net worth.”
Your accessible net worth is equal to your net worth, minus the value of your home.
An example of your accessible net worth
Let’s say your assets and debt were as follows.
- Home: $500,000
- Cash: $10,000
- Retirement accounts $100,000
- Other investments $5,000
Total assets: $615,000
- Mortgage: $250,000
Net worth: $365,000
Here’s how your accessible net worth would look.
- Cash: $10,000
- Retirement accounts $100,000
- Other investments $5,000
Total assets: $115,000
- Mortgage: $250,000
Accessible net worth: negative $135,000
Think of your accessible net worth as your level of wealth you could access if you decided never to sell your home.
2 ways to use your money to increase your accessible net worth
- Pay down debt.
- Diversify your wealth by investing in new assets.
Remember, for every dollar of principal you pay against your debt, you increase your net worth by a dollar.
In the previous example, by paying off the $250,000 mortgage, you would increase your accessible net worth from negative $135,000 to positive $115,000.
While at the same time, investing in financial and business assets can help you diversify your wealth and put you on the path to financial freedom.
Four assets I buy in the pursuit of financial freedom
Many people believe that investing in the stock market is too complicated. People who believe are working under the assumption that you need to be incredibly knowledgable to pick stocks and make money.
The truth that the most profitable way to invest your money in the stock market is also the simplest.
To make money in the stock market, all you need to do is buy a handful of low-cost index funds and never sell until you reach retirement.
It’s beyond the scope of this article to explain what index funds are and how they work. If you want a crash course in index investing, check out this article.
When you buy a bond, you are making a loan to a corporation or a government.
Bonds have a lower expected return than stocks but are less volatile. Depending on your situation, it may be well worth giving up some return on investment to reduce your overall level of risk. This is especially true if you are nearing retirement age or you have a low level of job security.
The best thing about bonds is that they have historically acted as a hedge against stock market crashes. Remember, investing in the stock market is a psychological game.
The only way to lose money investing in index funds is to sell at a loss when the market is down. Having an asset like bonds hold its value during a market crash might allow you to keep calm and not sell at the bottom.
3. Rental properties
Investing in rental properties can help you build wealth in three ways.
- Monthly cash flow from the rent you collect.
- Paying down your mortgage.
- Potential increase in the price of your properties.
However, running a profitable real estate investment involves a lot of time and expenses.
It also presents a diversification issue. If the bulk of your net worth is tied up in your home and rental properties, that means your wealth is directly tied to the real estate market.
If the only asset you own is your house, it probably makes sense to invest in stocks and bonds before buying more real estate.
4. Starting a business
It used to be the case that starting a business required a huge financial and time commitment. This acted as a barrier for many people to try their hand at entrepreneurship.
That is no longer the case.
It’s never been easier or cheaper to start a digital business as a side hustle. For the past three years, I have been running a digital side-business while working a 9–5 job.
Gone are the days were starting a business meant you needed to sell a physical product at a physical location during a pre-determined number of hours.
Selling a digital product that requires minimal customer service provides me the ultimate flexibility to work when, where, and for how long I want.
As I continue to scale up my business, I invest 100% of the profits in stocks, bonds, and real estate, which allows me to diversify my wealth and increase my accessible net worth.
Solving the housing paradox
There is nothing wrong with owning a house. It’s one of the tried and true ways to put yourself on the wealth-building path.
However, given how difficult it is to access the equity in your home, it’s important that your house does not makeup too much of your net worth.
Once you buy a home, it’s critical to begin diversifying your assets and focus on your accessible net worth. There are three ways to increase your accessible net worth.
- Paying down debt.
- Investing in financial assets like stocks, bonds, and rental properties.
- Starting a business.
Owning a home is a great first step to build wealth. The important thing is to remember that it should be your first step, not the last. Owning a home is great, but you will never reach financial freedom if it’s your only asset.
If you want to learn more about the steps to financial freedom, I invite you to enroll in my 4-day free course that blends basic money management with digital entrepreneurship.
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.