Introduction
Traditional thinking influences individuals to buy a house because we see spending money on rent as a waste of money. I’ll admit I thought this way when I was just getting out of college because it is traditional wisdom. However, for individuals just getting out of high school / college and for young professionals, I urge you to really try to understand what buying a house means. In addition, I urge individuals to learn about retirement accounts and their drastic advantages and power. Retirement accounts are available to most of us however so few of us participate. Why? Because it goes against traditional advice. But let me tell you…NOTHING in real estate can come close to the power of compound interest for someone who possesses a 30-40 year time horizon.
I am referring to “traditional real estate” as the purchase of a tangible house. I label traditional real estate because in today’s technology driven world, it is possible to purchase real estate through crowdfunding, REITs, and real estate portfolios without physical ownership of a tangible house. This post strictly refers to traditional real estate.
I am not saying individuals should not buy traditional real estate. In fact, real estate can be extremely lucrative. Especially if the intent is to purchase real estate as rental property. But the average individual who purchases traditional real estate usually makes the purchase with intentions of buying a place to live. They do it because they think it is a “good investment” and that they are no longer “throwing away money” on rent.
Now I could get into the specific finances of the two options, but there are truly too many variables to weigh, especially with purchasing traditional real estate. The simple truth is that most people have no idea what to do with their money, especially early in life. This is why so many people go down the conventional path of buying a house. Early in life, 99% of the time investing into retirement accounts is the much better alternative. But no one does it because they are not educated regarding money.
Buying Traditional Real Estate vs. Investing Into Retirement Accounts
The Costs
Opportunity Cost
Time is perhaps the most valuable commodity on the planet. It is for sure the most important element when it comes to investing and building wealth. If a house is purchased to live in, you immediately establish a Non-Current Asset (house) and Non-Current Liability (mortgage). By doing this, you have an asset that you can hopefully sell for a profit at some point, but the latter action of establishing a mortgage is a dangerous cost because it constricts your cash flow and introduces an individual to the most dangerous cost of all…opportunity cost.
Opportunity cost is defined as a benefit that a person could have received, but gave up, to take another course of action. Establishing a mortgage equates to a debt that must be paid every month in order to pay off the loan acquired to purchase the house. In addition, multiple other expenses are established when purchasing a home including high transaction costs, property insurance, maintenance, property taxes, interest, and the time required for house related requirements. These expenses add up and restrict the amount of money that you could potentially throw into the market within your retirement accounts and allow for compound interest to work its unbelievable magic. Let’s look at the numbers.
For example, let’s use 10 years as our time frame for an individual who is 25 years old. Let’s say you did well in school and you struck a well-paying job that pays an annual salary of $70,000. Would it be wise to purchase a house or max out retirement accounts? Let’s look at the table below.
| Home Ownership (10 Years of Ownership) | |||
| Item | Monthly Cost for $100,000 House | Multiplier | Monthly Cost for $250,000 House |
| Transaction | $ 125.00 | 2.5 | $ 312.50 |
| Maintenance | $ 167.00 | 2.5 | $ 417.50 |
| Property Taxes | $ 83.00 | 2.5 | $ 207.50 |
| Property Insurance | $ 42.00 | 2.5 | $ 105.00 |
| Interest / Opportunity Cost | $ 417.00 | 2.5 | $ 1,042.50 |
| Total | $ 834.00 | $ 2,085.00 | |
| Cash Flow ($70,000 Example) – No 401k Savings | |||
| Home Ownership | Renting | ||
| Income | Monthly Amount | Income | Monthly Amount |
| Salary | $ 3,880.00 | Salary | $ 3,880.00 |
| Expense | Monthly Amount | Expense | Monthly Amount |
| Home Ownership | $ 2,085.00 | Rent | $ 850.00 |
| Net Amount | Net Amount | ||
| Total | $ 1,795.00 | Total | $ 3,030.00 |
| Cash Flow ($70,000 Example) – Max 401k Savings & IRA Contributions | |||
| Home Ownership | Renting | ||
| Income | Monthly Amount | Income | Monthly Amount |
| Salary | $ 2,865.00 | Salary | $ 2,865.00 |
| Expense | Monthly Amount | Expense | Monthly Amount |
| Home Ownership | $ 2,085.00 | Rent | $ 850.00 |
| IRA Contributions | $ 458.00 | IRA Contributions | $ 458.00 |
| Net Amount | Net Amount | ||
| Total | $ 322.00 | $ 1,557.00 | |
For the Home Ownership (10 Years of Ownership) section, I did research and was able to determine the various costs associated with home ownership per month. We will say for simplicity sake that the individual is looking to buy a $250,000 house. Please see the total monthly cost calculation.
For the Cash Flow sections, I summarized a basic monthly cash flow representation for an individual who either does not contribute to their retirement accounts or maxes out their retirement accounts. In both scenarios, I illustrated the costs of home ownership as well.
The key takeaway here is to illustrate the understanding of how difficult it would be to contribute to retirement accounts if you were to buy a house and as a result restrict your cash flow tremendously. It would be pretty much impossible to own a home and max out retirement accounts given the current scenario. However, if you were to rent, you could be flexible with your cash flow and you could max out your retirement accounts and still have some discretionary income left for other various expenses. Let’s look at two scenarios:
Scenario One: For simplicity, let’s say the house raised in value by $50,000. Buying a house with no retirement contributions after 10 years would maybe yield you a house with enough equity in it to equate to ~$100,000.
Scenario Two: Not buying a house and maxing out retirement accounts would yield you no equity within a house. However, the compound interest figures are ridiculously beneficial. Maxing out retirement accounts equates to a $24,000 annual expense. If the individual were to do this at 25 years old and STOP contributing at age 35 (ten year timeline for both scenarios), the individual would end up with a year-end balance of $420,748. For this scenario, I used a 3% inflation rate and a 10% market return. For those finance nuts, let’s reduce the market return to 9.2% which is what an aggressive mix of stocks / bonds would yield using the efficient frontier. We would end up with $401,997.
Here’s the beauty of it. For Scenario Two, not only would the individual end up with more money at the end of a 10 year time horizon, if the individual would leave the dollar amounts within their accounts and not contribute one additional penny…guess how much you would end up with at 70?
10% = $10,749,131
9.2% = $8,012,953
That’s over 10 MILLION dollars folks. This is why opportunity cost is the most expensive cost regarding real estate and/or maxing out retirement accounts. In addition and again, nothing in real estate comes even remotely close to the power of compound interest for a young individual with a lengthy time horizon.
Cash Intensive
Investing into traditional real estate is extremely cash intensive. As illustrated in the example above, buying a house is a serious purchase. It is a hindrance on your cash flow. In addition, it is very expensive up front to purchase and it is expensive to sell. During the time span of homeowner ship, various things happen that can drastically accumulate additional costs as well.
Illiquid and Immobile
When you buy a house, you are growing roots. This may not be practical at an early age and during a time when you are figuring out who you are and what career you want to pursue. My portfolios are mobile. Meaning I can continue to invest, monitor, and access them wherever and whenever life takes me. When you buy real estate, you are investing serious amounts of cash into an ill-liquid asset.
Balance Sheet Recognition
When I invest into my retirement accounts, I am solely increasing my assets. If traditional real estate is purchased incorrectly (as it very often is) you are increasing your assets but at the same time increasing liabilities.
Final Thoughts
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If you want to be financially independent…one of the best things you can do for your financial future from ages 20-30 is to max out your retirement accounts. I thoroughly believe that building as large of a savings/investment portfolio at a young age should be a top priority. Traditional real estate is not only expensive initially, it requires constant maintenance and can squeeze your cash flow quite hard. It can make you immobile as a young professional…this is extremely risky for your future. Once a strong portfolio is established and enough cash is saved for an adequate down payment, I recommend then looking into real estate. You do not want a mortgage and the multiple other expenses associated with owning house affecting your ability to save for retirement. Before you buy property, you had better make sure you got your money right. If you don’t, you will end up retiring with a house. While those who developed a strong portfolio at an early age will retire in Jamaica.
When people ask me…”When are you going to buy a house? You’re just throwing money away on rent.” I just look at them and smile. 99% of the time, the person who asks me the question knows nothing about money.
Redefine
-James
Note: For retirement calculations above, I used the best retirement calculator I could find located at the Financial Mentor website. For the example illustrated above regarding home ownership, I used the basics. I did not get complicated on purpose.