Myth: The End Result Is All That Matters
A Shocking Discovery
I was recently watching a financial self-help video from a very popular finance guru, and I was shocked to hear this person say that buying a home was a great investment because it would yield a very high return in the first year that it was owned, and that it would continue to give high investment returns throughout the life of the home. This is surprising, because any one well grounded in finance would be able to tell you that a home is a very very bad investment for the first 3-5 years. It is not until after that time range that the home’s appreciation will begin to actually give a positive investment return.
How Could They Miss?
If the point of the high cost of a mortgage and the need for longevity in a mortgage are such a fundamental principles, then how could the guru have possibly missed it? The answer lies in the cash flows the guru used for the analysis. See, from a certain perspective, the guru was right. But it’s not the whole story. It’s kind of like in Star Wars, when Luke accuses Obi-wan of lying about his father’s death. Obi-wan tells Luke that what Obi-wan’s statement that Luke’s father had died was true, from a certain point of view. And it was. But did Luke realize that he was not hearing what he thought he was hearing? No. He thought that his father was physically dead, while Obi-wan meant that he was dead in a less literal sense. So, while what Obi-wan had said was true from a certain perspective, it certainly succeeded in deceiving Luke. Such is often the case in finance. What you hear may be true from a certain perspective, but it is still deceptive and does not tell the whole story of what is happening to your wealth.
So What Is Happening?
Before I can answer the question of what is really happening and what return you are getting from your investment in your home that first year, I first need to explain a financial tool called a cash-flow diagram. The diagram is fairly simple: it consists of a horizontal line with vertical hash marks all along it. Each hash mark corresponds to a specific time period (ie a month, a year, etc). The diagram must be consistent in that each hash mark must represent the exact same amount of time that each other hash mark represents. On each hash mark, the relative cash flows for that period of time are listed. A cash-flow diagram helps us visualize where the money is flowing, when it is flowing, and which way it is flowing (in to your pocketbook or out of your pocketbook).
With that brief introduction, let’s take a look at the two cash-flow diagrams below. Here’s the scenario: you make a $10,000 down payment on a $160,000 house, meaning that you must borrow the remaining $150,000. Closing costs (typically ranging from 3-5 percent of the balance of the loan) come out to $6,000, a conservative 3% of the loan amount. The home appreciates 4% the first year that it is owned. The top diagram shows the full, actual reality of what the calculation of mortgage returns would look like; the bottom one illustrates a diagram like the one the guru was using for their analysis.
The areas highlighted in yellow are cash-flows which the guru neglected to account for. Notice that in the top analysis, we have taken into consideration EVERY expense and EVERY income associated with the mortgage. In both cases, the final amount of equity in the home that you get when you sell the home is the same, but the amount of the expense is different. The difference in the “investment return” is 138%!
Okay, time to break out the ol’ thinking cap. A negative investment return means that you are losing money at that particular rate. In order to get an idea of the implications of this loan, think of the cash-flows above as a savings account. If you put $16,000 (the $10,000 down payment plus the closing costs) in a savings account today, and deposited $997.95 into that account every month and you only had $17,923.71 in that bank account at the end of the year, what would you think? You deposited almost $38,000 between the initial deposit and the monthly deposits. And at the end of a year, you have less than half of what you deposited in the first place. Wouldn’t that make you mad? I know I would be calling the bank and giving them an earful if my savings account exhibited such behavior!
This is why it is so very very important to consider all cash-flows associated with a purchase/investment. I am not trying to say that buying a home is a bad thing to do. I am only trying to show the importance of understanding and applying the effects of all relevant cash-flows when considering an investment. Suppose you had gone in to the bank and your mortgage officer had told you that you could earn a 79% return on your home in one year. Before you read this post, you would probably have believed him, wouldn’t you? But that fact remains that, while the equity growth from $10,000 to $18,000 is indeed 79%, it does not really tell the whole truth. What about the expense of closing costs? What about the interest expense? Shouldn’t that be considered? Isn’t that important? Doesn’t that strongly affect the investment returns your home is providing? Absolutely. So before you jump into a financial decision, stop and ask yourself the following questions: (1) What will it cost me, both now and in the future? and (2) What will I get (income) from it, both now and in the future? If you do that, you will find yourself making much better financial decisions. And if you can’t figure it out, or what a specific calculation in regards to your decision, then ask a (unbiased!) financial professional for help.
Posted on 3 Nov 2008