Let’s start with a simple scenario.
Family buys a house for $100,000. Let’s assume they’re not in one of the expensive areas of the country for the sake of easier math!
Five years later, the growing family is ready to move on. So they put their house on the market. As house prices tend to increase over time, their $100,000 price tag has now turned into a $150,000 selling price.
“Brilliant!” The family think. “We’re so lucky! Now we can increase our budget for the new house even more.”
So the process begins again. They buy a new house for $200,000. They sell it on for $250,000. They’re increasing their profit every time, and after three sales, they have made $150,000 just by buying and selling their family home.
“Huh?” You might think. “They bought the first house for $100,000 and they sold it for $150,000 – so obviously… they made a profit on it.”
It’s easy to see it that way, and that’s why people tend to get in trouble when it comes to investing in property. They look at the raw price, the simple figure that was at the top of their mortgage contract.
Let’s think about that mortgage contract for a minute. Say their mortgage rate was around 4%, which is about average for a 30-year mortgage. They’re a young family, so it’s a feasible figure.
That means they spent $20,000 on interest over the five-year period that they were in the home.
So now their $50,000 profit has been cut, down to $30,000.
“That’s still not bad! They’re doing well, it’s a good profit and they can reinvest it in their next house…”
We’re only getting started, I’m afraid.
What do most of us do when we move into a new house? We think about all the ways we can change it. Very few of us buy a house, walk in, and don’t touch a thing. We make changes. They might be small – redoing the paintwork or planting new trees in the back yard – or they might be huge changes, like an extension or a completely new bathroom.
“So? Everyone pays that…”
Of course they do – it’s normal to want to improve your home. Let’s say for the sake of argument that they decide to do a few tasks around the house.
“I’m not arguing.”
Neither am I.
“I still want to know what these projects are, of course.”
Aren’t we civil? It’s nice that we can be civil.
Anyway, so let’s take a stab at the kind of DIY that a young, growing family tends to do. We’ll keep it conservative for the sake of argument.
- Bathroom refurbishment: $5,000
- New appliances in kitchen: $2,000
- New carpets: $2,000
“I think I see where you’re going with this.”
So you see that I’m now going to subtract those costs from their profit? Which, let me remind you, stands at $30,000.
“Yes. However, a young family isn’t going to spend more than $10,000 on refurbishments, so that’s where I draw the line. That leaves them with $20,000.”
Indeed it does.
“So they still make a good profit!”
Yes, they have made $20,000 – a good profit, worth $4,000 per year. Not bad when all they have done is live there.
“So… where’s the issue?”
They’ve looked at the raw numbers. They have gone and ploughed extra money into their new home, haven’t they?
Exactly. They have made an assumption based off the raw figure. No mortgage broker is going to tell them to be realistic about their profits. We just don’t factor in the fact that the renovation work we do should be calculated.
This is something that developers and house flippers calculate, of course – but for the general public, for whom our house is a home first and an investment second? We don’t think about it.
That means that you can find yourself over-invested in property. If it goes really badly, you could find yourself in negative equity – a phrase that should terrify all home owners.
“Is there any way to prevent it?”
To an extent, you might not need to.
The reason that the entire world isn’t defaulting on their mortgages is because the market tends to rise. We see the panicked news reports when house prices stagnate, because it bucks the general trend.
So people can ride the fact that they have overestimated the profit they make on each house, because the market is going to go along with them. It’s not the soundest financial tactic – and you should always be circumspect when considering how much profit you really made – but so long as the markets are stable, it does work.
“So it doesn’t matter?”
It does if you are using your house as a retirement fund.
“Who does that? A house is a house. A home.”
Actually, a lot of people see their investment in their home as a crucial part of their retirement plans. The thinking goes along the lines of:
- Invest in bigger and bigger properties to accommodate their family.
- Make a profit on each property, lowering the borrowing costs and thus saving them money every month.
- When the children have flown the nest and they have retired, they sell the existing house and downsize into a smaller home.
- The smaller home – thanks to the continual accrued profits over the years – is then bought outright, so they don’t have to be concerned with a mortgage while drawing their pension.
It is, to an extent. It relies on the housing market to remain stable. People who did this during the last financial crash will have been in for a rude awakening. They were at the point where they were ready to sell their “big” house and downsize… except buyers were nowhere to be found. While the crash was in 2008, it’s easy to see that the recovery has been slow and arduous, so those people may have been waiting awhile.
“They probably have other retirement plans.”
That’s undoubtedly true – for many, their house is just part of their retirement portfolio. But for others? That’s not the case – they’re going to rely on a meager pension which can’t afford to continue paying a mortgage. And it’s a dangerous game. Don’t forget we’re headed for a pension crisis anyway – so even those who have been prudent and spread their investment might be in trouble.
“So how do you tackle it?”
If you’re going to dabble with investment income coming from your home, to an extent, you have to stop thinking of it as a home. You have to stop seeing the raw profit and thinking how great it’s going to be to be able to pick a new home that has got a swimming pool. That’s focusing on the moment, the immediate perceived profit, rather than the future.
Your home can still be your home, of course – but the decisions behind it have to be based on cold, hard cash. That means making some stark choices, and perhaps not pushing for the “home of your dreams” if it stretches your budget to breaking point.
“Is there any way to help this along?”
It depends on how much hassle you’re willing to go to.
One option is to guarantee a higher profit by buying a house that’s in a bad condition and needs a lot of renovation. The renovation might be expensive, but should pay for itself with a higher selling price. A decent example would be that same family doing this:
- Buying a house for $75,000 due to its bad condition.
- Spent $40,000 renovating it up to standard.
- Sell for the aforementioned $150,000
The profit here? $35,000. That’s $15,000 more than with the previous example, and it’s assuming a huge $40,000 on renovations – so it’s perhaps going to be worth more than $150,000 by this point. You could make even more if you know your way around DIY, thus reducing the need for labor costs.
The other option is to look to buy land, which is comparatively cheap. A quick Google suggests you can find an acre of land for $1,000 – which is enough for a huge house and garden. You would then need to spend to build, of course; the cheapest methods would be to source pre-created house plans so you don’t need to hire an architect. The cost of building a house is around $150 per foot, but this varies massively. You could always start small and build extensions and more before selling – and there’s that huge plot of land to attract buyers, too.
“Is it sensible to rely on your house for retirement income?”
Yes – but not as the only source.
Real estate is one of the best investments you can make, and it makes sense to invest in the home you live in. Should it be your sole retirement plan? No – but then again, nothing should be your sole retirement plan. The more diversified you are the more protected you are.
“Good to know.”