Since I started this blog, I’ve written 115 posts and nearly 150,0000 words. That’s nearly two Harry Potter Books.
And I don’t think I’ve ever published anything more controversial than this table:
How to Lose Money On Your House (Even After it Doubles in Value)
A little bit of background:
About a year and a half ago, an otherwise normal workday ended with me overhearing yet another person bragging about how much money they made on their house.
At first, I was really impressed, and overall feeling pretty happy for the coworker. But as soon as the conversation shifted towards something resembling the following exchange, my demeanor shifted.
- Older Coworker 1: “Yeah! I bought the place for $240,000 [10 years ago] and just sold it for $260,000. Easiest money I’ve ever made!”
- Younger Coworker 2: “Wow… I really need to buy a place fast!”
I quickly realized coworker 1’s math didn’t add up. Rather than making him feel bad and potentially outing myself as The Money Wizard in my place of employment, I made a quick counterpoint to the younger coworker, then packed it up for the day.
But the exchange kept replaying in my head. That night, I found myself pounding away on the keyboard, writing about how most people completely miscalculate the investment returns of their house.
What I ended with was this post.
In it, I showed how somebody could own a house that doubled in value, and still not make any money. The post finishes with the above table.
Admittedly, the article isn’t perfect. For simplicity’s sake, I left out the tax advantages of owning a home, although the mortgage interest deduction is mostly overrated.
(65% of Americans own homes yet only about 30% itemize their deductions. In other words, most home owners get no tax benefit from their mortgage, and instead just take the standard deduction. And by all accounts, this benefit became even less appealing after Trump’s latest tax plan.)
I also framed the article as a little too much buy vs. rent without enough direct comparisons between the two. I should have made the article’s main point (that a house is a lousy investment) more direct.
In any case, what followed was a staunch defense of the home. This didn’t surprise me. I don’t know if it’s just The American Dream talking or what, but home owners won’t take anyone dissing their decision without a fight.
But as the hate mail kept flooding in, one argument took me completely by surprise. Email after email, comment after comment, and even a few forum replies as the article made its way around the internet, showed something I wasn’t prepared for.
Most people completely misunderstand home equity.
The Big Home Equity Mistake Most People Make
I’ll include the chart again here for a quick reference:
According to these comments and emails, I completely dropped the ball by subtracting the $200,000 purchase price of the home out of the final profit.
As their line of thinking goes, as you repaid the loan, you built equity in the house. Since you get to keep that equity, it shouldn’t be counted a cost.
In their view, Joe Average actually made $223,000 on his house flip, because that equity was his. Or something.
The trouble is, they’re completely wrong.
And judging by the number of identical comments I got about this topic, there’s clearly a whole subset of the population buying homes without actually understanding how equity works.
A lot of people seem to view equity as a free lunch. This is dangerous, because it leads to a mindset of “buy anything you want” because in the end, you’ll always profit. Because equity.
No wonder Americans overwhelming view real estate as the best investment.
So let’s look into it.
What is Home Equity?
First off, a few thing’s equity is not. It’s not:
- A magical gift from the bank.
- The only way to riches.
- The best performing asset class in the world.
Home equity is simply your house’s market value minus any loans against it.
Home equity = home value – loans
Put another way, it’s how much of the house you actually own. You could also call it your net worth in the house.
A quick home equity example:
You find the home of your dreams:
- Purchase price: $200,000
- 20% cash downpayment: $40,000
- Immediate Equity? $40,000.
(You own $40,000 of the house and you owe the bank $160,000 for the rest of it.)
Simple enough, right?
As you make your mortgage payments, a portion of those payments go towards principle (aka “building equity” in the house) and some of the payment goes towards paying the bank interest on your loan.
Now, here’s where most people get it wrong.
Say we’re approaching year 30, and we’re about to give that home loan it’s final K.O.
Because you’ve been steadily contributing a couple hundred dollars each month to build equity, over the life of the loan, the bank has received enough “equity payments” that they’ve recouped the initial $160,000 they gave you as a loan.
The bank is essentially cashing in all those payments you’ve made, and giving you a home free and clear. For their troubles, they’ll keep all the interest you paid as their profit.
The important part to note, and the part so many hatemailers were confusing, is that equity isn’t a free benefit from having a loan. It’s a real cost, so you have to subtract the amount you paid to build equity from your profit.
If you sell the house tomorrow for $200,000 (remembering that you have $200,000 in equity now) your profit isn’t $200,000.
It’s zero. Because you paid for that equity every month for the past 30 years.
What if I sell the house before loan is paid off?
Say you sell the house after 5 years. The mechanics are similar:
- Initial Equity from the downpayment: $40,000
- Equity built from 5 years of monthly payments: $15,000
- Total Equity: $55,000
- Principle outstanding to the bank: $145,000 ($160K initial loan – the $15K of principle payments you’ve made.)
(These are rough numbers. If you want to get exact, you can use a mortgage calculator and your amortization schedule.)
The bank isn’t going to just let you walk away without getting the money you still owe them.
So they’ll take the sales price and first apply it towards your loan, before you get to collect any of that sweet, sweet profit.
Let’s say you fetch the same $200,000 sales price. The bank takes that $200,000 applies it to the remaining loan amount of $145,000, and writes you a check for the difference.
In this case, that difference is $55,000. Hey, look at that! The exact amount of your equity.
Does that mean you made $55,000 off the sale?
Remember, you paid $40,000 for the downpayment and $15,000 of principle through your mortgage payments. You got out what you put in, which is exactly what we’d expect to see when you buy a house and then sell it for the same price.
Are you sure I didn’t make $55,000 on the sale? I’ve got $55,000 in my pocket…
No matter how many people with a misunderstanding of equity try to make this true, that $55K of equity is not profit. Sure, it might be better than blowing money on rent, or maybe you’d have been better renting and investing the difference.
But if you’re going to compare the two, you need to accurately calculate returns. And if you’re trying to calculate the return on any investment, you HAVE to consider your initial investment.
- If I buy a share of Apple stock for $10, and sell it tomorrow for $10, I haven’t made $10!
- If I buy a TV for $500 and sell it for $500, I’ve made zero dollars.
- Even if I buy a TV with a $500 loan, and pay the loan back over 30 years, then sell the TV for $500… still zero dollars.
Final Thoughts on Home Equity
I can think of a few million articles I planned on writing, but none of those would have been 1,200 words explaining that you don’t make money when you buy and sell something for the same price. Yet here we are.
I don’t know whether its the lobbying real estate agents, the sneaky mortgage brokers, or the misguided baby boomers pushing for their American Dream at all costs, but somehow the three groups have managed to cloud a simple concept for a lot of people.
The real truth? Equity can help you make money on a home sale, it can have you lose money, or it can leave you indifferent.
In some instances, building equity can be better than renting. In some instances, it’s not.
But one thing’s for sure, building equity doesn’t automatically make a house a good investment, and equity doesn’t come for free. Don’t ever let anyone tell you differently.
Tom @ Dividends Diversify says
Totally agree Mr. Wizard. I think people have been brainwashed into thinking one’s home is a good investment. It can be if one gets lucky in a hot market, sells for profit and then goes and lives some place else that is cheaper. But selling is so expensive. So many folks and governments have their hands in your pocket on the sale transaction. One needs at least 6% appreciation to break even. And you won’t get that appreciation if you do not continually dump money into keeping the house fresh and updated. Over the years, I have made money many different ways, but my home has never been one of those ways. Tom
Well thought out and detailed post on this.
Sometimes I feel as if we inflate our net worth number for home equity. I have always come at it from a Net Realizable Value (Sales Price less costs) standpoint. Essentially, this means how close can you come to realizing (cash in your pocket) a true profit. Will you ever receive Zillow’s estimate of your home as their estimated sales price? Are you including all of the fees, commissions and historical costs from past home repairs that you sunk into the home.
Lots of good arguments for and against. Thanks for sharing.
Under a strict definition, sure, a house is a bad investment, but it can still be a good financial decision.
Nothing is really free and even if you “own” your home, you’re paying “rent” to the government in the form of property taxes along with maintenance and other costs, so I think the idea of making money on your home is a bit misguided or at least doesn’t really describe the situation accurately. Generally what we all want is to have lower monthly costs in order to increase our net worth more quickly. In my eyes, owning that home really costs the $23,000 plus the missed investment return had the buyer invested the money in the stock market over 20 years and rented. Paying $23,000 over 20 years in housing costs sounds great initially, but I’m guessing that after taking the missed stock market opportunity cost into consideration buying would be close to breaking even with renting depending on how much rent is in the area.
Rent vs buy is highly based on neighborhood. Where I live, I could buy a $200,000 house or rent the same level of house for $1,400 – $1,600. This is what people need to look at when trying to decide rent vs buy. Considering mortgage interest, maintenance, taxes, and even if I amortize the buying and selling costs over the length of the mortgage, my monthly cash flow would be higher by owning a house if you consider the principal part of the mortgage an “investment”. Although home equity doesn’t grow as quickly as stocks, this is mostly negated by the fact that you benefit from growth of the entire value of the home, even though you’ve only had to “invest” the down payment, principal payments and closing costs. This is the beauty of leverage.
Anyway, I think it’s a really complex discussion and mainly depends on neighborhood. I am luckly that my city is very favorable for buyers and makes Trulia’s list for cities where buying nets a better deal than renting.
Young FIRE Knight says
Nice post explaining the way equity works. Real Estate can be really tricky for many to wrap their heads around (including myself) due to the many moving parts and consideration points of purchasing (and selling) a property.
What makes it even tougher is that nearly every person’s situation is different due to the city you live in, income levels, % down payment, etc.
What could be a no brainer buy decision for one person, could be a no brainer rent for another. Most people get caught up in what’s best for them (or what they think is best for them) and don’t consider the other potential avenues available.
Money Hungry says
You also didn’t factor in the cost of having the Property Brothers come and redesign the home so you can sell it for more than the original cost.
Leverage can maximize gains, but then again it can maximize losses as well. Lets hope those homes only appreciate in value right?
I’d like to see the costs of renting & investment returns put into the math as well.
I believe a landlord would charge to cover costs & keep some profit, so over $1k probably on a $200,000 home. Over time, rent prices would increase too, so 20 years ago, the price may have been around $1000, but assuming you don’t have a long term contract, landlords will charge $2000 for new tenant 20 years later.
Some quick math says to double in 20 years, using the rule of 72, the house price went up at 3.5%. Assuming rent goes up at about 3.5% too, and assuming someone changes homes every 5 years, they’re paying $1,000/mo for 5 years, $1187 after moving 5 years later, $1410 moving 5 years after that, and then $1675. That’s $316,320 in rent over those 20 years ($240,000 if rent never went up). You’d also have invested that $40k down, at 6% interest, that’s about $130,000. There are too many numbers jumping around, do you count $130k or take off the initial $40k? Either way, I think this number is either a cost on the house, or a gain for the renter, and neither number is big enough to offset the money that went into renting.
Hopefully that is all correct, and changes the calculus of the exercise – do you see any omissions?
One of the main advantages of owning a home is that once you have paid off the mortgage loans, you only have to pay for taxes and insurance (and possibly HOA dues). I bought a 4 year old house in 2013 and have not paid anything for maintenance yet. Additionally, you can pass the property or properties to you heirs. You may make more money by paying less for rent and investing, but most people don’t want to rent their entire lives. There’s a sense of pride that comes with home ownership.
The numbers do not lie. Just like Wall Street, real estate has its own set of half truths and downright lies to get you involved. I am a homeowner, and happy to be one-I just knew what I was getting into as far as the real dollar amounts that I am paying.
One of the worst ploys I ever heard, and I’m sure this is still around, is for the homeowner to buy the absolute most expensive house that they can afford. The justification is that the larger the payment, the larger the interest amount they will be able to deduct from their taxes. “Because everybody knows that you have to have deductions when you file taxes!!!” If I I am in need of deductions at the end of the year, I can always give extra to my church or some other nonprofit group. One of the worst “spend money to save money” schemes ever…Thanks for all your great posts, I wish they were even more frequent… Have a great day.
Your logic is right on. I don’t understand how an individual can think equity is free money or part of profit. Interest on the mortgage is big part of the overall cost. But remember, when an individual rents, the rent includes the tax, maintenance cost, interest all in one single cost and there are renter out there believing they don’t pay maintenance or property tax, etc… yes, the owners of the condo or the building pays all these costs, but it’s coming out of the rent you pay, so in the renters are paying majority of the costs similar to homeowner. I’m not preaching renting is better or owing a home is better, this all depends an individuals situations.
I just sold my home and there are so many hands in the jar. Anywhere from selling costs to fees, to fixing up the before selling to make it nice. Even the freakin HOA wants their share of the pie. However, in the long run over 20 to 30 years, I do believe owning is better than renting for that same amount of time.
Loved the article! I’m late 20’s and own a home and frequently tell people to reconsider buying a house when they ask if it’s worth it, despite that there’s been immense upside for me. I bought my place 4 years ago with 5% down. I purchased (unknowingly) in a neighborhood that has EXPLODED with development. We’re talking all the retail, restaurants, parks and entertainment you can ask for. I also rent out one of the rooms so my monthly out of pocket cost is around $300. Due to all the growth the neighborhood has had, my place is selling for 65% more than what I paid for it. Had I rented a similar place (even a less stellar place) my monthly cost would triple. Granted, I’m not taking into account the adhoc repairs I’ve made but even if you factor that in, my monthly would’ve balance out to be around $500. Getting a roommate in an apt in my neighborhood would easily run $1000. Buying allowed me to invest the rest of my funds in the market. Overall, I think my case is rare to have that much appreciation so rapidly, which is why I tell people the benefit of renting and just invest in the market. I always hear the argument about rent is throwing money away but is it? I see it as a service. You pay someone for the convenience. You could grow your own produce but you are cool paying a premium to buy it from the grocery store.
Completely disagree with the analysis here. The home also provided you with “home services” i.e. you lived in that home and saved the rent you would have otherwise paid to a landlord. How much rent have you saved over the years? That amount (I presume $1,500/month times 240 months=$360,000) goes straight back into the plus column. I’ve done some calculations very much like yours and found examples where the house return calculations the way you did them looks really bad, but the actual IRR taking into account all costs and benefits are astronomical, easily beating equity returns!
And I should have added a link to a recent post of mine, quite aptly titled “See that house over there? It’s an investment!” that shows how a house that appreciates only 2% p.a. (and less than that after taking into account broker fees) can have an IRR of almost 12%. Try to get that with equities these days!
Another important consideration is the length of time in a particular location. While house ownership certainly pays off over the long run, renting can be a much better option in the short term. Especially when considering banks front load interest payments. The New York Times has an excellent rent vs buy calculator which shows the break even cost for home ownership. In my area, it takes about 7 years for a home purchase to beat out renting a comparably sized home.
Also, I do think when you look at the whole buy vs rent argument you must always look at it from an opportunity cost. Digs against buying frequently illustrate it as if you wouldn’t be spending the same money had you rented. I guess the best comparison would be to factor in the cost to acquire (down payment/security deposit), monthly expenditure (rent/mortgage payment), tax benefit from owning, maintnce cost and the $ benefit you realized when you walk away.
Alexandria Perez says
I think maybe but what they are trying to say is at least you get that money back. Yes, you paid all of those expenses over the years (maintenance, taxes, interest, etc.) but you get that back (most of it in the first example) once you sell vs if you rent, you don’t get any of your rent back. This is a separate topic but maybe that’s why people boast about homeownership.
That’s my philosophy Alexandria – using money wizard’s example (which is obviously correct when people are talking about whether or not they made a straight profit on the sale of a home….you’re generating cash with the sale of a home, but that cash isn’t synonymous with an increase in net worth, which is what would constitute profit), over 20 years you lost $23,000.00 on the ownership of that home. My current rent is very cheap @ $450/month, so if I rented for 20 years with no inflation I’d pay $108,000. Looking at it that way, losing $23,000 over 20 years does look more attractive than losing, or paying, $108,000. (assuming that my theoretical house appreciates enough in value to cover the spread, but based on this example, it wouldn’t have to appreciate all that much to break even)
**With all that said, this article was never a rent vs. buy article, it was an article on the [apparently common] misunderstanding of the term home equity, and resulting profit (or loss), on the sale of a home.
If I may, I do think the “profit” problem is easier to understand if it’s simplified for the sake of the discussion:
Let’s say you purchase a $100k home with no money down, a 5% 30 year mortgage. You of course then start with a loan mortgage balance of $100k. You make only the minimum payment every month, and so by the time you’d paid off your home, you’ve paid your $100k principal, plus roughly $93,255.00 in interest, meaning you’ve actually paid $193,255.00 for your home. Then the day after you pay it off, you decide to sell for $200k. So yes, you’ve sold your home for twice it’s value from when you purchased it, but you only actually profited $6,745.00 (then you add in all those other variables, taxes, insurance, tax deductions, and they swing the pendulum one way or the other, but it seems like the crux of this issue is a base misunderstanding of the above concept).
Sorry, I may just be rambling and that may not be helpful at all, but I was bored at work ^_^
Yes, but you have to live somewhere right? So, if market rent is $1,500 and your mortgage payment + insurance + property tax are $1,500, then in essence, your calculation should remove the interest, property tx and insurance.
+closing costs (buying / selling)
Selling Price – input costs and any related selling taxes = Net Investment
Ken Hale says
I’m going through this with my parents right now, ironically enough. As they prepare to sell their current home to get in to something smaller for their remaining retirement years, they’ve oversimplified the math to the point where they’re deluding themselves on how much money they’ll make (basically subtracting the original purchase price from the price they’ll sell it for… struggling to even factor in the sales commission, closing costs, etc.!) As I talk to people in similar situations, I get the sense that this is a very common misunderstanding.
That all said, assuming we’re talking about a primary residence (ignore this if we’re talking about an investment property), I think that laying out the math in the way you did above misses an opportunity because you’re not factoring in the alternative (rent, usually); that alternative can change the calculation considerably. When my wife and I bought our house in the greater Seattle area close to 15 years ago it was because we were looking to hedge our housing costs against inflation, thereby positioning us to pay less than market rate over time. When I compare the costs of purchase + interest + maintenance to what market-rate/inflation-adjusted rent would have cost over the same period of time, I come up with a much more useful set of numbers to compare with. The numbers become even more compelling, every single month, now that we’ve paid the mortgage off (our 2017 Christmas present to ourselves – WOO HOO!!!). Since we plan to occupy the house for another 20+ years, the materially reduced cost of maintaining a roof over our head continues to cost us far less than the alternative, making for a sound argument FOR the original investment.
I just think that’s a more holistic way to think about the investment, by calculating the mortgage+interest+maintenance+lost-revenue-on-a-competing-alternative-investment versus what renting would have cost us (both up to this point and for the foreseeable future).
Mr. Tako says
I wrote a similar post a couple years back, detailing all the costs of my home and how we’re just breaking even despite all the leverage.
That post got its share of haters too.
The love of real estate runs deep!
Such a great article! I appreciate your clarification on the ‘equity’. I really didn’t think through it until reading this. A visual might help some people understand your point better but just wanted to say thanks as this was quite the interesting topic!
I couldn’t agree with you more. I have this argument with people almost every week.
The only way a home is a good investment is if you leverage it and it appreciates and then you sell it or pull out your cash and put it into a real investment. A paid off house is the worst investment imaginable. Let’s say (in California) you pay off your $500,000 house and live in it for 30 more years. Yay you. 30 years of no payments. (We will ignore that it cost you $1M to pay off that house, the upkeep, property taxes of $5000 a year, etc. ) And we’ll say the value of your house doubles to $1M in those 30 years. You’ve done awesome, right?
If you immediately had sold that house and invested your $500,000 at 7% per year average without adding another dime, in 30 years you’d have $3,806,127.52.
Property doesn’t compound. Property appreciates (sometimes). Without the compounding, you are literally leaving millions and millions on the table. Let’s say you inherit your parents $500,000 home on your 20th birthday and you live in it until you are 80. You saved a lot of money, right? If you had sold the house and got 7% gains for the 60 years you were there you would have just short of $29 million dollars. If you could get 10% gains you’d have $152 million dollars.
If you think your $500k property will ever, EVER, appreciate to $152 million dollars or generate that much in rent after all your property expenses, you’re nuts.
A home is a great bank for when you are starting out. Once you have enough equity in it to invest with, pull it and invest it. It’s easy to find investments that pay 10% yields in dividends. That’s $50,000 a year for doing nothing, not including the investment going up. You could rent a home for $3,000 a month and still be making money.
But you lived somewhere nearly free for 60 years. If you put $3500 into the stock market (instead of paying that to live somewhere) for 60 years and earned 7%, you would have more than $39 MILLION! Which is more than the 29 million for your 500K investment. It’s not as black and white in either direction as each of you say it is.
What this seems to boil down to is equity is not equal to profit. For example, if I buy a house (doesn’t matter what the value is) and put $200K down, I have $200K in equity in the house, but if I sell the next day, I will not have $200K profit.
I do have equity (the unrealized value in the property).
There is also the fact that if I sell, I will have to pay fees that will substract from my realization of the equity.
However, If I buy a house, put $200K down, and sell the next day for X+$200K, the extra $200K minus the fees is profit.
sejal patel says
I’d love to see you do the same comparison table with building equity in a home vs getting nothing in return from rental. One need a place to live, so either own or rent!
I think if you can live in a home where cost of BUY Vs. RENT is justified by adding (just the mortgage interest + taxes + HOA + insurance) = (rent + tax benefits or lost opportunity cost + rental insurance) One should no doubt rent!
But often time that’s not the case…. building equity in a home with low interest is a better investment than trying to build that in a volatile market thru savings.
Money Beagle says
Equity and profit really have nothing to do with one another, yet they keep getting mixed together in here. I’m not sure I understand doing that in this context. Equity is simply the amount of cash you would walk away with if you liquidated the asset and satisfied all loans. Profit is how much more (or less) you sold it for compared to what you bought it for. There is no direct relationship. You can have any combination of positve, equal, or negative equity, and positive, equal or negative profit. I mean, you could sell the house for more than you paid for it, but if you took out loans against the property while you owned it, you could actually owe money. There’s no correlation so I don’t get why the discussion bounces back and forth.
Nice article,Thanks for sharing with us.You really clarified “equity” term and the concepts related to it in depth.
Keep posting such articles,really amazing
Wow, it’s sad this article needed to be written. I really don’t mean to be elitist but seriously? A house is the largest purchase the average person will ever make and costs years worth of wages.
You would think people would take a few hours and learn about the financial effects of owning a house. Nothing about it is overly complicated.
Im glad there are people like you writing articles like this to correct this kind of common misconceptions.