Two weeks ago I promised to introduce you to my good neighbor, Jim. When we bought the house we’re living in now (hey, I like to practice what I preach, what can I say?) we discovered the back fence has a gate leading to the two neighbors behind us. And it didn’t take long for them to introduce themselves and invite us over for a drink — about two or three hours, if I recall correctly.
They are great people and we soon became friends, even though they are of diametrically opposing political and religious views and they don’t care a hoot about the Broncos. Who said you need things in common to be friends?
What Jim and I have in common, though, is our views about money. Beneath his bonhomie and down to earth veneer, he is a smart man. Retired now, he managed to become the quintessential “millionaire next door,” despite only earning an average income from an average corporate job all his life and raising several children.
His secret? Actually, he claims he has four:
- Never move
- Never divorce
- Never stop investing
- Never buy anything you can’t afford in cash
We can argue about all of those pointers, and no doubt some will be tempted to take up the cudgel on a few. His first point, though, is a serious one, and that’s our focus today. It often goes by a different name:
Every time you buy or sell an investment, there is a cost associated with that transaction. That’s what transaction cost is.
When you buy stocks or bonds you pay a broker a commission. Likewise, every time you buy or sell a property, there is a real estate broker standing with a hand out to collect another commission. Through competition and technology commissions on stock and mutual fund transactions have dropped — if you are paying more than $10 a trade, you’re doing something wrong. So the transaction cost of switching out stock investments has become trivial.
That hasn’t happened in the real estate world just quite yet. The typical cost of a real estate sale is something like 6% of the property’s value. On the $200,000 home in our example, that amounts to $12,000.
Well, you might argue, that’s steep but hardly the end of the world. Whip out your smartphone and think again, buddy, this time with a little key tapping on the calculator app — the only way to think when it comes to money.
Your down payment in our example was, what? $40,000, let’s say. That’s your entire investment, right? So if you decide after a year the avocado toilet bowls are simply too ghastly to stay in the place and you decide to sell it, you are incurring a transaction cost of $12,000… which comes straight out of your equity. You just lost 30% of your investment… and that’s before you add in the thousand or two (at least) for the actual move!
This is not the way to make your money grow. Smart people stay put.
Your home doesn’t need to be perfect. Jim and Eileen have lived in their house for more than 30 years… and they have no plans to move now. When they were raising their kids they felt pressure to get a bigger place, and now the kids are gone they are tempted to get a smaller place. Jim’s hatred of transaction costs, though, has kept them from caving to those temptations. And helped him become a millionaire.
It should stop you, too… if, that is, you want that investment in your home to be a true success. But that’s not all — there is another reason to think not twice but a hundred times before selling:
Your mortgage is that miracle working thing called leverage. But it has a finite shelf life of usefulness. The whole idea behind your lifetime program of investing is to reach a date, about 30 years from now or so, where you can segue from making your living from your labor (your job) to making your living from your capital (your investments).
Your biggest expense is housing. Therefore, one of the biggest variables as to when you can stop living from a job and start living from your investments is the day you no longer have to pay rent. The sooner that day comes, the better off you will be.
When you sell your home and buy a new one, what usually happens is you get a new mortgage… and the clock starts ticking all over again on that period you have to wait till you achieve that financial freedom. Generally, that’s a bad thing. Yes, we all say when we buy that new place we will go for a 25 or 20 year mortgage so the overall time to retire doesn’t change. But you never reckon with the persuasiveness of those brokers. They make more money on big and long mortgages, and so they will pressure you into taking out a new 30 year mortgage. “Just think of the extra $200 a month you will have to live free and easy.”
Far better to stay where you are and be very, very, very sure it’s a good deal before exchanging one home for another. And when you do, arm yourself ahead of time to keep the total elapsed time on your mortgage the same as where it was on the original home (or shorter, of course). Next week’s post will delve into the whole exchange issue more.
When you rent, that pretty much is your total housing budget, except for stuff like utilities. When you own, though, that is a horse of an entirely different color. There is no end to the things you will spend money on.
The obvious, of course, is maintenance. The older your home, the more you will spend. An owned home needs to be repainted every few years, inside and out. It needs wiring work done more frequently than you want to. You will replace the furnace at least once, and possibly the AC unit, if you have one. Carpets don’t last forever, and neither does your taste in countertops and cabinets. None of those costs are in a renter’s budget, and that is one of the reasons people who advocate renting get so adamant about it — and they have a valid point. What will those maintenance costs be for you? It’s impossible to predict them, but you can count on something like $5,000 a year, it seems to me. Some years it will be more, others less, but it’s a budget item and you need to work that into the cost of owning your own home.
But apart from maintenance, there are many other costs which are optional, but through some force of the universe as yet unidentified, they end up being inevitable. When we bought our home, it had a maple tree in front. It died last year from who knows what, so we had to open the old wallet to get it extracted. Extricating a 20 year old hardwood tree is not for the faint of budget (note: the picture is ten years old, so the tree was a lot thicker and bigger when it croaked). The process reminded me an awful lot of a wisdom tooth extraction: a lot of cutting and digging and mauling, fussing and cussing trying to dig out the roots… until we had to stop the meter, which kept running. This year we are spending more money on a new tree to replace it. (A cheaper sort, to be sure.) Chaching. Why not save the money and leave the front tree-less? That’s that mysterious force of the universe again, this time disguised as certain people in the household love the look of a tree in front, so a tree in front has to remain a feature.
If we rented, that would not have happened.
Then there’s the interior. When you rent, you set yourself a low standard of what is acceptable. When you own, that mysterious force in the universe makes that standard go way up for some reason. You see a wall in a pastel shade of light green in a movie or magazine, and now it’s a trip to Home Depot to load up on a few cans of pastel green paint. Chaching. Either you DIY and paint the place or, if you’re un-handy like me, you open the wallet yet again and get someone.
The drapes you had when you moved in are guaranteed to not fit the windows you have now. And of course what you have is no longer available, so you have to get all new window coverings. Chaching. Then, right after you finished, you get a coupon in the mail for blinds that go up with an electric motor so you can lie in bed and raise them to see the beautiful Colorado sunrises we always get. Chaching.
It never ends.
Most of what you spend money on with your own home is optional — let’s be clear about that. But spend you will, because our homes express our personalities more than anything else, and we spend more time there than anywhere else (even if it is only sleeping). So just know you will be spending more money in a home you own, as opposed to rent. But, in return, you will live in a place which is nicer. It is a bit like saying a Bentley is a much more expensive car to own than a Corolla, but it is so much nicer to ride in. Just know that “nice” will take away from your retirement.
And so, even though owning your home is a good way to get to the day you can be financially independent, just know it comes with its own traps. Each trap postpones the day of your financial independence, but at least you live in a nicer place while you wait. 🙂
If you know there is a good chance you will move to a different city, for job, family or marriage, the transaction and other costs should make you think twice about buying because the transaction cost involved can take an enormous bite out of your equity, even when it doesn’t feel like it.
Unless, of course, you plan to turn the home into an rental investment. That’s a topic we will get to in the not too distant future.
But moving, and its accompanying transaction costs, can put a serious dent in the attractiveness of owning your home as investment. Therefore, be careful.
Next week we will take a look at the economic cycle and its impact on owning your home as investment.