Timing is everything when you buy your first home, as we saw last week. If you already own the home you live in, you might be tempted to yawn, close the post and go looking for popcorn.
Millions of people who already own homes are making a terrible mistake today, as we speak. I see it when we go for a walk down our street (without our now deceased beloved doggie).
Why? Because they don’t understand that timing is everything even when you trade one home for another.
How? Two ways:
- The delusion of wealth from your growing home equity
- Making the wrong trade at the wrong time
[Buzz word alert: all transactions are called trades as a generalization, to encompass both buying and selling. Because all investing consists of is buying, selling and holding. Oh, and collecting income along the way, of course. So, when we talk about your home as investment, we use the generic term trade for either buying or selling.]
The Home Equity Illusion
We have a gate in our fence to the two neighbors in the back (which gets used often), and an active block party group in the front, but I know not everyone is quite that social with their neighbors. Nevertheless, when home prices in your area are going up (as they are in most of the country these days) you don’t need to be that social for word to spread throughout the neighborhood.
Be honest: doesn’t that feel good? You can’t help but feeling rich, can you? On the other hand, when you see the value of your home dropping it makes you feel exposed, threatened, unsure and, yes, poorer.
Both, though, are illusions. The economy giveth and the the economy taketh away, as every Drop Dead Money reader knows.
These days home prices are on the high side, so let’s talk about the illusion of wealth those prices bring.
Let’s say you bought your first home for $200,000 some time ago. With inflation, the economy and whatnot, you just learned your home was worth, say $300,000. Your mortgage is down to $120,000 so your equity is ($300,000 – $120,000 =) $180,000. You can’t help it: you begin to feel rich. And that feels nice.
You see your neighbors leaving like rats off a sinking ship as they grab that increased equity and buy nicer homes in “better” neighborhoods. They call that an upgrade. They even invite you to the housewarming, from which you can’t help leaving green with envy. Why can’t you have a nice house like that, too? Didn’t you also have that nice bump in your equity?
You can, of course… but it’s definitely not a smart thing to do.
Here’s your problem: after you sell for $300,000 and pocket the lovely $180,000 equity, you have to buy something else — you have to live somewhere. If you buy something equivalent to what you sold, it will cost you $300,000. Now remember: that home you’re buying was sold for $200,000 when you bought yours. (They’re equivalent, remember?) So you gain nothing by the trade… and you lose a ton because of the transaction costs we talked about last week.
Key point: don’t ever think you can sell a high-value house and buy a low-priced house at the same time. The same market which lifts your price will lift the price of the place you buy. It’s funny when you think about it, but most people, when they do the trade-up thing, unconsciously think theirs is the only home that went up in value; the home they’re buying is still stuck at the low price they paid when they bought theirs. I’ve not met a single uptrading person who admitted that the home they bought was as inflated as the one they sold. The illusions we love to adopt for ourselves…
So, if you do what your fleeing neighbors did and buy a more expensive home (trading up), you only end up with higher mortgage payments, more debt and a smaller margin for error. (My wife will also have you know that now you have more square footage to keep clean every week.)
What’s the smart move in times like these? As my millionaire next door told you last week: don’t move. If everyone wanted to really be a millionaire and do like Jim says, there would be no real estate agents… and we know there are millions of them. Everywhere. Like ants.
Trading Up Or Down
People move. All the time. They just do… especially in times like these.
Okay, so let’s look at the math, starting with trading up. Let’s say you look around and find:
- $250,000 is your current home value (your “now house”)
- $350,000 is the price of the house you’re eyeing (your “new house”)
(The principle is the same, regardless of the actual numbers, so don’t worry if these are not your exact numbers.)
At the bottom of the recession, the prices for both houses were lower than what they are now. For the sake of argument, let’s say at the bottom of the recession your “now house” was worth, say 10% less than today. The house you are eyeing (the “new house”) was also worth 10% less than today, not an unreasonable assumption. So, at the bottom of the recession
- $225,000 was the value of your now house
- $315,000 was the value of the new house
To complete the picture, let’s say in a few years, when the market hits its new peak (as it always does) your house will be worth $325,000, which is 30% more than today. (Again, actual numbers don’t matter – the principle holds true, no matter which actual numbers you use.)
Here is a table which summarizes our scenario:
The amounts in blue show how much you will be paying for that upgrade.
- If you upgrade at the bottom of the recession, you will pay $90,000 more.
- If you sell the same home when prices are high and your equity cup runneth over, and buy the same new one, you will be paying $130,000.
Upgrading in the recession will add $40,000 (in this example) more to your net worth by the time you retire. Likewise, indulging your fantasy when times are good will flush $40,000 from your net worth. Same house sold, same house bought. Very different dollar amount you pay.
The only difference is the date.
Trading down is the exact opposite.
So, in summary:
- The best time to trade up is in a recession when prices are low.
- When prices are high, the best move is to trade down.
Timing is everything, you can see, not only when you buy your first home.
This may simple, but it is not intuitive. None of us like to sell our house for way less than what we think we can eventually get for it, and all of us feel good selling something for a profit. So trading up in a recession will never feel like the right thing to do. Likewise, trading down when prices are high also will feel counter-intuitive.
Welcome to one of the universal truths of investing: quite often the smartest moves are counter-intuitive.
Timing Is Everything
Remember how we said earlier the only reason a home’s price goes up is inflation?
The only variable in inflation is the date.
So, by extension, whether you are a first-time buyer or already own a home, the date you make your moves is one of the most important variables in the equation that is your finances. Timing is everything when you deal with an asset whose value is only affected by inflation.
The feeling of wealth when you hear your home has gone up in value is a delusion. Ignore it. You can’t tap into that wealth by selling, because you will need another roof for your head. Oh, and do not even think about tapping into that illusion with a home equity loan — much better to drown yourself in a bath of chocolate: death comes quicker and it tastes a lot better. Sorry to be a wet blanket.
But fortunately there’s a dry blanket side to this. Now you know how to turn the fluctuations in home values to your benefit, instead of having them destroy your net worth.
Your first home purchase pretty much “locks you in” to the home market. The earlier you buy, the better off you are. And picking a good entry point cements your good financial fortune for the rest of your life. But, as time passes, and you absolutely, positively, have to trade up or down, you know how to do it in a way which adds to your net worth.