People always talk about how buying a home is the only way for the common person to obtain leverage. Please excuse my ignorance, but how does the common person use that leverage, exactly?
Leverage in finance is the concept of buying an asset with money that's not yours (i.e. a loan).
So suppose you have $100, and you believe a stock will increase by 10% in value, then borrowing $900 and buying $1000 of the stock, will leave you with $1100 if your prediction is true. When you pay off the loan, you'll be left with $200, and you will have doubled your money.
The loan thereby acts as a leverage multiplying the 10% return on investment to in this case a 100% return on investment.
Now imagine that instead of having $100, you have $50k, and instead of borrowing $900, you borrow $450k, and instead of buying stock, you buy a home with the 50k deposit and 450k mortgage. The same applies, the home appreciates 10% to 550k, but your equity increases from $50k to $100k. Again, the mortgage loan acts as a lever.
The difference is that most consumers do not have large and cheap capital available to them, say to borrow $450k to invest in the stock market. But most people do have such opportunities to invest in the real estate market with a mortgage.
Anyway, wether it's a good investment really depends on many factors. The NYT buy or rent calculator is still one of the best sources to get an intuition on what is best for your circumstance. https://www.nytimes.com/interactive/2024/upshot/buy-rent-cal...
Right, my question is more about how the average person can actually use that leverage. So you've got $80k in leverage, it grows (presumably), but how do you actually use it?
You have to sell the house, right? So you can only cash in on that leverage when you reverse mortgage or otherwise downsize, right?
Yes, but thanks to leverage you have effectively created higher returns for your retirement portfolio than you would have been able to without the leverage.
Higher returns than what though? It sure sounds like the only financial advantage to owning a home vs other investments is the leverage. Yet the S&P will return far more even considering the 80% leverage in most cases.
If you take all the money that you have spent on a down payment, closing and selling costs, taxes, and maintenance, subtract rent, and put the remainder in a market index fund, for the vast majority of situations you will have FAR more money by retirement. Like it's not even close.
I guess I'm just a bit tired of the messaging that real estate is such a great financial investment. Historically it's better than a lot of options but not even close to the best investment vehicle. Houses are homes first, not money makers, and if we continue to emphasize the latter, we will never solve the housing affordability crisis.
Let me put it to you another way: if homebuyers didn't have access to cheap leverage, then a stock market index fund would appear much more appealing than house as an investment. But when homebuyers have access to cheap leverage (and stock investors don't), the balance tips more in favor of home buying. And when I say "more in favor", I mean when compared to no leverage.
Perhaps you're making an argument that even with leverage, most people would be better off investing in the stock market rather than real estate. And perhaps that is true. But leverage does tip the balance in favor of real estate.
I'm saying even with leverage you would make far more money investing in index funds. The math is very clear. In the best real estate decades (which may be behind us), index funds may not win. But on average, over multiple decades it's not even close.
Can you show the calculations you made? I would expect the result to depend a lot on the assumptions you put in, particularly regarding leverage ratio, interest rates, stock market returns, and real estate returns.
It does depend on a lot, but the majority of scenarios you’ll put into rent vs buy calculators, for various places across the country, come out in favor of renting. In expensive areas, dramatically so. When interest rates are high, even moreso.
Let's take a quick look at my current situation as an example. Right now my family spends $2650/mth renting a nice home in the Denver metro area, with an excess of $2-3k/mth that goes into market investments at ~11% annual historical average. An equivalent house would cost us $600,000. Let's ignore the currently bleak housing market (where house prices have fallen ~10% in real dollars over the last 2.5 yrs), and assume your RE returns is a historical +4% annually (past 50 years).
Equation for compound interest at a fixed rate with initial sum:
P = P_o * e^ (rt)
After 30 years we would have the following equity in our home:
P = 600000*e^(.04*30)
= 1.99 million
This is with a total monthly mortgage payment of ~$4200 (including taxes and PMI), to have 1.99m at retirement.
Now let’s compare to renting and continuing to invest the money we would have spent on the house into market index funds.
Equation for previous month’s interest added to $2k/mth (use excel):
P_monthly =[previous month balance]*e^(r*t)+[monthly savings]
After 30 years we would have the following equity in our investment account:
P_monthly =[previous month balance]*e^(0.11/12*1)+2000 (use excel)
= 5.73 million
So I'm paying almost the same (2650 rent + 2k/month), but have more than 3 MILLION DOLLARS MORE at retirement.
This is to say nothing of all the other costs of a mortgage besides loan interest (essentially the cost to get you to the point of buying a home). Throw out $12k in closing costs. Throw out the 10 yrs of opportunity costs putting our savings in a secure HYSA (4.5%) rather than index funds (11%) to afford a $100k down payment. Throw out maintenance ($5-8k annually) and all the time spent maintaining the home (thousands of hours).
You would be more than 3 MILLION DOLLARS wealthier if you continued to rent. The leverage helps you, but that 7% differential in average returns makes it inconsequential. The power of compound interest - it's literally the only way average people have any dream of becoming wealthy.
Homes are terrible investments, relatively speaking. It’s not even close.
You have an error in this calculation where you make the assumption that real estate prices keep rising over 30 years but rent prices remain stagnant. Both of these things can't obviously be true at the same time. A more realistic calculation would have both real estate and rent prices increasing over the 30 years.
Your calculation also obscures what is the interest rate on the loan, which is the most significant component affecting the result. Sure, if you assume a high interest rate (currently baked into the $4200 number I presume), then your result will be that home ownership will look very bad. Whereas if you assume a lower interest rate, you will get a result in the other direction.
I'm not claiming that homes are great investments. And I know that renting is currently cheaper than buying a home (with current interest rates). But I am saying that your calculation isn't making a fair comparison.
Valid-ish points. My calculation is my situation right now, and I don't claim it is going to be true for everyone across all time and eternity. But over the course of someone's working life, renting will net you far more money than buying in the vast majority of cases.
It's a basic power law situation. The only real question is WHEN the 11% return will overtake the 4% return. The interest on the 4%-returning loan is a factor, but it's secondary.
> The only real question is WHEN the 11% return will overtake the 4% return. The interest on the 4%-returning loan is a factor, but it's secondary.
If we ignore the interest rate on the loan and simply assume stock market always makes 11% and real estate market always makes 4%, then the situation becomes really simple and is in favor of real estate investing.
Suppose a person has $20k to invest and they are considering putting it as down payment on a house, or investing in the stock market. (Let's ignore future cash flows and how those are invested, just consider the initial investment of $20k.)
Stock market option: $20k with no leverage -> 11% ROI on a $20k investment
Real estate option: $20k of your own money + $80k of the bank's money -> 4% ROI on $100k investment (counting both your money and the loan) -> 20% ROI on $20k investment (counting only your own money)
20% is better than 11%, so if you could get a zero interest loan, then the real estate investment would be much better.
Now, if we assume the interest rate is not 0%, but is instead 4% (same as our expected return), then of course the situation looks bleak.
So the interest on the loan is not a "secondary" factor. It's the most important factor.
I think the main point grandparent in this thread was trying to say that it's very easy to get cheap leverage on a mortgage, and basically impossible to get cheap leverage on stock market investments, and when you put the math on the back of the napkin like this, it becomes clear that the access to leverage can make real estate investing more appealing than stock market investing.
>Let's ignore future cash flows and how those are invested, just consider the initial investment of $20k.
But that's only a tiny piece of the money you will spend on the house and ignoring this will obviously lead you to a false conclusion.
Anyway, you don't have to agree with the numbers. I can link you to articles where Warren Buffet also points out the same thing, but you don't have to believe him either. Or you can Google rent vs buy calculators and do the full picture math yourself, if you're really that interested.
An 11% return will always beat a 4% return eventually, no matter what the initial conditions are. The question is just when.
> An 11% return will always beat a 4% return eventually, no matter what the initial conditions are.
No, it won't. I already gave you a very simple and easily verifiable scenario where that 4% return will beat that 11% return because of leverage. If you don't even accept that hypothetical, then you must be arguing just for the sake of arguing.
> But that's only a tiny piece of the money you will spend on the house and ignoring this will obviously lead you to a false conclusion.
That simple example was not supposed to be a realistic model of the world. I'm fine expanding the simple example step by step into a fully realistic model of the world. But there's no point going there if you refuse to accept very basic arithmetic facts in the simple example.
Hey, I don't view this as arguing at all. I'm sorry you do. I find it valuable as a check on my own thinking and assumptions. If you are feeling negative emotions with this exchange, please walk away!
>if you refuse to accept very basic arithmetic facts in the simple example
I refuse to accept your assertions because they're simply incorrect. Basic power law math - a higher value exponent will always win, eventually.
>Stock market option: $20k with no leverage -> 11% ROI on a $20k investment
P = P_o * e^(r*t)
P = 20,000 * e^(0.11*t)
>Real estate option: $20k of your own money + $80k of the bank's money -> 4% ROI on $100k investment (counting both your money and the loan)
P = 100,000 * e^(0.04*t)
Set these two equations equal to each other and solve for t. This will give you the number of years the 4% return with a 100k initial investment will beat the 11% return with a 20k initial investment.
20,000 * e^(.04*t) = 100,000 * e^(0.11*t)
t = 23 years. After 40 years, the 11% return has beaten the 4% return by 3.3x
If I'm misinterpreting your "very simple and easily verifiable scenario," please let me know. But I don't think so. Your error is in this statement. I'll leave it to you to figure out why, let me know if you need help! ;P
>(counting both your money and the loan) -> 20% ROI on $20k investment (counting only your own money) 20% is better than 11%,*
Oh crap, you're right. Sorry about my tone earlier. What I didn't consider properly is that the leverage ratio goes down over time as your equity in the house increases. So even though you start off with a leverage ratio which allows you to beat the returns from the non leveraged stock market investment, after some point the leverage ratio goes down below that point.
I tried to do the math now (independently from your calculations) and I ended up with the number 16 as "years after which the stock market 11% return has beaten the leveraged 4% return". I think your calculation result 23 is different from 16 because it assumes the loan can be kept as "free money" instead of paying it back.
However, the flaw in this is that most people don't have the discipline to put excess cash they would have spent on a home into index funds and forego touching that money until retirement.
So a mortgage is a very compelling enforcement mechanism to get average people to save for retirement.
If we're being honest that's a much more powerful reason to buy a home than "leverage."
