Does buying a house stack up financially?

I recently wrote an article on why I’ve chosen to rent for life.

I had some hesitancy in including my email address at the end. My view about housing is personal. I don’t think buying a house is right for me given my goals in life, my personal circumstances and the cost to buy a house in Australia. I have no issue with homeownership. And I certainly have no issue with anyone who buys a home.

But to my surprise, I received an outpouring of emails – most of which were supportive and espoused a similar worldview.

Interestingly these came from both homeowners and renters. They came from all age groups including retirees who had benefited the most financially from homeownership given the massive run up in prices.

In this article I’ll conduct a deep dive into the numbers, and what to consider when deciding whether a house stacks up financially.

What is the source of returns from a primary residence

Many of the people that contacted me had questions about the sources on a primary residence. Here is a brief breakdown of the four components of returns:

1. The “forced” savings from principal payments

Each mortgage payment you make has an interest component and a principal component. The interest goes to the bank and the principal increases your ownership stake in the house.

Many people describe this as forced savings. There are some nuances to this - at the beginning of your loan term the majority of the payment consists of interest. The bank is taking their cut early:

In the first year of a 30-year loan 80% of your mortgage payments will go to interest.
It isn’t until around year 18 of a 30-year loan that 50% of the mortgage payment goes to principal.
In the last year of the loan 97% of the loan goes to principal.

You are building equity when you own a home but it does takes some time. One thing to keep in mind is that as you pay back principal you are deleveraging yourself. This has an implication on your total return.

2. Price appreciation

This is a simple one to understand. If the value of your home increases that is a positive contributor to returns.

3. The impact of leverage

This is by far the largest contributor to returns from real estate.

Any time you borrow money to buy an appreciating asset it will increase returns. Shares, houses, beanie babies – everything. This will happen as long as one condition is met. The asset needs to appreciate more than the interest rate.

4. The cost to maintain your home and sell it

Maintenance costs, interest expenses, taxes and transaction fees will impact your total return. Many people ignore these expenses and only focus on the difference between the purchase price and sale price.

Below is a full example of the returns you can earn on a home given the following hypothetical scenario.

You purchase a $1,000,000 home with a 20% deposit. There is a 5.5% interest rate that remains consistent over a 30-year term. House prices increase steadily at 7% per year. Stamp duty is $40,000 and maintenance is 1% of the purchase price annually. I have not included any transaction costs.

A driver of housing appreciation in Australia is that it has largely been driven by housing becoming more expensive on a wage to price ratio. In 1984 the average house price to average wage in Australia was 3.3 times. In 2023 it is 10 times. In Sydney it is 15.3 times and in Melbourne 12.1. At some point appreciation faster than wages will be unsustainable. We may have already reached that point now.

Therefore, in the next scenario I’ve model price appreciation of 3% a year with all other variables consistent. This is in line with annual wage growth in Australia since 1998.

In this case house prices on a wage to price basis would remain steady at world leading levels. In this scenario we see the impact of an interest rate that is higher than price appreciation.

It is important to point out that both of these scenarios are looking at the financial ramifications of owning a home. You also get utility out of this – you get a place to live. Not buying a home means significant expenses for rents which are not captured in either scenario.

My approach of building wealth while renting

I emphasised in my previous article that my own goals are better served by focusing on cash flow than purchasing a home. I received several emails asking for details on what this looks like in practice.

I am happy to go into detail with the preface that this is simply what I believe works best for me. This does not mean that anyone else should follow my example.

Buying a home requires a large initial cash outlaw to cover the deposit and other upfront costs including stamp duty. It also entails meaningful cash outlays over the course of owning the house for maintenance, renovations, and other expenses that I do not face as a renter.

My goal is to be intentional about my spending and the uses of any financial resources I’ve been able to amass. For me that is directing those resources to pay for experiences and not where I live.

My financial goals largely fall into two buckets.

Bucket one: Retirement

The first is retirement. And I hope to be able to maintain my lifestyle once I’ve stopped working. This was my primary focus when I was younger to take advantage of the compounding effect of tax advantaged retirement accounts.

Readers can use this step-by-step guide to calculate how much they need to retire.

My goal was to put myself on track to meet my retirement needs by the time I turned 35. That does not mean I don’t save for retirement, and it certainly doesn’t mean that I don’t need to save more for retirement. But I did manage to get myself into a position where I was comfortable that I would be able to meet my retirement goals with the compulsory super contribution of 10.5% a year. I’ve stopped trying to maximise my retirement savings through concessional and non-concessional contributions.

This is not an approach for wealth maximisation. Directing all my savings into super would lower my tax obligations. But my goal is not to have the most money possible.

And it is worth acknowledging that purchasing a home is also not about wealth maximisation. It is a place to live and raise a family. It is a way to form ties to a community. It provides the stability that many people crave. If life were about wealth maximisation there would be no vacations, family pets, nights eating out and countless other things that we spend money on and that make our day-to-day existence into a life.

Bucket two: Cashflow

My second goal is to build an income stream. I want to use the excess cash in my budget to try and create a sustainable and growing income stream that would be able to support my life prior to retirement.

Readers can use this guide on how to build an income portfolio.

When I was younger this meant living frugally and saving as much as possible to take advantage of my greatest asset – time. The more I could invest when I was younger the more time for growth through compounding.

My income portfolio pays for more travel. That is what brings me joy. I started an investment account when I was younger that invested in shares. I used the dividends for travel.

Initially dividends would pay for a portion of a weekend. I would cut back significantly on my current lifestyle to save money. If I managed to save $10,000 I would invest that money and receive $300 in dividends. None of my friends could figure out why I just didn’t save less and spend money out of my salary.

But I was building something. My sacrifice had an immediate payoff. The next year if I saved another $10,000 I had $600 in dividends to spend. There was a tangible benefit to saving more money and it encouraged me to focus on saving. And if I bought the right shares, I would get an added boost from increasing dividends.

I found this incredibly motivating. I was motivated to save, and I was motivated to spend time on my portfolio because it provided an immediate benefit. This approach also encouraged a long-term focus to benefit from the compounding of dividend growth.

I wasn’t spending all the money that I received in dividends. I reinvested the dividends on the majority of my holdings to accelerate the compounding of my income. When I turned 40 I increased the amount that I was spending from my dividend income. I will do the same next year when I turn 45 and each 5-year increment until I retire.

This is why I balk at the notion of taking a huge chunk of money and using it for a down payment. When I look at that down payment all I can see is the dividend income I would be forgoing and the experiences I would be missing.

I don’t think owning a house would bring me joy. I don’t want to spend my weekends at Bunnings and working on some DIY project. I don’t want to worry about how to pay for an emergency home repair. I want to call my landlord and go on a trip. I’m not judging anyone who gets joy out of homeownership. I’m trying to be intentional about how I spend my money and my time.

The benefit of living in a free society is that we get to make the choices that work best for each of us. Having that freedom does not mean there are not a lot of influences shaping our decision making. This makes it hard to take a path that goes against conventional wisdom.

I would encourage everyone to challenge that conventional wisdom to see how applicable it is to the life you want to live.

As always, I welcome any feedback at [email protected]