Real estate can be one of the best wealth-building tools. You can significantly improve your finances by strategically choosing when to rent versus when to buy and invest your money in real estate. 

But how does buying a house work? And how can you start investing in real estate? In this article, these important questions will be answered. 

How buying a house works

Buying a home isn’t quite as simple as it may seem. Thats because houses are very expensive, and most people don’t have the money to buy them upfront. This is why people take out mortgages. 

“A mortgage is a loan that the borrower uses to purchase or maintain a home or other form of real estate and agrees to pay back over time, typically in a series of regular payments. The property serves as collateral to secure the loan” – Julia Kagan, Investopedia.

So even if you don’t have enough money to buy a house upfront, you can take out a loan and pay it off over time. Usually, mortgages are paid off over 15 or 30 years by making monthly payments. But if you can’t make the monthly mortgage payments, your house will get foreclosed.

“Foreclosure is the legal process by which a lender attempts to recover the amount owed on a defaulted loan by taking ownership of and selling the mortgaged property. Typically, default is triggered when a borrower misses a specific number of monthly payments, but it can also happen when the borrower fails to meet other terms in the mortgage document” – James Chen, Investopedia.  

Down payments 

In order to take out a mortgage, you will have to make a down payment. A down payment is a sum of money you pay to your lender when you first buy a home. 

“The reason for requiring a down payment on a home is that it reduces the risk to the lender in several ways:

1. Homeowners with their own money invested are less likely to default (stop paying) on their mortgages.
2. If the lender has to foreclose and sell the property, it’s not on the hook for the entire purchase price, which can limit its potential losses if the home is sold for less than the remaining mortgage balance.
3. Saving a down payment requires discipline and budgeting. This can set up borrowers for successful homeownership” – Bankrate.

Typically down payments are between 5% and 20%, with the average being 6%. You might be thinking, “Why don’t people just put down the minimum amount required?” Well, the first big reason is that your monthly payments will be higher, and you will pay more money in interest because you’re borrowing more money. Another big cost to consider is mortgage insurance, which is charged to protect the lender if you have a small down payment.

Owning vs. renting

There are many key differences between owning and renting, and answering the question, “Which is better?” isn’t as clear-cut as you might expect. But knowing whether or not buying a home is right for you in your specific situation can help you save a lot of money.

Intrest 

Because houses are so expensive, most people can’t afford to pay the full price of one upfront and instead opt to take out a mortgage. But mortgages aren’t free. Lenders make money by charging interest for a loan. 

Currently, in 2021, the average interest rate for a 30-year fixed-rate loan is 2.84%. That means that each year you have to pay an additional 2.84% of your mortgage to the lender.

This is a significant expense that renters avoid, although the interest on your mortgage will still be far less than the average annual real estate growth.

Up-keep 

When you rent, if there’s a problem with an appliance or some maintenance issue that needs to be taken care of, you can call your landlord and have it taken care of. But when you own a house, there’s no one to call; you have to pay for any issues that arise. 

This isn’t something you can easily calculate, but the cost of upkeep is definitely something to consider when deciding between renting or owning.

Property Tax

“Property tax is a tax paid on property owned by an individual or other legal entity, such as a corporation. … It is calculated by a local government where the property is located and paid by the owner of the property. The tax is usually based on the value of the owned property, including land” – Julia Kagan, Investopedia.

Across the united states, the average property tax is 1.24%, but there is significant variation from state to state. As a renter, this is yet another expense you avoid. Although this probably shouldn’t be a deal-breaker, it is another thing to consider. 

Opportunity cost

“Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another” – Jason Fernando, Investopedia.

Buying a house requires a lot of money that could be invested somewhere else. Although it’s true that houses usually go up in value over time, you probably won’t see the same returns as if you were investing in the stock market.

According to Zillow, the average home price in America has increased by over 81% since 2012. In the same time period, the S&P 500 – a popular stock market index – increased over 210%.

So from an investment perspective, your returns from investing in an index fund would be better than in real estate, but that doesn’t take into account leverage. And although there are so many costs involved in buying a house, the benefit of leverage can make all the difference.

The benefits of leverage

When you take out a mortgage, you are leveraging your money. 

“Leverage is the use of debt (borrowed capital) in order to undertake an investment or project. The result is to multiply the potential returns from a project. At the same time, leverage will also multiply the potential downside risk in case the investment does not pan out” – Adam Hayes, Investopedia. 

Even though real estate has historically had lower returns than the stock market, you can take advantage of relatively safe leverage to outperform the stock market. 

But this all sounds pretty abstract, so here’s an example. Let’s say in 2012, you invested $40,000 into an S&P 500 index fund. Today that would be worth approximately $84000. If you had bought a house for $200,000 with a down payment of $40,000 at the same time, you would have generated $162000 in interest. This is the power of leveraging money. 

This works because even though your returns in the stock market are higher, you essentially invest more money when you buy a house because you’re leveraging your money. This is what makes real estate so attractive, and the less you pay for the down payment, the more apparent the benefits of leverage will be.

Real estate investing

Now that you understand how owning a home works, and the pros and cons, here’s how you can make money by investing in real estate. 

There are many different ways to make money in real estate, but here are some of the most common approaches:

Fliping houses

Flipping houses may be the first thing you think of when you hear the words “real estate investing.”

Essentially, flipping a house means purchasing a property, renovating it, and selling it for more. Sounds pretty great, right? But it’s a lot easier said than done. 

Buying and selling a home has a lot of expenses that you might not think about. For example, real estate agents usually take 2.5% of the property value in commission. But because you’re buying and selling the home, you’ll likely have to pay 2.5% for each transaction, 

Flipping a house also comes with some significant risks. There are infinite problems that can come up during a renovation.

And just because you have money doesn’t guarantee you’ll make a good return on your investment. It takes a lot of knowledge and experience to successfully flip a house. You have to know if a house is a good deal, what renovations are profitable to make, and a lot of other knowledge to make a successful flip. 

That being said, experienced house flippers can make consistent and substantial profits.

Rental properties 

“Residential rental property refers to homes that are purchased by an investor and inhabited by tenants on a lease or other type of rental agreement. Residential property is property zoned specifically for living or dwelling for individuals or households; it may include standalone single-family dwellings to large, multi-unit apartment buildings” – James Chen, Investopedia. 

To own a rental property, you need to have enough money for a down payment on a home. Once you own a home, you can rent it out to a tenant. Then using the monthly payments they give you, you can pay off the mortgage. 

If the amount a tenant would pay in rent is lower than the monthly mortgage payments, you can pay out of pocket to cover the difference. 

Once again, this is much easy said than done, and there are a lot more nuances that I won’t cover. But if you can manage to buy a rental property, this can be extremely lucrative because essentially, the tenant is paying the mortgage. It’s even better if you’re able to get multiply rental properties. Then, when the loans are all paid off, you’ll have a lot of equity as well as cash flow from the monthly rent payments.

REITs

If you want a more passive approach to real estate investing, you can invest in REITs or REIT ETF. 

“A real estate investment trust (REIT) is a company that owns, operates, or finances income-generating real estate. Modeled after mutual funds, REITs pool the capital of numerous investors. This makes it possible for individual investors to earn dividends from real estate investments—without having to buy, manage, or finance any properties themselves” – James Chen, Investopedia. 

This way, you don’t have to be hands-on. You can just sit back, relax, and grow your money. The main downside of this, though is that the returns are generally a lot worse than the other two methods I mentioned.