Owning your own home is possibly the surest way to build long-term wealth. But since real estate appreciates at about the same rate as inflation over time, many would-be home buyers assume that they will make only as much as the inflation rate on a home purchase. Let’s explore why that’s not true.
Leverage, the Magic of Other People’s Money
Leverage happens when you earn money not only on your own money, but on other peoples’ money. Sophisticated investors have long known this principle, and used it to make millions. Active, wealthy investors are allowed to borrow against their stock portfolio to invest in yet more stocks. If the market goes up, they win double. The average person isn’t allowed to leverage in this way. Or are they?
When you buy real estate, you can put as little as 3 percent of the purchase price of the home as a down payment. (Even 0 percent, if you are a veteran or buying in a rural area.) Only a small portion of the investment is actually your money. You have to pay rent on the rest of the money, in the form of interest, and you have to pay it back, but you are investing the lender’s money as if it were you own.
Let’s say you put 20 percent down on your home, and your mortgage company puts down 80 percent. As the home appreciates, 100 percent of the home appreciates – your 20 percent and the mortgage company’s 80 percent. But you own 100 percent of the appreciation.
That’s a pretty neat trick, but how much of a difference does it really make? Quite a bit, actually.
Don’t let the math scare you; leverage is pretty simple.
Net profit:$11,494$54,968 ROI:3.00 percent10.78 percent
|Without Leverage||With Leverage|
|Down payment:||N/A||$50,000||(At 20 percent down)|
|Loan and purchase costs:||N/A||$2,500|
|Yield/appreciation:||3 percent||3 percent|
|Balance/value after 7 years:||$61,494||$107,468|
|Pay off financing:||$ -||$200,000|
|Less initial investments:||$50,000||$52,500|
Let’s say you are comparing two possible investments. You could invest $50,000 into a high-yield CD, or you could buy a $250,000 home with 20 percent down, and get a first mortgage for $200,000. We assume there are loan and purchase costs of $2,500 on top of the down payment. To make the example simple, we’ll assume the mortgage is interest-only. You’ll keep the property for seven years and then sell it. How do the two investment opportunities compare?
Let’s assume that the CD will pay 3 percent (that’s rare today, but let’s be generous) and your home will appreciate at 3 percent per year. Looking at the example, you can see your investment in the CD is worth $61,494 after seven years, a profit of $11,494. Not bad.
If you have held the belief that your investment in your home will only yield a return equal to inflation, please reconsider, as you are missing out on one of the most powerful investment tools there is – leveraging other people’s money.
But look at what happened to your initial investment in real estate! At 3 percent per year appreciation, your home is now worth $307,468! You still owe $200,000, so you have to pay that off. You’ll net $107,468, which gives you a tidy net profit of $54,968, which turns out to be a 10.78 percent annualized return on your investment.
How did 3 percent appreciation turn into a 10.78 percent profit? You were earning money on the mortgage company’s money. Leverage.
This example is simplified to illustrate the principle. It ignores how your mortgage payment compares with the rent you would otherwise be paying, sales costs, maintenance costs, tax advantages of owning real estate, pay-down of principal as you make payments and the emotional satisfaction of owning your own home. Some of these factors would decrease your return, others would increase it. But if all of these were factored in, the result would be similar.
There are non-financial reasons to buy (or not buy) a home, too, that you should consider. However, if you have held the belief that your investment in your home will only yield a return equal to inflation, please reconsider, as you are missing out on one of the most powerful investment tools there is – leveraging other people’s money.