If there’s one thing that will delay or even stop you from reaching FI, it’s being locked into the large, recurring expenses that only a house can dole out. I owned a house from 2004 to 2012. My experience is the makings of a separate post, but long story short, the place, while modest in size and in decent shape, was still a money sink. The best financial move I ever made was to unload the house and rent a studio apartment instead.

Is FI a priority for you? If so, the most efficient route is to rent a small, comfortable, efficient place for as long as possible, and funnel the savings into your investment portfolio. Remember how compound interest works: it’s the earliest dollars that do most of the heavy lifting. You need to start saving early. If, in your 20s or 30s, you buy a house that soaks up all your cash, reaching FI will likely be difficult. Instead of funneling cash into investments at an early age – money that will compound exponentially over the long term – you’ll be spending it on a pleasure purchase that, if you’re lucky, will appreciate at just over the rate of inflation. All the while spending more and more on the relentless, never-ending expenses of home ownership.

Like a New Pair of Shoes, It’s a Purchase

Buying a house is not an investment, it’s a purchase that, like a new pair of shoes, will (hopefully) give you pleasure over the years, but that’s all. It’ll help if you kill your television, or at the very least, turn off HGTV – that stuff will brainwash you into thinking you need an enormous, custom home to be happy. You don’t. Having a big, custom house is not on the “what makes you happy” list. Nor are new, expensive cars, or having a bunch of stuff.

A Look Through the Investment Income Lens

It helps to view the recurring costs of home ownership through the investment income lens. Remember Sue from this post? She needed $750,000 in her portfolio just to pay her $2,500/month housing costs, assuming a 4% withdrawal rate. Once she downsized – i.e., sold her house and moved into an $800/month apartment – she was at FI and could retire.

Some Considerations

If you’re interested in buying a house, here are a few important points to consider in your evaluation. And be sure to read this brilliant post from Jim Collins before you consider buying a house. It’s a nice counterpoint to the pro-home ownership camp.

The Price/Rent Ratio

Much like how the P/E ratio can provide a rough guide to whether the overall stock market is overpriced or underpriced, the price/rent (P/R) ratio for real estate can do the same. In most markets, don’t buy a house if it costs more than 12 times the average annual rent. For example, if a house can rent for $1,200/month ($14,400/year), don’t pay more than about $14,400 *12 = $173,000 for the house. This pencils out to a 1/12 = 8% nominal return. Net out 3% for taxes, insurance, and maintenance, leaves a 5% real annual income stream. Add a 1% real price increase and you’re looking at a 6% real total return.

Once Again, Total Return = Yield + Growth

It’s helpful to evaluate home ownership in terms of yield and capital gains, the same as a stock. The price appreciation of a home (capital gain) is generally equal to or slightly above the rate of inflation over the long term. This makes sense. If home prices rise more than the average cost-of-living wage increase, then soon everyone would be priced out of the market and there will be no buyers. Most home values generally track inflation, especially if you live away from the coasts. And closing costs, mortgage interest, private mortgage insurance, property taxes, homeowner’s insurance, maintenance, and upkeep will likely wipe out any capital gains of home ownership over the years.

The lesson? Don’t try and make money on housing “capital gains”. This includes significant remodeling in order to sell at a higher price, trading up to an unnecessarily large house, or owning vacation property. There may be intangible benefits to these items, so if you enjoy these things, by all means: just don’t expect it to be a financial winner.

In addition to capital gains, your house also provides a yield. Remember that yield is just the cash flow generated by an asset. When you own a house, you’re both the tenant and the landlord. Your house throws off cash flow each month: it’s what you could have charged someone else to rent your place, except that you’re renting to yourself. It’s called “implied” rent. A little confusing, I know. The takeaway is that you should buy a house that is just big enough for you and your family, and no more. Otherwise, you’re paying too much in implied rent (i.e., you have too much house).

Home Prices Can Fall

Many homeowners learned an expensive lesson during the brutal real estate market of 2007-2012. Home prices can, and do, fall. Most who bought in 2005-2006 are still in a tight spot as prices in some parts of the country fell by 50%, and many of us are still climbing out of the hole.

Leverage Can Bite

Sure, buying a house with borrowed money can leverage your “investment” – you reap the rewards of a percent increase on the entire house price, not just your down payment. But this is only true in the early years of your mortgage, and in a rapidly rising market. And you’re paying mostly interest during the early years, which can cancel out price gains. Over time, your equity builds and your leverage decreases until you have the house paid off and you no longer have any leverage at all. Leverage can also bite – many of us bought a house with no money down in 2006 and suddenly found ourselves tens or even hundreds of thousands of dollars in the hole.

An Illiquid Asset

A house is an illiquid asset. It can take up to six months or longer to sell a house. During the real estate downturn of 2007-2012, this time period increased up to 12 months or more. Some of us had to turn down job opportunities in other cities because we were stuck with a house. Others who lost their job and couldn’t afford the mortgage, taxes, insurance, and maintenance felt a financial squeeze because they couldn’t sell their house. Some were so far underwater, they just walked away.

The Equity is in Your Walls, Not Your Pocket

Your equity is tied up in the house. Most of the time, your equity just transfers from your old house to your new (bigger, more expensive) house, where it’s again locked up in the walls. Until you turn your place into a rental property or sell your place and buy a cheaper one or rent, the only way to tap into your equity is through a home equity loan. For many of us, our home equity is locked up in the house until we die (!), at which time our heirs finally tap into the equity when they sell it or rent it out.

Screaming High Investment Costs

Investment costs are high compared to, say, a stock or REIT index fund, where you pay maybe 0.1% each year in investment costs and can buy and sell shares with a few clicks of a mouse. It costs a lot of money to buy a house (closing costs, inspection, title insurance, etc.) and even more to sell it (final home repairs and upgrades, staging, and realtor commissions). These costs will erode your gains if you’re constantly buying and selling.

A Relentless, Ongoing Drain on Time and Cash Flow 

Don’t underestimate the time and money required to keep a house from turning to dust. It’s called a “money pit” for a reason. Oh, the money you’ll spend! Most of us only focus on the mortgage payment. But expenses such as the opportunity cost of tying up money that could be invested elsewhere, mortgage interest, private mortgage insurance, homeowner’s insurance, taxes, maintenance, upkeep, renovations, remodeling, and higher utilities (compared to an apartment) will keep rolling in year after year, so be prepared for significant ongoing expenses above and beyond the mortgage payment.

In general, taxes and insurance may be in the 2% range, while routine maintenance is in the 1% to 2% range. Assuming 4% total, that’s an average of $8,000 per year on a $200,000 home. Add remodeling and/or renovation costs to these routine costs. Plus, private mortgage insurance and association fees if they apply. And don’t forget the non-routine maintenance. These are the unpredictable, big-ticket items that keep us up at night – replacing a roof, a cracked foundation, new drain line, black mold, termites, etc. Just one of these will quickly drain your bank account. And if you move from a small apartment to a house, be prepared for a significant increase in your utility bills, especially during summer and winter.

And once we buy a house, we fill it with furniture, beds, bedding, televisions, appliances, cooking equipment, fixtures, yard tools, hand and power tools, hardware, and on and on. All this (depreciating) stuff diverts lots of money away from building our investment portfolios.

Home Ownership?

There are good reasons to buy a house, but it’s not a slam dunk and requires some analysis. If you have a stable job, a growing family, and aren’t looking to move any time soon, then buying a house might make sense if you can afford it and it’s a priority for you.

Some advantages to home ownership are: (1) A constant mortgage payment over 30 years. While the mortgage payment in the initial years might be painful, the payment in later years may seem cheap relative to your rising income; (2) Once your mortgage is paid off, the only expenses you’ll carry going forward are taxes, insurance, and maintenance, which may be cheaper than rent; (3) Home ownership will force you to build equity over the years; (4) For married couples, you pay no tax on the first $500,000 in capital gains when you sell your primary residence. The cap is $250,000 for singles.

If you do buy a house, buy just enough house that you can comfortably afford. Put 20% down and use a 15- or 30-year fixed rate mortgage, which are predictable and easy to understand.

Rent?

Renting has gotten a bad rap over the years, yet there are a lot of advantages. You know the “all-in” monthly cost with certainty, at least during the contract period, so you don’t need to worry about the big, unpredictable costs that can blindside homeowners. If the roof blows off your place, just call the landlord. Plus, it’s efficient – I live in a small, quiet, comfortable place with zero wasted space.

Renting is generally cheaper than a mortgage, and you won’t have to pay taxes, insurance, maintenance, and upkeep year after year (after year). With a little discipline, you can invest the money you save in renting and build equity in stocks instead of a house.

You’re also flexible when you rent – if your neighborhood is on the decline, if your office moves across town, or if you need to relocate to another city or state altogether, just give your landlord notice and move.

And don’t buy into the “you’re throwing your money away on rent” argument. What you’re doing is paying someone else to shoulder risk while providing you a place to live. Plus, if you own a house, you’re also “throwing your money away” on closing costs, mortgage interest, private mortgage insurance, property taxes, homeowner’s insurance, maintenance, renovations and remodeling, all the depreciating stuff you buy to fill your house, and maybe association fees, so don’t be so hard on yourself for renting.