These 2 Variables Dictate the Financial Wisdom of Homeownership

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For much of the past century, the financial wisdom of buying and owning your own home was unquestioned. It was considered far and away the best investment one could make with his or her money.

And then the Great Recession came along and left in its path a wake of foreclosed homes and families with plunging net worth. The knee-jerk reaction was quick and decisive: Buying a home as an investment suddenly made no sense at all.

I personally added to that commentary a little more than two years ago, coming down on the side of renting. But life situations change -- my wife and I are once again pondering buying a house after moving our family to a smaller community to settle down.

Our primary considerations have little to do with money. As I'll show below, for the fiscally disciplined, I still don't believe homeownership provides the financial windfall many believe it does. Rather, we simply want to be able to make the home our own, remodeling or building as we see fit, and we also want the social benefits that come with establishing yourself within a community.

The fact that those reasons -- in our opinion -- don't usher in financial rewards is just fine with us. What's money for anyway, if not to help you live the life you want?

That being said, there are countless people buying homes to live in for the investment, rather than the soft variables, and for many of them, that's a mistake.

A quick look at both sides
The value of homeownership is one of those topics that can cause normally mild-mannered folks to jump up and down with indignation. Luckily, some of the brightest minds here at The Motley Fool can disagree and still remain friends.

No one has spent more time talking about the perils of homeownership than Morgan Housel. You can click the link to read his full argument, but it all basically boils down to this: Homes are fabricated goods, and as they improve, the one you own will become outdated and accordingly devalued. On the whole, expecting the price of your home to do more than keep pace with inflation is dangerous.

Morgan also pointed out  that many will end up owning a home for 10 years or less and that during that time, all they've really done is pay off a large sum of interest to the bank because of how amortization schedules work. What's the difference between that and paying rent?

On the other end of the spectrum we have Anand Chokkavelu. He penned a piece talking about why buying usually wins. While he concedes many of Morgan's points, he points out that, given the financial behaviors of many people, buying is better because it incurs forced savings via equity.

Though we might save money by renting, he notes, "I think a greater percentage of us than we'd like to admit end up blowing the money anyway." That's a fair point, and one that matches up with reality for many people.

As a simple matter of fact, however, my wife and I have spent the better part of the last four years figuring out what "enough" is for us. We're quasi-minimalists, and any money we might make beyond our "enough" simply gets put away in retirement, college or -- more recently -- down-payment funds.

The two variables that make all the difference
If you're in our situation, how can you determine whether it makes financial sense to buy a home? One of the tools I come back to over and over again is a nifty calculator designed by The New York Times. It takes 21 different variables into account before letting you know how the dollars and cents all play out.

Let's say I want to buy a $200,000 house, which is about the median price for existing U.S. homes right now. Let's also say I'm renting a house that's almost identical. Though it varies wildly by city, let's say that the price-to-rent ratio where I live is 19, which is the current average among 54 major U.S. metropolitan areas. That means I'm paying about $880 per month.

Using the default function of the calculator, I see that if I buy the house and live in it for six years, it's a better financial decision to buy.

But there are two default settings that I find to be highly misleading. The first is the assumption that home prices will increase by 3% per year, while inflation will push a 2.3% pace. Historically, the spread between the two is much thinner: 0.2%.

By changing my home's appreciation to 2.5%, I find that I now need to live in the house for nine years before it makes financial sense to buy instead of rent.

Another issue is that the calculator assumes your down payment will be invested and will return about 4% per year. But that flies in the face of the market's historical compounded annual growth rate of 9% (since 1871).

Even if you don't believe consistent 9% returns are possible anymore, you'd have to average below 6.2% returns in order for buying to make financial sense after living in your home for 40 years. That's significantly lower than what the market has historically yielded. 

Seeing the trees for the forest
You can play with the calculator all you want to see how your own situation would play out. And, of course, there are a lot of real-life variables to consider that have nothing to do with money. That's why I said from the beginning that my wife and I are considering buying even though we believe it to be the financially inferior choice.

Everyone has their own situation, but the numbers don't lie. If the century's worth of data we have is any indication, buying a house should almost always be a lifestyle decision over a financial one.

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