Worst Advice I Ever Received Series: #1: “Buy the Biggest Home You Can Afford.”
Welcome back, readers. We’ve decided to create a new series called “Worst Advice I Ever Received” as it relates to finance, where we take our friend’s, twitter colleagues’, and various other’s stories of the worst advice regarding finance they ever were told. Our first one up is “Buy the biggest home you can afford; it’s value will only go up.” We will tailor this post just to people interested in home buying, but will consider renting in another, later post.
The ironic part of this is thinking that you need to buy the most expensive home you can is at least partially what leads to an asset bubble on the demand side of things, and what leads to unaffordable housing crises on the supply side of the equation. (Think of it like this: why would a home-builder manufacture inexpensive homes when he thinks everyone wants to purchase expensive ones that they think will rise in value faster and in greater volume?)
Of course, houses traditionally were going up in value, un-glamorously, but steadily within the 20th century in the United States. Earning 2-4% per year on the value of the home was fairly standard for a long time. It was also the largest piece of wealth most American families had. In fact, this stat remains true for many age and ethnicity groups in the United States according to the U.S. Census Bureau.
But when people start to see homes more as a safe investment and less a place to live that might lose value, they are more likely to assume more risk. Combine this with Government policies that practically forced lenders to lend money to those who they otherwise wouldn’t have, not organizing the way the loans are organized and collateralized, and sure enough, you end up with an unstable asset bubble, and if you purchased “the most you can afford” before said bubble pops, you’ve ended up with a house that’s underwater.
Look, it’s tough house shopping. The government gives incentive for you to buy the most expensive home with the ability to claim mortgage interest as a tax deduction. “Keeping up with the Jones'” is an easy trap to fall into when you see the house that has the granite counter-tops, the hardwood floors, and spacious, open kitchen and living areas and the next house you see is perfectly livable, but it’s three year old carpets, less glamorous counter-tops, and maybe only single vanity in the bathroom suddenly seems like it’s a house for those well below your means.
Perhaps the better advice would be “buy the least amount of house you are confident your family can be comfortable in.” I can already here others clamoring to ask “But what about the value going up? You’ll be missing so much!” There are way too many other investment vehicles for you to choose with higher annual rates and similar risks than something that might get you 2-4% outside of most “boutique” cities.
Compare a $180,000 house to a $250,000 one. Let’s say the house goes up 4% that year: The house went up to $187,200 while the $250,000 one went to $260,000 in value. The naysayers to my advice will say: “see! Look, the bigger house gained the owner $10,000 in value while the smaller house gained him only $7,200!” To which my response was, “what did the owner do with the other $70,000 he/she didn’t spend on the larger house?” If it was the market, over time 8% is a fair number to pick. That $70,000 is now worth 75,600. So, add 5,600 to 7,200, and you see that the owner of the small house has increased his/her net worth by 12,800 instead of just 10,000. Compound this over time, and it’s easy to see the smaller house owner ending up with significantly higher net worth. This doesn’t even account for the lower amount of debt the smaller homeowner paid over his/her mortgage.
In addition to all of this, when an asset bubble does pop, is it easier to unload the less expensive asset than the highest, most expensive one in an area? Let’s say you need to sell at the bottom of the market. If you own the biggest, most tricked out home on the block, you’ve limited yourself to a lot less buyers than the owner who purchased the middle-of-the-pack house.