Thursday, June 16, 2016

“The Foundation of Financial Independence is a Paid-for Home”

This article’s title is a frequent quote from journalist Jonathan Chevreau (see here for one among many examples). He is a baby boomer and this advice has worked out spectacularly well for most baby boomers who have followed it. However, today, this advice is likely to lead young people astray.

In much of Canada, house prices have become—pardon the technical term—stupid. My first mortgage was less than one-and-a-half times my family’s yearly gross income. Even cheaper fully-detached homes on nice lots were available at the time. Today I see families getting mortgages for four to five times their gross incomes. The multiple on their take-home pay is even higher. This creates enormous multi-decade financial burdens at a time when secure long-term employment is becoming scarcer.

Getting back to baby boomers, buying a home had many advantages. One such advantage was that in the period shortly after buying a home, mortgage payments forced a family to control spending and save indirectly by increasing home equity. Then as inflation eroded the value of the owed payments, the pressure eased off. Falling interest rates caused mortgage payments to drop even further.

However, today’s home buyers can expect a different experience. Rather than creating a sensible level of forced savings, many families have mortgage payments that are a huge burden eating up a big chunk of their take-home pay. Low inflation takes away the hope that future mortgage payments will be more affordable. There is very little room for interest rates to decrease and they may increase. Even a modest interest rate increase will drive up mortgage payments significantly.

Baby boomers enjoyed huge increases in the values of their homes. In most cases, these increases exceeded inflation by a wide margin. Today’s home buyers can’t expect the same outcome. For house prices to increase by as much in the coming decades as they did in the past few decades, there would have to be a flood of rich people to pay the astronomical prices. It’s possible that house prices will manage to increase with inflation, but another possibility is a substantial drop in prices at some point.

Young people face too much marketing and parental advice to take on huge financial commitments such as expensive houses and cars. A much safer path is to pay as you go by renting and buying modest used cars. The trick with this path is to save a significant fraction of your income along the way. I usually recommend 20% of take-home pay.

The purpose of such saving isn’t just a very far off thing like retirement. Maybe you’ll decide to buy a house when you can better afford it. Or maybe you’ll go back to school. Or maybe you’ll need a cash buffer while you change careers. If this doesn’t motivate you, then just think about the reality of working for several years and having nothing to show for it. You should have some savings in return for the work you put in.

A big benefit that baby boomers got from owning their own homes was ending up with a paid-for home 20 to 30 years later. Those who rent are certainly at risk of having nothing to show for their years of working if they don’t save any money. However, home ownership has its risks as well. Many people today have over-extended themselves and are destined to repeatedly re-expand their mortgages or lose their homes entirely. This risk would become much worse with job loss or if interest rates rise.

Baby boomers who bought homes when they were starting out did well, but this strategy is much less likely to work out well today. Now it’s definitely a bad idea to borrow as much as a bank is willing to lend you for a house. You’re likely better off taking a lower risk path that includes renting a home and saving some of your income as a foundation for financial independence.


  1. As is usual, any one-sentence mantra ends up being oversimplistic -- and also susceptible to misinterpretation. I think Chevreau's statement needs to be taken in the context of his definition of financial independence ("Findependence Day"), i.e. a state where you are well-off enough that you can do what the he** you want in terms of work/career.
    Within this frame, I do think a paid-off home is nearly-but-not-quite a necessity to be financially independent. If you are renting, your cash flow needs are bigger and more uncertain long term (who knows how your rent will evolve, and when you might be forced to move) and so the nest-egg or level of passive income you need to be able to depend on is much higher. That does have as a corollary that I think very few people can become financially independent by their 40s or even 50s in Toronto or Vancouver by being a high-savings wage-earner. If that is their goal, they need to move elsewhere.
    I also agree with you that an awful lot of people fall into the trap (and Chevreau's statement doesn't help) of feeling the main and priority goal must be to buy a house as a soon as possible; that this is the marker of being financially responsible. As you say, this forces too many constraints too early -- and exposes them to too much concentrated risk.
    I'd amend it to:
    "The first crucial step to financial responsibility -- and eventual financial independence -- is making a habit of living within your means, and in particular making your lifestyle inflation lag your income increases." The rest then follows, with home ownership, and paying off the mortgage, also being steps on the staircase, but where exactly they sit versus other steps depends."

    1. @Martin: I tend to think of it in terms of likelihood of achieving financial independence at some point. I've told my sons that I think they are likely to be better off financially in the long run if they plan to rent for several years while saving a good chunk of their incomes. I think the risk that they will simply spend all the income is lower than the risk of blowing up if they stretch to buy a home at today's inflated prices.

  2. I remember when we bought our first house back in 1999 with a mortgage equal to our household annual take home pay. Now, buying the place we live would be 3x our gross salary (or 4x take home)!!! We plan to be mortgage free within 2-3 years and always kept saving 25-40%

    Numbers are very different with rates in the 2-3% range than it was 15 years ago @ 6.55% !!!!!!!

    When the boomers will be forced to sell their houses (and their cottages) in mass, the prices will be likely to fall for sure.

    We often thinks to sell our place when our children leave if prices are still good at that point. Hopefully, our house represent no more than 35% of our assets and this % keep decreasing every year.

    1. @Le Barbu: Your experience with rising a house value is similar to mine. The interest rate on my first mortgage was much higher than 6.55% though :-)

      I wouldn't count on a sudden increase in boomer selling. It is likely to be very spread out.

  3. "I'd rather die than rent", was a quote from someone on Preet B's twitter feed, and that seems a little extreme to me.

    A paid for house is Nirvana to old folks, but will it in this generation? Baby boomers really are thee first generation to "retire", but will they be the only generation who can retire?

    1. @Alan: I'm pretty sure that retirement will continue to exist, but the best path to get there may not ever involve owning a home.

    2. I certainly agree that home buyers should avoid taking on as much housing debt as the bank will allow. I remember purchasing our first house in 1997 and I couldn't believe that the bank would allow our housing costs (mortgage payments, insurance, heating costs) to equal around 40% of our take-home pay - this seemed too high to me and would have left us "house poor". We ended up purchasing a house that kept our housing costs much below that level so we could afford other things.

      Nowadays, especially in Toronto and Vancouver, housing is much less affordable. If I was starting out in those markets, I would probably just rent or settle for a more affordable condo. Perhaps a single family home is no longer realistic for the average family in some markets like Vancouver and expectations should be reset. An average family in New York for example probably doesn't expect to be able to afford a house and just aspires for an apartment or condo.

    3. @Blitzer68: I agree that banks will lend way too much. I'd certainly be more comfortable renting a condo before buying one in today's market.

    4. Hi Michael,
      As someone who sold their home in Toronto about 7 years ago and has since been renting a condo, I can tell you that it is not all a bed of roses. I have actually rented two condos and in both cases, had to vacate since the owner wanted to sell. Rents actually exceeded what I would pay for a mortgage on a much larger home so have now decided to buy again at almost age 60. Simply tired of being asked to move at the landlord's whim. And if you suggest renting from a commercial landlord, you are back to using the public laundry room, etc. which just doesn't cut it anymore. So, I agree it makes sense to rent for longer while young. I also think that certain folks don't realize what you give up when renting, especially a condo (security, space, etc.)

    5. @Anonymous: It sounds like you've had some bad luck. I've chosen to continue owning my home for lifestyle reasons, but that doesn't mean it has been a good idea from a purely financial point of view.

      Your comparison of the mortgage to rent misses the huge costs of upkeep, property taxes, and insurance. If you're prepared to make the jump into ownership for lifestyle reasons, and you understand this will come at a cost, then it can be a sensible choice.

  4. It's not the "paid-for home" which creates the foundation, it's the reduction of expenses and creation of 'stable' costs. Similar to living in a rent controlled apartment. Everyone has their bias.

    But yes, I completely agree, home ownership (aka residential real estate) was (perhaps) the best thing to pursue within a certain economic era. That era no longer exists thus the results will be different, and most likely much different. "Home ownership" has been a massive marketing scheme since the end of WWII and doesn't seem likely to end any time soon, although that lemon is getting a lot harder to squeeze.

    1. @SST: I'd like to think that lemon is getting harder to squeeze, but when I ask people in their early twenties about their hopes, owning a house is still high on the list. I try to point out that it is possible to rent a nice home, but most people still associate renting with apartments.

  5. Let me start by saying that I'm a big fan of the stock market but I think most people miss the key ingredient about buying a home: cheap leverage. The average person cannot get access to a loan for 4-5 times household income at sub 3% for anything other than a home. I would argue this is the chief difference between investing in stocks and owning a home. For stocks one only achieves returns only on the capital invested. On a home, however, one achieve returns on the whole value of the home minus what is paid in interest. In other words, one can achieve cheap leverage with buying home that one is unlikely to achieve otherwise. This is really how people make lots of money on owning a home although few people realize it.

    1. @Unknown: Leverage can lead to making lots of money or losing lots of money. In the recent past, the real estate boom allowed people to make a lot of money. The future can't be as rosy. Even factoring in leverage, renting looks like the better financial choice to me.

    2. Leverage is definitely a double edged sword. If your position is that a housing correction is likely in Canada then I would be careful about my asset allocation toward the TSX as any housing correction is going to drag the Canadian market down with it.

      Personally, I feel that the story of Canadian housing is often misinterpreted. Toronto and Vancouver housing prices don't look normal to baby boomers. That's because housing used to be priced as a place to live but now it is priced as a financial asset. Especially in Toronto and Vancouver it is now priced as part of a global market. While it is true that neither of those cities are New York, London or Shanghai the prices in Toronto and Vancouver are still as well below those levels. I think, the combination of foreign capital looking for a safe place and the fact that most immigrants in Canada end up in Toronto or Vancouver will continue to push up prices in those markets. And while a correction will always eventually come I think those two markets will recover quickly.

      I actually think the bigger risk is in the surrounding areas of those markets. If a house in Toronto isn't worth $1.5 million than a house in Brampton isn't worth $700-800k and a house in Hamilton isn't worth $500k. I think the latter markets will have a much harder time recovering from a correction than core Toronto or Vancouver. The surrounding markets are not global markets (immigrants for the most part have no interest in investing there or living there).

    3. @Tom: I have no opinion about whether a correction is coming or when it would arrive. What I am confident of is that Canadian house prices over the next 15 years can't rise by as much as they did in the past 15 years.

  6. The following exchange is reproduced to remove broken links.

    ----- BHCh June 17, 2016 at 12:13 PM
    Not sure why this is so focused on the boomers. I bought my first house in 1995, 2 times family income. Sold in 1999, same price plus inflation. Second house was worth 2.5 family income. Sold it 5 years later at 2.4 times the purchase price. My third house was worth over 5 times annual income with the mortgage of about twice the income. The price more than doubled in 10 years. About time to downsize as the kids have moved out.

    There are several factors to consider

    - location. The number of rich people in the country does not have to increase as long as they all want to move to your town.

    - Freedom to set everything like you like it that comes with ownership.
    - you move when you want, not when the landlord decides to kick you out.
    - you talk about financial risks vs prices going up. There are other considerations, like your monthly expenditure should be lower if you own the place.

    ----- Michael James June 17, 2016 at 12:49 PM

    @BHCh: It's true that the cohort just younger than the baby boomers benefited from the run-up in house prices as well.

    It's funny how most people think it's cheaper to own than rent. This is almost never true when you do a full accounting. People compare mortgage payments to rent, which is ridiculous. What about upkeep, property taxes, and insurance? If you own the property with no mortgage, then you eliminate the mortgage payment but add in opportunity cost for the capital (over the long term, stocks outperform real estate). Dropping interest rates have accelerated house price growth for so long that we now have unrealistic expectations for continued growth in house prices.

    ----- BHCh June 17, 2016 at 1:15 PM

    Right. Shouldn't compare mortgage payments to rent. For one thing, most of the payment goes against your debt, so it's almost a "saving".

    And yes, there are other expenditures relating to upkeep.

    On average running costs for ownership should be less than the cost of renting for the simple reason that the landlord has to take the risk and make a profit.

    So, given that you have to live somewhere, ownership might be a good option financially even if stocks are expected to outperform.

    We can argue that house prices are unusually high right now, thus lowering expected returns, but isn't it "timing the market"? I mean... If interest rates were to sharply rise then yeah, there would be a crash, but we have no idea what's going to happen.

    In the end of the day, Canada has a healthy population growth compared to most countries. They all have to live somewhere, and most seem to prefer Vancouver or Toronto. I have trouble believing that money used to purchase a house is less safe than money used to purchase shares.

    ----- Michael James June 17, 2016 at 1:40 PM

    @BHCh: If you're going to treat the non-interest portion of the mortgage payment as saving, then you have to factor in the opportunity cost of not putting the savings into stocks.

    For reasons that are not clear to me, many landlords routinely accept overall returns (counting rent and resale profits) that are lower than what can be had in the stock market. However, a more important factor is that successful landlords can maintain a property much cheaper than most individuals can. So, the landlord's running costs are lower than my running costs.

    When I have looked at a specific situation where I can buy a house or rent a similar house on the same street, the total costs for renting come out much lower. This may change if house prices come down significantly or rents increase significantly, but for now it's not close. This isn't "timing the market"; it's just comparing two options.

    Whether real estate investments are safer than stock market investments all comes down to how you define "safe". I feel safer with my investment in almost all the stocks in the world than I feel with my investment in my house.