Investing Vs. Homebuying: Where Should Your Money Go?

Investing in the stock market or buying a house are both passive income sources. However, the two options have different pros and cons, and which one is better depends on an individual's financial health, risk tolerance, and short- and long-term goals.

The stock market can potentially yield better returns over time. For example, investments in the stock market post about 10% annual returns, while real estate earns just three to four percent per year historically.

On the other hand, investing in real estate is a more stable option. Even after a slump, only recent purchasers are underwater. Most people buy and hold their own homes for many years or even decades. Additionally, a house that is worth, say, 20% less than what you paid for it still does its job as a house.

Moreover, it is easier to get a loan to buy a house than to invest in the stock market. For example, a bank will lend you £400,000 to buy a house at an interest rate that, even in normal times, is just a smidgeon above inflation. In contrast, it is challenging to get a loan to invest in the stock market.

However, buying a house requires work and upfront costs when it comes to house-hunting, screening tenants, and hiring property managers. Being a property owner is also work in itself, as you must take care of repairs and renovations and handle tenant questions and concerns.

Overall, it is a personal preference regarding what one chooses to invest in. Whether buying a home, buying a rental property, or investing in the stock market, it is essential to consider all factors carefully before opting for one route or the other.

Homeownership vs renting

Homeownership and renting each have their advantages and disadvantages, and the best option depends on an individual's circumstances, goals, and finances. Here is a detailed comparison of the two:

Homeownership

Homeownership is a significant financial commitment that requires planning and consideration of one's life trajectory. It often entails a down payment and closing costs, with better mortgage terms typically available to those who can afford a larger down payment. While owning a home provides stability and peace of mind, it also comes with regular maintenance and repair costs, which can be expensive if the homeowner is not handy with DIY tasks.

One of the biggest advantages of homeownership is the potential for long-term financial security. Historically, the housing market has tended to increase in value over time, rewarding homeowners with equity and borrowing power. Additionally, homeowners have control over renovations and customisations, which can boost the home's value.

Other benefits of homeownership include:

• The ability to build equity over time, increasing personal wealth.
• Stable monthly payments with a fixed-rate mortgage, protecting against fluctuating rent prices.
• Tax benefits, such as deductions for mortgage interest, property taxes, and some closing costs.
• The freedom to make decisions about future home and yard development, such as adding rooms or a pool.

However, there are also disadvantages to consider. Homeownership can be expensive, with various upfront costs and ongoing maintenance expenses. Property values can also fall, and it may take years to build significant equity, especially without a large down payment. Selling a home can be challenging, and one may need to continue making mortgage payments and maintaining the property during the selling process.

Renting

Renting typically requires less upfront cost, with many landlords asking for the first and last month's rent, as well as a security deposit. Repairs and maintenance are generally the responsibility of the landlord, and relocating can be easier for renters, as they have fewer financial ties to the property.

Advantages of renting include:

• Lower upfront costs, making it a more affordable option for those who cannot afford a large down payment.
• Flexibility, as the obligation to a rental property is limited to the length of the lease.
• No responsibility for repairs and maintenance, which can be costly and time-consuming.
• No HOA dues or other additional fees associated with homeownership.

However, there are also disadvantages to renting. Renters may have limited control over the property, needing permission from the landlord for any desired changes or improvements. Rent amounts may increase over time, and renting does not build equity or improve one's credit score in the same way that owning a home can.

In conclusion, both homeownership and renting have their pros and cons. Homeownership provides stability, control, and the potential for long-term financial gains, but it also comes with significant upfront and maintenance costs. Renting offers flexibility and lower upfront costs but may provide fewer opportunities for building equity or customising one's living space. The best option depends on an individual's financial situation, lifestyle preferences, and long-term goals.

Appreciation vs depreciation

Appreciation and depreciation are two sides of the same coin. When an asset appreciates, it means its value has increased, whereas depreciation is when the value of an asset decreases over time.

Appreciation

Appreciation occurs when there is a change in the demand and supply of a service or product, which can result in inflation and lower interest rates. For example, when there is an increase in demand for a commodity and a decrease in its supply, the value of that commodity will appreciate.

Appreciation can be seen in two ways:

• Capital Appreciation: This is the increase in profit a firm receives from an investment bought at the market price, or the difference between the buying and selling price of an investment.
• Currency Appreciation: This is the increase in the value of a currency in relation to another currency, which impacts the forex market.

Depreciation

Depreciation is a decrease in the value of an asset, which can be viewed in two ways:

• A decrease in an asset's value over time.
• A decrease in the value of an asset due to wear and tear.

There are several reasons why assets lose value over time, including:

• Short Life Span: Some assets become less relevant over time, especially inventories compared to fixed assets.
• Depletion: Assets that are used frequently will wear out and need replacement.
• Obsolescence or Ineffectiveness: Old and outdated equipment can become obsolete and be replaced by newer, more effective equipment.

Real Estate Appreciation vs Depreciation

While a property's physical structure tends to depreciate over time, the land it sits on typically appreciates in value. This is because land is in limited supply, and as the population increases, so does the demand for land, driving up its price.

Therefore, when investing in real estate, it is important to consider the potential for land appreciation and how it can offset the depreciation of the physical structure of the property.

Liquidity

Real estate is generally considered an illiquid asset compared to stocks, bonds, and ETFs. This means that property assets are typically more difficult to exchange for cash. There are several reasons for this:

• Private markets: Real estate transactions are often private, whereas public markets provide investors with continuous access to information such as stock prices, annual returns, and company reports. Private markets, on the other hand, tend to lack transparency, requiring buyers to conduct their own market research and due diligence, which can be time-consuming.
• Complicated transactions: Finalizing a sale in real estate involves multiple parties, including buyers, sellers, lawyers, real estate agents, brokers, accountants, and property inspectors. This process can take weeks or even months, and it involves significant transaction costs.
• Market fluctuations: Real estate prices can vary considerably depending on market fluctuations, such as whether it is a seller's or buyer's market. This uncertainty can make investors concerned about their ability to quickly liquidate their real estate assets.

The illiquid nature of real estate can pose challenges for investors who may need quick access to cash, such as when unexpected expenses arise or when they want to seize new investment opportunities. However, it's important to note that not all real estate investments are equally illiquid. For example, real estate investment trusts (REITs) are publicly traded companies that own or finance investment properties, and their shares can be bought and sold during market hours, making them highly liquid.

Additionally, certain real estate investment strategies can help mitigate liquidity risk. For instance, commercial property flipping involves buying and renovating a run-down property before selling it, potentially increasing its liquidity. Another strategy is wholesaling, where investors buy undervalued properties and quickly sell them to buyers at market rates.

Tax efficiency

Investing in the stock market and investing in real estate are both passive income sources. However, there are several differences between the two when it comes to tax efficiency.

Taxable Accounts

A taxable account, such as a brokerage account, offers more flexibility than tax-advantaged accounts. The returns are taxed based on how long the asset was held and sold. Investments held for longer than a year are subject to long-term capital gains rates of 0%, 15%, or 20%, depending on the investor's tax bracket. Investments held for a year or less are subject to short-term capital gains tax, which is based on the individual's ordinary income tax bracket.

Tax-Advantaged Accounts

Tax-advantaged accounts can be tax-deferred or tax-exempt. Traditional IRAs and 401(k) plans are examples of tax-deferred accounts, which provide upfront tax breaks. Investors pay taxes when they withdraw their money in retirement. On the other hand, Roth IRAs and Roth 401(k)s are tax-exempt. Contributions to these plans are made with after-tax dollars, but investments grow tax-free, and qualified withdrawals in retirement are tax-free. These accounts have restrictions and penalties for early withdrawals.

Tax-Efficient Investments

Some investments are more tax-efficient than others. For example, tax-managed funds and exchange-traded funds (ETFs) tend to be more tax-efficient because they trigger fewer capital gains. Municipal bonds are also tax-efficient as they are exempt from federal taxes and may be tax-exempt at the state and local levels. Treasury bonds and Series I bonds are exempt from state and local income taxes.

When it comes to investing in real estate, there are tax implications to consider as well. For example, property taxes and the impact of depreciation on taxes. Additionally, renting out a property may have tax consequences, such as the need to pay income tax on rental income.

In summary, both investing in the stock market and investing in real estate have tax implications that should be considered when making investment decisions. It is important to consult with a financial advisor or tax specialist to determine the best tax strategy for your specific situation.

Leverage

The most common way to leverage your investment in real estate is by using your own money or taking out a mortgage. The easiest way to access leverage is to use your own money, with a standard 20% down payment getting you 100% of the house. Some financing programmes allow you to put less money down.

To avoid the risks of leveraging, it is important to make sound investment decisions and account for potential vacancies, a tough economy, and other factors that can affect your ability to make mortgage payments. It is also crucial to remember that past performance does not guarantee future results, and real estate values can decrease as well as increase.

Frequently asked questions