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What should you pay for a house?
Answer: It depends on rents and interest rates.
Rent and interest are the same kind of thing. They are what you pay to use
something -- either to use a house, or to use money.
Interest is the rent paid on
borrowed money. To know whether to buy, you just have to compare one rental
option to the other.
Even if you use your own money to buy a house, you're still in the rental game,
since you're giving up the interest (rent) you could get on your money.
Say you can pay cash for a $250,000 house that would rent for $1,000 per month.
Should you buy it? That depends on current interest rates.
$250,000 invested at the current interest rate will produce a certain amount of
income for you each year. Right now, you can easily get 5% by investing in CD's
with no risk of loss. This means that $250,000 will return $12,500 per year,
since $250,000 x 5% = $12,500.
So if you have $250,000 and need a place to live, your choice is between these
two options for the coming year:
- Buy the house for $250,000 and don't pay any rent.
- Invest the $250,000 at 5%, and pay $1,000 rent per month to live in a house.
income, but not paying any rent either. Owning outright means giving up
interest rather than paying interest, a different kind of loss, but a loss
nonetheless. In the second case, you're getting $12,500 in interest income from
your CD's, but paying out $12,000 in rent. $12,500 income - $12,000 rent =
$500
So you would be $500 better off in the coming year as a renter.
"But I don't have $250,000 to pay for a house. I would have to borrow it."
In that case, it's an even worse deal to buy a house. Let's start with thesimplest case: an interest-only mortgage. To borrow $250,000, you'll have to pay
at least 6%. If your credit is bad, you'll have to pay more. Let's assume you
have good credit and get a 6% interest-only mortgage.
The interest on $250,000 at 6% is $15,000 per year. In effect, that's the yearly
rent you have to pay to use the money. These are now your two options for the
coming year:
- Buy the house for $250,000 in borrowed money, and pay $15,000 in interest.
- Pay $1,000 rent per month to live in a house, so $12,000 per year.
Buying would cost $15,000 in interest, but you could pay only $12,000 in rent.
So you would be $3,000 better off per year as a renter.
"What if I put down 20%? Would that help?"
Not much. That's just a combination of the two cases above, both of which showit is worse to buy than to rent. So it would still be worse to buy.
If you have 20% of $250,000, that's $50,000. You could get 5% by putting that
$50,000 in CD's rather than in a house, and that would be $2,500 per year in
interest income.
These are now your two options for the coming year:
- Buy the house for $200,000 in borrowed money plus your $50,000 downpayment,
and pay 6% interest on the $200,000, which is $12,000. - Pay $12,000 rent per year to live in a house, but collect $2,500 in CD
interest.
So buying would cost you $12,000 per year, and renting would also cost $12,000
per year, but if you rent, you get the $2,500 in interest on your $50,000.
So you would be $2,500 better off as a renter.
"But I'll get a conventional 30-year mortgage, not an interest-only mortgage."
That's still just a combination of the first two cases. As you pay off the debt,the interest you pay each month decreases, but the principal you are putting
into your house is still a poor investment relative to your other options, like
CD's, the stock market, or bonds.
"What about the tax advantage of mortage interest?"
It's not enough to offset the other costs of owning a house. It's true that youcan reduce your taxable income by the amount of mortgage interest you pay, but
the other costs of owning eliminate that advantage.
Take the previous case, but say that you pay that $12,000 in interest with
pre-tax money. You've really paid it, and it's really gone, but since you didn't
have to pay income tax on that money before spending it on interest, it's not
quite as painful. At a 28% income tax rate, it's only 72% as painful as paying
$12,000 in post tax money. So let's say your interest payment is only $8,640,
which is 72% of $12,000.
But we should also consider that you'll have to pay property tax, maintenance,
and insurance on your house, forever. Property tax is typically 1.5%,
maintenance is about 1.5%, and let's say you can get house insurance for $1,000
per year. So for your $250,000 house, that's $3,750 property tax, $3,750
maintenance, and $1,000 insurance, a total of $8,500.
These are now your two options for the coming year:
- Buy the house for $200,000 in borrowed money plus your $50,000 downpayment,
and pay $8,640 interest after income deduction, plus $8,500 in property tax,
maintenance, and insurance, a total of $17,140. - Pay $12,000 rent per year to live in a house, but collect $2,500 in CD
interest. Property tax, maintenance, and insurance are paid by your
landlord, so you have a net cost of $9,500 as a renter.
So you would be $7,640 better off as a renter.
"But haven't houses always appreciated in the long term?"
Prices did rise a lot from 2001 to 2005, but that was very unusual, caused byexceptionally low interest rates and very lax lending standards. Prices peaked
in the middle of 2005, and have been falling since then. If prices fall another
5% in the coming year, as they did last year, then your choice is this one:
- A cost of $17,140 from the previous case, plus a 5% loss on your
$250,000 house. That 5% loss is $12,500, for a total owner's cost of $29,640. - The renter has the same $9,500 cost as before, and does not care about
the depreciation of the building he's in.
If you look at the very long term, houses have been the worst investment
available to the general public:
Average Annual Real Returns beyond inflation
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| Real Estate | Stocks | Bonds | T Bills | |
| 5 Years | 1.39% | 6.97% | 2.91% | 3.01% |
| 10 Years | 1.28% | 6.91% | 2.75% | 2.85% |
| 20 Years | 1.25% | 6.67% | 2.54% | 2.65% |
| 30 Years | 1.36% | 6.59% | 2.34% | 2.47% |
From Yahoo finance
"But the CD interest is taxable, so you don't really get 5%"
Buying a CD is just the simplest possible investment example and not necessarilythe best one. You can actually get 5% and defer taxes for decades, or not even
have to pay tax at all. There are a few well-known ways:
- Buy your CD's in your 401K account. 401K's are tax-deferred until
retirement. - Buy your CD's in your Roth IRA. This is even better. The principal you put
into your Roth IRA is post-tax, but all the accumulated earnings are completely
tax free, as long as you keep them in the account until retirement. - Buy US Treasuries. Though the rates are a bit lower than CD's, maybe 4%
instead of 5%, there is no state tax on US Treasury interest. - Buy municipal bonds from your state. Now the interest rate is even lower,
maybe 3%, but there is no state or federal tax on the interest. - Buy and hold stocks. If you hold a stock for more than a year, the tax rate
on any gains is only 15%. And you can put off the tax indefinitely just by
continuing to hold the stock. - Buy and hold index funds. Index funds, which are mutual funds that mirror
stock market indexes like the Dow or S&P 500, have risen at 10% per year on
average. And you can hold them indefinitely and put off the capital gains tax as
long as you like. - Pay off debt. If you pay off credit card debt and avoid 20% interest rates,
you're way ahead of even the best professional investors. If a penny saved is a
penny earned, then 20% saved is 20% earned. Actually, it's even better because
it's tax free. - Pay rent in advance for a discount. If you can get a 5% discount by paying
an extra month's rent in advance, you've earned 5% in one month. That's an
annualized rate of 60%, which is an insanely great return. This, however, gives
up some of your leverage over your landlord to get things fixed when necessary,
since you cannot withhold rent you've already paid.
"What about leverage?"
When you hear someone telling you why you should use leverage in real estate, run,do not walk, RUN to the nearest exit!
Leverage works only when appreciation is greater than the loss on the rest of
your loan. For example, if you buy a $100,000 house at 6% with nothing down, and
the house goes up 5% in a year, are you $5,000 ahead? Absolutely not. You spent
$6,000 in interest to get your $5,000 gain.
It gets worse: leverage works both ways. What if the house goes down 5%?
Then you've spent your $6,000 in interest, AND you've lost $5,000. Leverage is
the evil that bankrupts the most people during every housing market downturn.
Warren Buffet said the greatest threats to wealth are "liquor and leverage." And
he's right.
"What about inflation?"
Inflation eats away at the real returns of all investments equally. What youreally care about is after-inflation returns. A glance at the after-inflation
returns of various investments in the table above shows that housing has the
lowest real return. Most of the apparent rise in housing has actually been
inflation.
Banks know what they're doing, and they take inflation into account when lending
you the money to buy a house. You can be sure you will be compensating the bank
for the expected rate of inflation. On the other hand, it's possible that
inflation could skyrocket, greatly reducing the value of the debt that borrowers
owe.
"But rents will rise, while a fixed mortgage payment will not."
Rents have not been rising in most places. In fact, they are being driven downby the large glut of available housing because there has been way too much
building going on. Rents in the San Francisco Bay Area are still less than they
were 7 years ago, during the dot-com bubble.
Rising rents are counted as inflation by the Federal Reserve, so if rents rise
significantly, interest rates will probably also rise as the Fed tries to
prevent inflation from from overheating the economy. That means it may still be
a worse deal to buy, because it will cost more to borrow money. Property taxes,
maintenance, and insurance will also rise with inflation.
If you own outright and interest rates rise, then the value of your house falls,
because fewer people can borrow enough to buy it.
"Anything else?"
Well, yes, I didn't mention the 6% that the realtors will take in commissions.
That reduces the resale value of your house to you by another $15,000. There
are also thousands of dollars in closing fees, and PMI (Private Mortgage
Insurance) if you can't come up with the 20% downpayment.
"So what should I do?"
Don't take financial advice from realtors, lenders, mortgage brokers, or anyoneelse who gets paid only if they convince you to buy. Put in your own numbers and
calculate what it would really cost you to own rather than to rent.
Here are some housing calculators that may be useful:
- beautiful rent-vs-buy calculator from NY Times
- rent-vs-buy calculator using historical price trends
- sell or hold from landlord's point of view
