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I received one of my monthly home value updates from Zillow the other day. It said our house was worth $530,000. That is pretty much exactly $100K higher than its purchase price just over 6 years ago.
Wow. The milestone of $100,000 in free value gained (i.e. appreciation). Seems like free money, right? Amazing!
What's In This Post
Our home finance story
It’s especially exciting to me to get an email about reaching $100,000 in home appreciation because I’m sort of a wannabe real estate junkie. I’ve always loved the real estate concept- owning rental property, flipping houses, renovating old, designing something smarter, etc. My go-to time waster during a workday or in bed at night is not social media or junk news websites, it’s mortgage prepayment calculators and Redfin property searches.
But in the 10+ years since we bought our first house, I’ve gained an appreciation (no pun intended) for the cost of realizing that milestone of 100K of appreciation over the years. So much expense goes into paying down a mortgage given its high up front interest structure, in addition to the expenses of maintaining a house which is of course critical to also maintain its market value. Those costs put a big dent in that apparently wild gain of 23% in appreciation.
What was the cost of our home’s appreciation?
What is that dent in actual dollars? Well, in those six years since buying this home, we have spent just shy of $95,000 in mortgage interest. Even I, a mortgage spreadsheet nerd(ish), didn’t have that cumulative interest number at front of mind. I knew interest offset a lot of our appreciation, but that’s 95% of it!
The bank just doesn’t highlight this cumulative interest paid number for you anywhere of course. 😉 You only pay any attention to your mortgage interest when you enter it into your annual tax return so you can get that nice deduction!
But, honestly, a tax deduction is a nice break but it’s only a discount. In other words, you wouldn’t go throw $10,000 out the window to get a $1,500 higher tax refund the following year, it’s nonsensical. So you don’t want to justify how you love paying mortgage interest just because you’ll get a tax discount.
The cost of our (old) 30-year financing
In terms of the finances, I think the tendency is to just see the difference between what your home is worth and what you owe (i.e. your total home equity) and, if favorable, your wheels start turning about what you could do with that amazing amount of cash. 100K in market appreciation?! We’re rich! Let’s buy a bigger house! This is an especially easy tendency after those early family years of having basically zero assets and plenty of debt.
We easily forget about the investment (opportunity cost) and expenses (interest, maintenance, taxes, etc) to get us there. That 100K of equity we have acquired indeed came at a cost– the opportunity cost of the cash we’ve invested in buying the house (the $18,000 down payment and the principal payments of $54,373 over 6 years – all of which certainly could have earned more return in the stock market), tons of interest ($94,947 in interest over 6 years), and all the fringe cost of maintaining, improving, and whatnot on our home (our new HVAC replacement for $10,000 and many other smaller things over the years). In addition, we paid $9,900 to refinance (into a 15 year loan) recently adding to our total spent on financing.
That’s $72,373 invested into equity for this property in the form of principal paid (down payment + principal payments).
And $114,847 spent on financing and a must-do major repair (total interest, refinance costs, HVAC replacement).
I should note that up until mid-last year we had a 4.25% interest rate on a standard 30 year fixed rate loan. So nothing outlandish to arrive at having paid nearly 20% of our home’s current value in mortgage interest thus far. Very standard stuff.
But you can see that even in a very standard mortgage we’ve spent far more on home ownership in the category of money we won’t ever see back (financing, required repair), than we have towards invested equity gain.
What our (new) 15-yr financing is doing for us
Let’s get back to that refinance. Last year (after 6 years and a few months into our 30-year loan) we refinanced into a 15 year mortgage where we pay far less interest. The lower interest cost is due in part to the lower rate offered by 15 vs 30 year mortgages, usually about 1% point lower or so from what I’ve typically seen. But also interest rates dropped further in 2020 so our current rate is 2.75% (much lower than our previous 4.25%).
But the biggest impact on interest paid is much more due to the structure of a 15 year home loan.
In the first month of our new 15-year, 2.75% loan, we paid $1,689 directly against the principal and only $856 towards interest. So that’s roughly 2/3 towards principal and 1/3 towards interest.
In contrast, in the first month of our 30-year, 4.25% loan we paid $561 against principal and $1,443 towards interest. That was closer to just 1/4 against the principal balance and 3/4 to line the lender’s pockets.
In the last month of our 30-year mortgage before the refi, our payment breakdown was $709 towards principal and $1,296 towards interest.
So, yes, six years into the loan the proportions were shifting… but not dramatically. It was still only about 1/3 towards principal and a whopping 2/3 towards interest.
Even starting over in a brand new loan, we flipped the proportion of principal/interest payments starting out in a 15-year home loan. Now it’s 2/3 principal and 1/3 interest (instead of the opposite), right out of the gate.
The other thing you’ll notice in these numbers is our 15-year loan (principal + interest) P&I ost total is $2,545 per month. Our 30 year loan P&I total was $2,005. So our payment only increased by $540. That’s a 27% increase in the size of the mortgage payment, but a 138% increase in the size of our principal balance reduction each month. Now that is quite a deal!
This happened because our monthly contribution to financing fees went down by $440 (a 34% decrease in monthly interest), and all of that is now going against principal instead too.
So, we committed to a $540 higher payment + gained $440 savings in interest = $980 net gain.
Previous principal payment was $709. New principal payment is $ 1,689. The difference = $980 net gain. Voila.
See how amazing that is?
Three key take-aways
1. Know your market’s appreciation trends
Now, why all that doom and gloom about paying for a house? I wouldn’t change a thing after all! I mean, you have to compare to the alternative of renting a home which would be a similar cost (minus maintenance) and you wouldn’t be realizing any bit of equity growth (though also not risking money lost in a bad market situation).
A key takeaway is that it is so important to consider the usual appreciation in the area you are shopping as a way of balancing your financing interest cost. The greater the amount of your interest paid is offset by appreciation makes your home not only a home, like renting would be, but an increasingly less bad, or hopefully good, investment.
Take our example above. Our balance has gone down by paying against the principal. This cash probably could earn more in terms of % ROI in other investments, but we have to live somewhere too. So that is money well spent. But the financing costs (i.e. interest)… how does that get justified?
Our appreciation has kept pace with the amount of interest we’ve paid. And that’s how we can view our cost to finance as covered by the home’s appreciation.
And then our cost to live can be viewed as our cash invested in the property (principal payments and improvement costs that we should see back some day- let’s call this a forced savings account, but without any compounding interest) plus the costs we won’t get back of basic maintenance, as well as escrow paid items like property taxes and homeowners insurance. That actually makes our house a pretty good bargain compared to renting something even remotely similar.
Everyone talks about “shopping around for a great mortgage rate” but no one talks about shopping around for a great appreciation rate compared to that interest rate. Of course, your home’s appreciation is an unknown. It’s a gamble. But just become something isn’t completely known, doesn’t mean it isn’t predictable to some extent and shouldn’t be studied during home shopping. Online tools like those from Zillow have algorithms to track and predict home costs that, while aren’t the same as a crystal ball, can give you a good sense of the area you’re buying.
Understand where home prices have been, where they are, and where they may be going relative to other areas you may consider. Don’t ignore this information! Knowing something about the appreciation you might expect in the neighborhoods you’re looking is very important to weigh against the cost of financing.
2. Always consider 15-yr loan terms when mortgage shopping
And then, always ask for the numbers on a 15 year loan when you’re looking at mortgages and getting a preapproval letter.
If shopping for a rate is important, shopping your loan lengths is important too. It may surprise you how little more it costs on a monthly basis to carry a 15-year loan which will take thousands off your interest bill each year.
Remember from above, we increased our payment by 27% in exchange for a 138% in the size of our balance paydown each month. A much, much greater fraction of your payment goes against the loan principal that way, so you’re better off even in Month 1 of your loan.
Even if you think you can’t afford it, make sure you know your numbers. Know your options. It may be that holding back some down payment money to afford the 15-yr loan would work for you. It may be that you could employ a few money saving hacks, like this trick to save $100 every month or taking a fresh look at your food spending, to make up the difference in monthly payment. At any rate, it is worth knowing your options and imagining how you could make that happen.
3. Know your rental market value
Another tip is to find out a home’s rental value. Maybe you don’t plan on ever being a landlord, but if something crazy were to happen in your life, or you grew a wild hair and wanted to live in an RV or go abroad for a year, would renting your house even be an option? Or would you be ‘upside down’ in your mortgage payment compared to a rent payment?
You should know the rental value for a house you’re buying- it’s just such a big transaction. Even if you moved permanently due to an unexpected new job opportunity, a house you’ve only been in a couple years might cost you more money to sell than you have available or are willing to part with. You might become a landlord after all.
Our first home is what turned into our investment property. The rent value was luckily in our favor when we moved out just two years after moving in. It would have probably cost about $10,000 to sell that house at that time since the transactional costs to the seller are rather high (as sellers in that market we were expected to provide assistance with closing costs to the buyer and pay both agents). More of the details of our rental property another time. However, our rent brings in about 10-15% above the monthly payment we make, even after an extra $100 towards principal we pay every month, so that is a favorable ratio.
In our current house with a (somewhat higher monthly payment) 15-year mortgage, the rent value would definitely fall short. (Note the benefits of the 15 year mortgage would still outweigh the lacking rent in the long run, but the rent value here is even slightly below what our 30 yr mortgage payment was so not ideal). As the market continues to appreciate, I expect this gap will close somewhat.
You can research your home’s rent value using Zillow (the section in the listing called Home Value/Zestimate… there’s a little number called Rent Zestimate). Also combine this with info from checking common rental listing sites (e.g. Craigslist) for homes in your area to get a feel for what a similar bed/bath home in that neighborhood may rent for. I have found Zillow to be extremely accurate for our rental property’s rental value, but high on home sale market value. And in our current home (in a different state, different market), it’s spot on for home sale market value, but maybe a little low on the rental market value.
In sum, rent value is another number and market direction that is important to know when buying (and while owning) a home. You never know what might happen in the future.
Soooo, is buying a home a good investment? Or not?
Your home’s primary value
A home is a good place to live. Let’s just remember that first. It’s important and valuable because it’s a roof over your head and that of your family. Our house checked off a lot of boxes for us, and we love our neighborhood for raising little kids… at least until we can get them out into the country! In reality, our neighborhood is one of the things I will very much miss when we do so!!
Your home’s investment value
Like it or not, though, buying a property is not just a major personal decision, but also a very significant financial decision. The cost is likely the largest in your financial pie. Make sure when you’re buying, especially the first time, you shore up your knowledge on 1) market appreciation trends relative to your expected loan interest interest rate, 2) home loan lengths, and 3) rental market values to make an informed financial investment.
Ultimately, the longer you own your home, the better the investment will get, month in and month out. You will continue to pay a set % interest rate on a decreasing loan balance over time. Simultaneously, you will realize a compounding % appreciation rate on an increasing home value. If the housing market drops off, that’s bad news for everyone, but again- staying put will save you because things will bounce back eventually and the damage (i.e. how underwater you are) will be less if you aren’t in the beginning of a loan.
So, you can make your home purchase not only a nice home for your family, but also a good investment by educating yourself on these three key factors for your market and thinking long term. I’ll crunch the numbers on our rental property, a totally different ball of wax, in another post so stay tuned!
