Not long ago, I put together a historical graph of our net worth. In response to this look back at our financial performance over the past decade, mbhunter asked how much of the increase in our net worth was due to appreciation in home value. My response was that our first house appreciated at roughly 7%/year for the four years in which we lived in it (2002-2006; we haven’t been in our new house long enough for it to have appreciated much at all). But all of this got me to thinking…
While the value of our home increased at 7%/year, this vastly understates the performance of our home from an investment perspective. The reason for this is that we invested far less than the the cost of our home when we bought it, and we used borrowed money (i.e., a mortgage) to cover the rest. In the investing world, the use of a small initial investment combined with borrowed money to finance an investment is referred to “leverage,” and it can dramatically amplify your investment performance.
Here’s the situation:
Our house cost roughly $180,000 when we purchased it, and we sold the house after almost exactly four years for roughly $240,000.
Now for the math:
A $60,000 profit on a $180,000 purchase is a 33% increase. Compounding that out over four years, it comes to just under 7.5% per year. Of course, that’s a bit generous, as we had costs associated with selling at the back end. Factoring in a 6% commission on the selling end, we cleared $225,600 for a profit of $45,600. This is just over a 25% gain, or just under 6%/year. Not too bad, especially considering that: (1) we weren’t in an overly-hot housing market, and (2) it was a tax free gain. But wait, it gets better…
When we bought our house, we didn’t pay cash. Rather, we took out an 80% mortgage with 10% down ($18,000) and another 10% from a second mortgage. We were, however, able to kill off the second mortgage in relatively short order (i.e., within about two years). Thus, for the sake of simplicity, let’s assume that our amount invested over our time in the house averaged $27,000 ($18,000 for the first two years and $36,000 for the last two years). Let’s just call it $30,000 to account for a small amount of closing costs.
Since the alternative to buying a home would’ve been to rent, and because a suitable property would’ve cost about the same as our mortgage payment (including taxes and insurance), I’m going to simply ignore our monthly mortgage payment for the purposes of this calculation — after all, we would’ve been writing a check of that same amount every month, whether it was to a bank or a landlord.
So… We actually banked a $45,600 tax-free profit on a four year investment of (roughly) $30,000. That’s an overall gain of 152%. Compounding that out over four years, we actually earned 26% per year on our investment.
Had we put even less down on our house, the percentage returns would’ve been even higher. This is exactly why you always see late-night infomercials touting “no money down” real estate investment. The thinner you spread your money, the more leverage you’ll have, and the higher your potential returns will be. Unfortunately, this sort of leverage can really amplify your risk, as well. Buying a house for yourself is one thing, but loading up on property (or any other investment) with minimal money down is an entirely different kettle of fish.