How Unseen Costs
Erode a Home's Value

Oct. 2, 2002 -- Many folks will tell you that their home is the best investment they have ever made. That may indeed be the case. But how the heck could they possibly know?

As the stock-market malaise drags on, real estate is being touted as a surefire investment. But is it? Homeownership involves so many financial crosscurrents that it is all but impossible to figure out what is going on.

Here's a quick guide to this financial quagmire.

Reaping Your Reward

When folks talk about their home as an investment, they are almost always talking about how much the price has appreciated or about how much home equity they have accumulated.

But in truth, the most reliable part of a home's return isn't the capital gain, but the dividend. What dividend? If you own your home, you get to live rent-free.

To get a handle on how valuable this is, think about how much you could collect each year if you rented out your house. This figure might come to 8% of your home's value, equal to $16,000 in annual rent on a $200,000 house.

Meanwhile, home prices have historically appreciated at 1% a year more than inflation. Thus, if inflation ran at 3% a year, your home's value might climb 4% annually. Add that to the 8% dividend and you have a 12% annual total return. Sound impressive? Unfortunately, things are rarely so simple.

Paying the Piper

One complicating factor is mortgage debt. Even though your home's dividend will likely dwarf any capital gain, it is still possible to make a mint from your home's appreciation, thanks to the leverage involved.

Suppose you bought a $200,000 home and put down $40,000. If your home's value climbs 20% to $240,000, the value of your home equity would double to $80,000. This leverage, of course, could also work against you. If your $200,000 home lost 20% of its value, your equity would be wiped out.

But whatever happens to your home's value, these leveraged results don't come cheap. Let's presume that, when you borrowed $160,000 to buy your $200,000 home, you took out a 30-year loan with a 6.5% mortgage rate. Let's also presume that, over the next four years, your home's value climbs 20% to $240,000.

That extra $40,000 isn't exactly pure profit. Over the four years, you would make 48 monthly mortgage payments that included a staggering $40,638 in interest. Even with the mortgage-tax deduction, we are talking about one serious chunk of change.

Moreover, the longer you own the house, the less your gain will be magnified by leverage. Suppose you hang onto your home for the life of the mortgage. You might have put down $40,000 and, after 30 years, the house might be worth $650,000, assuming a 4% annual price gain.

But the difference between those two figures doesn't represent your profit. After all, over the 30 years, you paid back the full $160,000 borrowed, plus another $204,071 in mortgage interest.

Running in Place

Your profit will also be reduced by the costs you incurred when buying and selling. When you purchased the place, you were likely dunned for a home inspection, mortgage-application fee, title search and legal costs.

Meanwhile, let's assume you kept your house for 30 years and then sold it for $650,000. Your real-estate broker would probably ding you for 5% or 6% of the proceeds, leaving you with a net gain of $611,000 to $617,500.

Feeling nickel and dimed? It gets worse. You should probably also factor in annual expenses like home insurance, property taxes and the cost of improvements and repairs.

Annual maintenance costs might run to 1% or 2% of your home's value, though you may get away with a smaller hit, if your house is less than 10 years old. These repairs are the price you pay to maintain your home's quality, thereby ensuring it continues to appreciate.

There are also home improvements. What is the difference between an improvement and a repair? The distinction can be fuzzy.

For instance, if you live in a house for 30 years, you will probably renovate the kitchen. Does that really count as an improvement? Over 30 years, the cabinets and countertop will likely become so worn that renovating the kitchen isn't a choice, but a necessity.

Even when you make true home improvements, the financial return isn't great. According to an annual survey by Remodeling magazine, you might recoup 70% or 80% of the cost of remodeling the bathroom, adding an attic bedroom or building a deck. That is based on selling your home a year after making these improvements. The longer you wait to sell your house, the shabbier your improvements will look and thus the less you are likely to recoup.

Home Free

So how much have you made on your home? Probably a lot less than you imagine. Nonetheless, your home is likely to be one of your better investments.

The fact is, buying a house forces you to save, thanks to the monthly mortgage payments. Sure, it may be a costly way to amass wealth. But once you have the mortgage paid off, you will own the place free and clear and have yourself an extremely valuable asset.

At that juncture, you will also be rid of a major monthly expense. That is no small deal. Indeed, for many folks, eliminating their mortgage opens the door to retirement.

Email your comments to rjeditor@dowjones.com.