It makes sense to buy your first home at the age of 50, after renting for 25 years

The following is an excerpt from Prof. Moshe Milevsky’s Your Money Milestones: A Guide to Making the 9 Most Important Financial Decisions of Your Life. It argues that the logic of ‘investing’ in real estate early in your life is a much less logical decision than waiting as long as possible to sink your capital into a relatively illiquid asset.

The Globe And Mail – Many homeowners should have rented

At first glance, when you buy a house for, say, $500,000, you are increasing the left side of your personal balance sheet (your assets) by $500,000 dollars. If you used $50,000 as a downpayment, which came from your own assets, the increase in assets was only $450,000.

On the right side of the personal balance sheet, you had to finance the purchase of this house with debt, so if you made a 10 per cent down payment and financed the other $450,000, your liabilities have increased by $450,000 in total. The important thing to remember is that the equity on your personal balance sheet has not changed. You have $450,000 more in assets and $450,000 more in liabilities–and you’ve converted financial capital into a down payment.

Now let’s examine what your personal balance sheet will look like in five years, ignoring human capital considerations. If you have been carefully paying down your mortgage debt, perhaps the remaining liabilities have been reduced to $400,000. And, even if housing prices have not increased at all, you have created $50,000 more in equity in your home, for total equity of $100,000. (This is the original downpayment of $50,000 plus the $50,000 in total payments over the last five years.) So far, so good.

But now let’s imagine that housing prices fell by 20 per cent over that same five-year period. This isn’t inconceivable–and is exactly what just happened in many regions of the United States over the last five years, as shown in Table 6.1. In that case, a 20 per cent drop in the value of a $500,000 house leaves you with a balance sheet asset of $400,000. This is exactly what you owe in debt (mortgage) on the house, and you have no equity. The $50,000 you originally invested in the house is gone, and all the payments you have made in the last five years could essentially be considered rent.

You are no further ahead now, financially, than you were five years ago. All you did was consume housing.

Here’s the argument against home ownership early in life: When you are young the vast majority of your true wealth is locked up in human capital, which is illiquid, nondiversified, and definitely nontradable. It therefore makes little sense to invest yet another substantial amount of total wealth in yet another illiquid and nondiversifiable item like a house.

Sure, if you could buy a house that has a bedroom in New York City, a bathroom in Los Angeles, and a kitchen in Chicago and perhaps a garage in Las Vegas, yes, your home would be diversified. Buying a house as an investment has strong similarities to someone being convinced that stocks are good investment in the “long run,” but they decide to buy only one stock for their portfolio. I don’t care how reliable that one stock is, or how large are the dividends, that stock portfolio is not diversified. The same goes for housing.

In addition, when you are young, your human capital and hence your total wealth is sensitive to the evolution of your wages and income over time. These two factors tend to decline in a recession and bad economic times, just like housing. In other words, there is a good chance that if your job wages take a hit, so will your real estate. […] In fact, evidence from the U.S.-based Panel Study of Income Dynamics suggests that controlling for levels of wealth, homeowners actually own less stock-based investments, compared to renters, possibly because of this same reason. Stocks are diversified, tradable, and liquid. Houses are not.

In sum, a strong argument can be made–absent all the psychic factors involved in the decision–that renting is the optimal choice when you are young.

However, when you are older (say 50 or 60) and you have unlocked a large portion of your illiquid and nontradable human capital and converted it into financial capital, you can afford to “freeze” some financial capital and lock into a home purchase. At that stage, not only do you have more wealth in total, but also your balance sheet (and especially your human capital) is likely not as sensitive to the state of the economy and its disruptive impact on wages. So, [the completely logical] Mr. Spock buys his first house–after 25 years of renting–at the age of 50.

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