Warren Buffett: Why Buying a House is a LOUSY Investment

Uh, I decided to buy a house when it was about when the down payment was about 10% or so of my net worth because I really felt I wanted to use the capital for other purposes. But that was a way different environment. Buying a house is usually a lousy investment. This sentence is enough to start a fight if you say it to the wrong person. But please, before you come at me with pitchforks, I'm not the one saying this; this is coming from legendary investor Warren Buffett. Let's just say he knows a thing or 135 billion about money.

Here's what Buffett had to say: "Hello, um, uh, my name is Nelson Arada. I'm from Southern California and um, I have a question. It's not really related to intrinsic value or any of that stock stuff, but uh, more on um, house houses. I'm still quite young; I don't have a house yet and I'm thinking about buying a house someday, uh, soon. And in order to do that, I'm going to have to put a down payment, uh, which means I might have to share or sell my shares. Um, and I was wondering if you can provide some insight on when is the best time to buy a house and how much down payment you should be putting down, um, in relation to interest rates and also in relation to available cash uh, and the stock market."

"Well, Charlie's going to give you an answer to that in a second. I'll just relate one story which was when uh, I got married. We did have about $10,000 starting off and I told Susie I said, 'Now you know, there's two choices; it's up to you. You can we can either buy a house which will use up all my capital and clean me out uh, and it'll be like a carpenter who's had his tools taken away from him, or you can let me work on this and someday, who knows, maybe I'll even buy a little bit larger house than would otherwise be the case.' So, she was very uh, understanding on that point and uh, we waited. Uh, until 1956 we got married in 1952 and uh, I decided to buy a house when it was about when the down payment was about 10% or so of my net worth because I really felt I wanted to use the capital for other purposes. But that was a way different environment uh, in terms of what was available to buy. In effect, if you have the house you want to buy, I, you know, I definitely believe in just going out and probably getting the job done. But I, in effect, you're probably making something in the area of a seven or eight percent investment implicitly when you do it, so, uh, you know, you'll have to figure out your own equation from that."

"Charlie probably has better advice on that; he's a big homeowner in both senses of the word. The uh, I think the time to buy a house is when you need one. And when do you need one? Well, I have very old-fashioned ideas on that too. Uh, the single people, I don't care if they ever get a house when do you need one? If you're married, Charlie, I'll follow up here. You need one when your wife wants one."

Yeah, I think you've got that exactly right. As a bit of background, there's a mindset that renting is throwing away money or that buying a home is always a great investment. While these statements do have some merit, as Warren Buffett pointed out in that clip, they don't tell the whole picture. Most people just look at the monthly mortgage payment and compare that to what it would cost to rent a similar place. They see that the mortgage payment is the same as what the rent would be and say, "Yep, that's it; renting a home is a waste of money; may as well buy." However, there is much more that goes into it than just that.

To demonstrate what I mean, let me introduce you to our friend John here. John has been working hard and saving money for years. He has done everything right financially and now has the ability to purchase a home. Let's take a closer look at John's true cost of living of buying a house. When buying a home, the first thing you have to consider is the down payment. In the US, there are some companies and government programs that offer low or even no money down mortgage options. However, these types of mortgages are generally considered relatively risky. Just look at the wave of foreclosures that happened during the great financial crisis. These foreclosures skewed heavily towards individuals and families that bought at the peak of the market with little or no down payment.

That is why it is highly recommended that home buyers have at least a 10 to 20% down payment when purchasing a home. Now, you also have to consider your mortgage interest rate. This is how much you have to pay a lender to be able to borrow the money needed to finance a house purchase. The current interest rate on a 30-year mortgage in the US is approximately 7%, making it the most costly time to borrow money to buy a house in roughly two decades. Now, the math gets a little complicated, but for simplicity, at a 7% interest rate, approximately 7% of your loan balance is getting paid to the bank in the form of interest each year. As you're about to see, the interest number can really add up over the life of a mortgage.

Third is private mortgage insurance or PMI for short. For borrowers with less than 20% down payments, lenders typically require PMI. This is essentially an insurance policy that protects the lender in the event the borrower stops making payments. PMI can add a few hundred to the monthly mortgage payment, depending on the loan balance. Fourth, we have property taxes. This cost can vary dramatically based on the state, but is typically calculated as an annual percentage based on your home's appraised value. Depending on the state, sometimes property taxes can exceed a house's mortgage payment. Money collected from property taxes goes to fund local services such as schools, libraries, local government, and first responders. Property taxes can range from a couple of thousand dollars in low cost of living states to tens of thousands of dollars for expensive houses and high-tax states.

Next on the list, we have homeowners insurance. Homeowners insurance helps cover the cost of replacing or repairing a home in the event it gets damaged or destroyed. If you have a mortgage, odds are you're going to be legally required to carry homeowners insurance as a way to protect the lender in the event the house gets damaged or destroyed. Similar to property taxes, this cost will also vary widely depending on what part of the country you're in. Homes located in areas of the country that are prone to natural disasters will pay higher rates than homes located in safer areas. The average homeowners insurance policy in the United States is approximately $150 to $200 a month.

As if these five costs weren't already enough, number six on our list is repairs and maintenance. Over time, things in a house break and need to be replaced. These repair costs are one of the biggest hitting costs of owning a home and can sneak up on homeowners. Repair costs can range from a few hundred for a plumber to repair a leaky pipe to $10,000 to replace the HVAC system to over $15,000 to get a new roof put on. As a rough rule of thumb, it is recommended to budget 1 to 2% of the home value each year to account for these costs.

Now, let's see how all these costs apply to our friend John here. For the sake of this example, let's say the typical house in John's area is selling for $500,000. If John wants to have a 20% down payment, he will have to come out of pocket $100,000. That means John will have to borrow the remaining $400,000 in the form of a mortgage. At a 7% interest rate on a 30-year mortgage, John's monthly payment would be $2,661. John put 20% down, so he isn't required to pay PMI; we can put zero for that cost item.

As a homeowner, John is also going to have property taxes. Assuming annual property taxes of 1.2% of the home's value, that comes out to $6,000 a year or $500 a month. Next up is homeowners insurance, and let's pencil that in at $200 a month. Maintenance, if John sets aside 1% of the property's value each year to account for repairs, that's another $5,000 a year or about $417 a month. This brings John's total cash out-of-pocket cost to $3,778 a month with $100,000 down on a $500,000 house.

The costs associated with home ownership don't stop there. There's an often overlooked cost associated with buying a home that most people make the huge mistake of ignoring. In fact, this cost is the exact reason why Warren Buffett delayed buying a house until his net worth was a whopping 10 times larger than the down payment on his eventual home purchase. What I'm referencing is something referred to as opportunity cost. Opportunity cost is the potential benefits that someone misses out on when choosing one option over another. This is why Warren Buffett didn't want to buy a house; the money that he tied up making the home purchase could no longer be used to generate high investment returns in the stock market.

Buffett's opportunity cost on his money was probably 30, 40, or even 50% annually. These are returns he would have been sacrificing if he bought a house earlier. I know you aren't Warren Buffett; however, historically, the stock market has dramatically outperformed single-family houses in terms of returns. Because of this, there is an opportunity cost associated with using money as a down payment on a house versus investing that money in the stock market.

Going back to our example with John, let's assume there is a 6% annual opportunity cost on the $100,000 he put down to purchase the house. This means that John has an opportunity cost of $6,000 a year or $500 a month. Opportunity cost brings John's total monthly cost of owning a home up to $4,270 a month, much higher than just his original monthly mortgage payment.

Now, of course, this example here is rough math. There are probably some costs or benefits that we are missing; however, it does demonstrate the point that from a purely financial standpoint, owning a home is much more costly than most people realize. Compare that to renting: when you rent, calculating your monthly cost is super simple. It is whatever the rent amount is, and that's pretty much it. At least in the US, renters typically aren't responsible for things like property taxes, maintenance, or homeowners insurance.

Right now is the cheapest it's ever been to rent compared to buying a home. As an example, look at this neighborhood in Indianapolis, Indiana. Homes in this neighborhood are selling for $500,000, which, as we talked about earlier, would cost around $4,300 a month to own. These same types of homes can be rented for anywhere from $1,700 to $2,300, literally right down the street. While this is just one neighborhood in one city, this trend is true throughout the country. In fact, there are only four US cities where it is cheaper to buy than to rent.

Just to show you how wild things are right now, let's take a look at this graphic dating back to 1970. It has never been this much more expensive to buy versus rent, and as you can see, it's not even close. So now that we have established that buying a home isn't necessarily cheaper than renting when factoring all the hidden costs, I want to get to the core of why Buffett says buying a house can be a subpar investment.

Let's go back to our friend John from earlier. Let's say John lives in his house for 10 years. After those 10 years of making monthly mortgage payments, his loan balance will have been reduced to $343,000. In calculating John's financial return, there's also the very nuanced factor of home price appreciation that you have to consider. Over the long term, home prices tend to keep up with inflation; however, so do things like repairs, property taxes, and insurance. So let's say that John's home appreciates at an average annual rate of 2%. That means at the end of 10 years, John's home will be worth approximately $610,000.

However, when John goes to sell the house, he will have to pay closing costs and commissions. This typically accounts for about 8% of the home's value, meaning John's net sales price will be $561,000. Subtracting out the loan balance of $343,000 leaves John with cash in his pocket of nearly $218,000. Using his $100,000 down payment as the base, that means that John's money grew at an average rate of about 8% in the 10 years he owned the house. If we redo the numbers and assume the house appreciated at 1%, John's implied return falls to about 5%.

Compare that return to what John would have had if he instead invested that $100,000 into the stock market. Additionally, for the sake of this example, let's say John can invest an additional $5,000 a year with the money he saved by renting. As we talked about earlier, assuming the long-term return of the stock market is about 10%, at the end of the 10 years, John's $100,000 would have turned into $339,000. This works out to an implied annual return of 13.3%. In this example here, John would have been better off financially if he would have passed on buying a house and instead invested that money in the stock market.

This is exactly what Warren Buffett means when he says that often buying a house is a mediocre financial investment. That's because when you buy a house, you are making a highly levered bet on the home price appreciation. To put it in another way, you are using a lot of debt to buy a house in the hopes that home prices will keep rising. If you put a 10% down payment and home prices rise 10%, you can double your money. However, with that same 10% down payment, if home values fall 10%, you lose 100% of your money. Without the effects of leverage, the financial returns from buying a house would look even more mediocre.

These numbers we just talked through earlier in the video help explain why even wealthy Americans are choosing to rent instead of buy. Now, we have spent this video talking about the financial returns from buying a house. However, as Buffett mentioned earlier in the clip, there are countless non-financial reasons to buy a home. This video wouldn't be complete without providing that disclaimer. Many people and families get unmeasurable intangible value from owning their home. Even though Buffett considers the purchase of his own house a lousy financial investment, he has said on numerous occasions it was some of the best money he has ever spent, not because of the returns it generated but because of the memories it produced.

So there we have it. Make sure to subscribe to the channel because it's my goal to make you a better investor by studying the world's greatest investors. Talk to you again soon. [Music]