I did the math, and I think our society has been sold a pile of crap that we’ve bitten on hook, line, and sinker. I’m not going to mince words or try to make this sound nice, because we’ve been duped, and we have every right to be upset about it.
Let’s rewind a bit and figure out where this particular dupe came from. Several decades ago, the “norm” was to work for one company for most of your adult life, with the assurance that they would provide for you for the rest of your life. My grandfather, in fact, still lives comfortably in a retirement community on pensions from the government and a university where he worked, as well as Social Security. He will be 87 years old next month.
My parents’ generation (my father will be 65 this year) was raised on those ideals, but it didn’t often work out for them that way. My father will grumpily point out that some of his friends who worked for corporations their entire careers have pensions, but he has “nothing”. My parents are both self-employed and are somewhat miffed that they didn’t get to partake in that.
This myth has slowly unwound all the way down to our generation. People in the 21-35 age range, including me, don’t have any illusions about working for any specific company and having that company pay for their retirement. The younger people you talk to don’t believe we will have Social Security to help us, either.
In the span of 2-3 generations, then, we have gone from working for one company as the ideal, to switching jobs every 3-4 years and not really having any idea of how to save for retirement past a 401(k) or similar plan.
What does this have to do with housing?
Housing has had a similar change, but I don’t think we’re aware of it. In fact, housing has shifted so radically in the past 9 years that we’re still trying to unravel the mess. Just 9 years ago, it was possible to buy a house right here in San Jose, CA for about $325,000. Remember, this was in the middle of the dot-com boom. I lived here in San Jose in 1999. I remember the crazy traffic, the 6-8 week waiting lists just to get a crappy apartment, and the scary projections in the San Jose Mercury News that we would never be able to build enough freeways to sustain the crazy population growth we had here.
It seemed that every week there would be another story of a young dot-com millionaire. I watched several of them get made — I worked for Cobalt Networks, and our stock price rose 618% in its first day of trading on NASDAQ. Everyone who was middle management or higher got their “golden ticket”. I watched multi-millionaires get created before my eyes. (No, I was not one of them!)
Yet houses still only sold for half of what they do now.
It is now so much cheaper to rent than to buy — not only here in the Bay Area, but in most high-cost locations in the country. I’m going to do the math and break down why it’s better to rent than to buy. Then I’m going to show you exactly why you won’t listen to the math…and what should sway you to seriously consider not buying a house instead.
The math
I live in a 3BR, 900sq.ft. duplex in the 95118 zip code. I’m going to pick a similar house in the area and estimate what my rent payments would be vs. mortgage payments, property tax, and maintenance on the house. Keep in mind that I won’t use “peak” housing prices here, but the prices as they stand today — about 15% down from the peak.
My rent: $1650/month — recently raised by $50/month so the landlord could install central heat and A/C. (Previously, we just had a gas heater on the wall.) My landlord lives in the other half of the duplex.
We’re going to use MLS #770964 as the comparison house. It’s a single family home in my zip code. It appears from the listing to have central heat and A/C. It is also 960 square feet…slightly larger than my current rental. It appears from the pictures to be in fairly good condition. It’s currently priced at $522,200, making it one of the lowest-priced houses in my zip code, and has been on the market for 40 days. To make a completely fair comparison, we’ll stipulate that the house buyer has agreed to accept $510,000 on our “offer”. We need to come up with a 10% down payment to buy this house.
Down payment: $51,000
Closing costs: (We’ll be generous and assume the seller has offered to pick up the tab.)
Mortgage payment: $2,570/month (10% down; 6% interest)
PMI: $100/month (since we put less than 20% down)
Property taxes: $5100/year
Maintenance: $5100/year (estimated at 1% of the value of the house, per year)
Total cost to own the house: $3520/month.
However, there’s another number that most people forget to add in. That is the opportunity cost of having your down payment sitting in an illiquid asset that will most likely decline over the next few years, as opposed to having it in an interest-bearing account. But, again, I’ll be generous, and give you 2% appreciation per year on the house — as opposed to a modest 6% return in the stock market. (Returns of 10% or more are still achievable with a bit of footwork, but that’s another blog entry.) The difference between 2% appreciation and 6% appreciation is $2000/year, or $166.67/month. Adding that in to the house payment, we arrive at $3686.67/month.
UPDATE: I forgot to add in the mortgage tax deduction, which Lena pointed out in the comments (thank you!) Basing this house purchase on a $150,000/year income, which is in the 28% tax bracket, according to Doug Webb’s calculations in the comments, you would save $800-$900/month as a deduction. Let’s take $900/month to be safe, and deduct that. Keep in mind that the mortgage tax deduction will get a bit lower every year. I’m taking the best-case scenario — by the time you’re 20 years in to owning the house, you will only pay about 1/3 as much in interest as you do the first year, so your costs of owning the house over time do go up.
REAL cost to own the house: $2786.67.
The difference between owning and renting, then, comes out to a shocking $1136.67/month.
Most people see those numbers, though, and it doesn’t sink in. To find out why, you have to look no further than Why You Don’t Save Money, Even Though You Know It’s The Right Thing To Do. Much like me buying the new car instead of a less-expensive used one, buying a house makes you feel good. It makes you proud.
So, instead of beating you over the head with numbers, I am going to give you an emotional reason to not buy a house.
What you SHOULD take to heart: Not buying a house means complete freedom!
Imagine if, instead of buying a house, you lived in a rental. Instead of taking that $51,000 and putting it in a down payment, you invested it. For this calculation, I’m going to assume you can earn 10% — with a bit of know-how and the right mutual funds, you can achieve that. Furthermore, since I assume you can afford the full house payment, I will also assume that you set up an automatic deduction of $2000/month into that same mix of mutual funds.
I will assume you start doing this when you are 26 years old, which is the average age of “Generation Y” homebuyers. (Coincidentally, it’s also how old I am.) You might balk at putting that much away, but I assure you — if you think you can afford the house, this is an essential first step. Also, if you find out you can’t do it, it’s much easier to fail now than have a foreclosure on your hands later.
Let’s take our $51,000 down payment and $2000 a month addition and hand it to the compound interest calculator. Using 10% as the interest rate, we find that 20 years is the magic number to get us to over $1,000,000 in principal. 10% interest means we can pull just under $100,000 a year out at that point without lowering our principal.
That means, just when those around us are paying off their mortgages and celebrating, you can celebrate complete financial freedom. That means never having to complain about the boss again, never having to work a job you don’t love again, and basically…retiring. Believe me, as someone who “temporarily retired” after selling my business several months ago, it’s incredibly liberating to know that you can do absolutely whatever the heck you want, and still have the money rolling in every month no matter what. It is an amazing feeling.
Redefining the “American Dream”
You see, up until I did the numbers, I thought I wanted to own a house, too. If prices came down enough, it made sense. And surely, if prices come down significantly, to where a house plus property taxes, insurance, and maintenance is cheaper or the same cost as renting, then I may consider it. There are places in this country where that is the case now. In that case, I say “buy” if you plan to stay in that area for a while. For most areas of the country, though, I can’t recommend buying for quite a while. Do the math. In most urban areas, you’ll find numbers similar to the ones I quoted above.
Rebutting the naysayers
Somehow, homeownership has become entangled with the words “American dream” and even “freedom.” I want you to have the courage to think differently. My goal is actually to be completely financially free by age 30, so I have my work cut out for me. Owning a house, unless it’s cheaper than renting with taxes, maintenance, and opportunity costs factored in, is not a feasible option.
If people ask me why I don’t own a home, I can simply say “My goal is to be completely financially free by age 30. Owning a home at current prices is not congruent with that goal.” I feel good with renting, because I know that by renting, I can sock away money for my future. That future can include spending years abroad, traveling the world, or taking time off to learn foreign languages or learning how to fly a plane. In other words, I can spend my life doing the things I love, instead of being tied to doing something specific for any length of time.
If you asked me how I define the “American dream”, I’d say: My American dream is to have the freedom to do what I want, when I want to do it, with no worries about my finances. That statement resonates more strongly with my heart than owning a home ever will. I encourage you to step up and define your “American dream”, too. Dare to go head-to-head to those who say that signing up for debt has anything to do with an “American dream.” Become a powerful voice for change in this country’s way of thinking. You, too, can be free just by changing the way you think about freedom.
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21. February 2008 at 10:44 am
Erica,
Your article is laced with a little nonsense. How do you assume with a little work that you can get 10% on stocks? Oh yeah, stocks always go up ! You can bring out all the charts you want about how stocks went up an average of x% a year but the plain fact is that stocks CAN be worth 0$– A house will always hold some value in addition to providing a roof. I would suggest with all the terrible talk about houses, that it actually is a good time to go out and and swing a deal with desparate sellers. I am not a realtor, dont own a home right now so I have nothing to gain by saying that. If you are sitting here waiting and waiting for the so called bottom, then you are speculating and will have to compete with other buyers. Funny how a few years ago, the people who said anything about a housing bubble were chastised , now it is opposite.
21. February 2008 at 11:58 am
RandyMan:
You point is well taken. For all the talk about being self relient and taking individual responsibilities for your action, I get amazed people begging for this bailout.
Secondly, lets not forget who is mostly funding our borrowings and helping us maintain this artificially high standard of living?
Its the oversea investors. You can burn them once. But the long term consequences are devastating. Remember the story about the guy who killed the goose that laid golden eggs?
21. February 2008 at 12:36 pm
Mark 51:
You may no be a realtor, but it appears from your writting that wife might be.
One need only to study the schedule of payment resets of sub-primes and alt-a (liar loans), in a chart widely circulated by German Bank Dushe.
What we have seen so far is only the tip of the iceberg. The actual tsunami is scheduled to land later this year. Housing is NOT turning around before 2011, is that.
You might want to study Japan real estate bubble for a realty check, which has painful similarities with ours.
People who bought in 90’s are still waiting to recover their intial investment, much less any appreciation. And Japan is densely packed affluent country.
But why confuse ourselves with the facts? NAR will say, its the best time to buy anytime.
Like we say, there is a sucker born every minute. Surely there are people thinking that it is best time to buy now. Just one thing, don’t come running later on and cry foul.
Want to buy now? go ahead. But you are probably better off giving money to the charity. At least it will recorded as a good karma! lol.
21. February 2008 at 1:10 pm
Where I depart a little from Erica is the veracity of equity markets for the mainstream investor.
I mean other than tobacco and utilities, most equities are not safe bets for the unseasoned trader. The mood of the public tends to jump in at the peak of bull runs or run with the momentum players like the Qualcomm (of the 90s) or Googles (of the 00s).
Others, however, who are bona fide intermediate swing traders, know how to mix and match the major inverse ETF indices with the bullish sectors (plus momentum players) to generate 10-25% earnings on their portfolios w/o negative years. For example, I knew someone who jumped in on QID, a double short ETF on NASDAQ100, starting Halloween with the cyclical knowledge of tech weakness at year’s end with a T/P target in mid-January, usually the start of the next tech round, regardless of rate cut info. Well, that was ~30% gain and it was only a hedging strategy (i.e. ~15% of total portfolio, [since aggressive rate cuts could have flatten his gains] contributing 4.5%+ to the yearly earnings total).
The more conservative, passive investors aren’t really game for this system. They tend to think that by modeling a Peter Lynch or Warren Buffett, via investment clubs/magazines, that 10%+ per annum is an automatic earnings potential. It simply isn’t the case.
21. February 2008 at 4:23 pm
Erica,
While I find your argument well constructed and insightful, I would like to point out one important correction needed in your math: You assume a 4% difference between the mutual funds and home price appreciation in your return on investment on the initial down payment. However, you need to take into consideration that your 2% assumed appreciation is on the entire home value and not just your down payment. Factoring that in will yield you a 20% rate of return (2% times your leverage in the house, which is ten times) on your down payment vs. your 6% assumed rate of return on the same figure in the stock market. That changes the math considerably.
Nevertheless, I agree with you on redefining the American Dream to fit your dreams.
21. February 2008 at 5:54 pm
Ravi Ji:
Common, expect little better presentation from a follow Indian nerd.
How about the extra money in form of hefty mortgage payment you giving away for the previldge of owning a home? This amount could be invested to off-set the appreciation.
As I mentioned, leverage is a two edge sword. Sure you can win lot, but then you can loose your shirt and probably underwear also.
Ravi Ji, please look this situation more balance. Old assumption that real estate prices only go up is in smoke, which does always go up!
With 1Million plus house in foreclosure 50% reduction is the best scenario.
21. February 2008 at 10:17 pm
Well the earth is flat and we can get free lunch.
For all of the posts above, claiming that the real estate is more profitable should back their claim with proof.
So, as a reference to support my argument, the stocks are better investment than RE, here is the article from NYT, no less:
http://infoproc.blogspot.com/2005/08/equities-vs-real-estate.html
22. February 2008 at 1:55 am
Everything depends from the values and aims in your life. The younger you are the more freedom you want to have and that is why you do not want to buy a house and stay on a one place. But vice versa, as we are getting older we are looking for some place to stay and enjoy the life. May be it is only my opinion, but the older you are there is bigger chance that you will bump into your dream house and you will say immediately “I want to live in this house”. Current situation on the market at least in the US is favorable for those who want to buy good and cheap real estate but there were times when it was not (e.g. dot com boom). Anyway, as a West Toronto Realtor I believe that owning a house is not a crime and you should always be very careful when buying a house. That is why, proper estimation of the value of a house is very important. There are many tools. I prefer Comparative Market Analysis so as professional home inspection.
22. February 2008 at 5:56 am
West Toronto Realtor:
I’m 46 and will *never* own a house until the numbers become viable (that means PRICE).
Erica’s point is that houses don’t have nearly the value popular opinion asserts.
Youth has nothing to do with. Financial perspicuity has everything to do with it.
22. February 2008 at 6:11 am
All these comments about “2%” and “4%” and splitting the difference between rates of return, taxes, yield on down payment… this is all chump change compared to structural difficulties of remaining middle class.
I’m going to need a real rate of return of at least 15-20% per year for the next 10 years.
And owning a home, or investing in stocks, or whatever single digit scheme proposed above or anywhere else just won’t cut it.
Which is why I am now a small business owner.
Worrying about a percent or two is missing the bigger picture.
22. February 2008 at 2:13 pm
West Toronto Realtor:
No owning a home is NOT a crime, but most stupid thing you can do at this moment is to buy one.
I don’t know how the realtors are in Canada, but here in US, NAR (National Association of Realtors) has lost all its creditability and then some.
Even late last year, when the bubble was its initial stage, they were projecting price increases.
Lawrence Yun and his predecesor, David Leach (not sure of spelling) are shameless people cheering people into traps of high priced houses, they knew well in their heart that people can’t afford.
I have another issue with realtors. Entry barriers are sooooooooooo low that basically if you can sign your name, you can become a realtor. Jesus, you need more qualifications to become a barber. Such low entry is an open invitation for kind of characters, undesirables included.
This was fine during the frenzy of gobbling house, when you need Realtors only to process the paperwork.
I have NEVER met a realtor who adviced me not buying a house, their whole commission system prevent such an action. In fact realtors are still calling me with the same old line, “Its the best time to buy a home”. But when I show scheduled arm resets (California being gound zero of sub-prime and alt-a, something like 40+ % of all loans were like that in 2006), they have no answer and move on to next victim.
Anyway, with the progress of online search engines, realtors are becoming increasingly irrelavant. I can log on sites like Ziprealty, see the house, get a picture of neighbhorhood and recent comps. Zillow will give me most recent price.
So why do we need to pay 6% realtor for all that? In California, with houses selling at 600K++, if you sell a house a month, realtor could make a good income. During the frenzy, there was no effort required to do so, as people in fact were outbidding each other. This was easiest way to make money.
With internet hopefully they will rest in peace just like the travel agents and stock brokers. I am sure some nerds in beloved India are working on a system to eliminate this whole class of vultures.
22. February 2008 at 4:00 pm
Hi there!
You are right on!!! The math is a bit off, but in general you are on the right path and I agree with what you are saying.
I’m so sick of agents saying the bay area ALWAYS goes up. And if I hear another person say “you just gotta get it now…it seemed expensive when I bought 10 years ago too” I’m going to puke. Or, a favorite… “you gotta buy for the tax deduction”…possibly the stupidest reason to buy a home in my opinion.
Although I’m glad to be hearing less of these voices, now that the long overdue bursting of the bubble has begun. Crying in the streets = time to think about buying.
23. February 2008 at 10:15 am
I’d say that neither RE nor stocks are a good investment for the non-sophisticated investor.
Really, the whole idea of the old triple decker was that the landlord lived in the smallest unit while renting out (and maintaining) the bigger units. In time, that place became a business once the final mortgage check (which was a 15-20 term loan agreement back then) was mailed it. That’s how RE was an investment, traditionally, for the non-sophisticated player. Also, a person with let’s say a steady corporate job at a Prudential Insurance had a defined pension along with his IRA savings which where in mix of bonds and nifty-fifty stocks (Carbide, BP, GE, P&G, etc) which paid dividends. His home was most certainly not considered an investment but a place to live in.
The world has changed since then. Today, only the great traders can make money consistently; others have to stick with the tried and tested utilities/tobacco firms (with dependable dividends) because the mutual funds typically under perform against their associated indices and take huge fees while the public sentiment (individual stock picker) tends to overload on the Amazons of the world, at the bullish highs [i.e wrong time], and as you know, many publically traded companies don’t pay dividends to mitigate the risks for their shareholders and instead, use the increases in P/E as some justification for not delivering an income stream to their legitimate owners.
23. February 2008 at 4:24 pm
Interesting article. From reading the comments, it looks to me that in general, both sides of this debate feel emotionally attached to their views and trying to rationalize their position.
While I think parts of this analysis are overly simplified (maintenance cost is likely more a function of age of house rather than price and with AMT etc. it is hard to make definitive statements about interest deduction, I don’t see an estimate of rental costs increasing over time and I don’t see a mention of the property tax deduction). Much more important in this debate is the expected return on the stock market vs the leveraged appreciation of owning property. A mistake in your calculation is to not take into account that the house is a leveraged investment, 2% of 522,000 = about 10,000 and 6% of 51,000 = about 3,000
“If you take a look at my last real estate post, you can see that there was very little appreciation on a house for sale that last sold in 2000.”
Using http://www.moneychimp.com/features/market_cagr.htm
if you bought the S&P 500 on Jan 1, 2000 your compounded rate of return would have been -0.06% Ouch! Buying a house in 2000 might well have been better than putting the money in the stock market:
http://financeambition.com/wp-content/uploads/2006/12/appreciationhist.jpg
While I agree that housing will likely drop for thge next few years, based on the above chart, I would say it is very difficult to say what housing prices will be 5 years from now. (If anyone is considering buying I would suggest not over extending yourself to buy a house and don’t buy trying to make a quick buck.)
24. February 2008 at 9:03 pm
Renting sucks. Even if I had to pay more to own, it is worth it because instead of throwing money out the door, I am building equity and can resale to buy a bigger home. Can’t do that with an apartment. All your money goes to your landlord and the only thing you get in return is a rent increase and a snotty attitude (gratis from your landlord) and the other thing the author leaves out is the rental increases over a number of years whereas if you have a fixed rate loan, that amount doesn’t change so actually the rental amount increases as the years go by to keep up with inflation and greedy landlords’ pocketbooks. Another thing is that you have no freedom to paint your place green if you wanted to. Your number and kind of pets are limited and usually if you have a back yard, you can’t change or add to it to meet your needs. It is stifling. I lived 20 years renting from goofy low life land lords that did not give a sh*t about making repairs and now I have just bought a home and I can tell you that it is the best thing I ever ever did and I would suggest to never give up owning your own home – that is the American Dream in my opinion and should be pursued. When you retire and your home is paid off in 15 or 30 years then you will understand how important it was to buy rather then rent.
Say goodbye to your lousy landlords and BUY!
25. February 2008 at 7:39 am
::When you retire and your home is paid off in 15 or 30 years then you will understand how important it was to buy rather then rent.
Well, if you can guarantee that your region will have employment, indefinitely, then I agree. What I’ve noticed, however, is that people have to move around a lot, esp these days, to maintain a certain lofty salary range. So that fine $600K place in Boston may become an albatross once your company (and/or associated industries) move to TX, VA, or even abroad, Beijing/Kuala Lumpur.
So in that situation, here’s a better idea… buy a cheap (< $100K) home, specifically for retirement in or around a college town (let’s say an Ithaca NY) or some rural town in Northern NH but rent where the jobs are. Then, once you’ve finished earning a bulk of your income, as a jet setter, par down the expenses, get a job at the library of a local college and live in that paid for retirement home. I suspect that a lot of Buffalo residents had to do exactly that since that western NY region has been in a downturn for over three decades.
25. February 2008 at 10:57 am
@Mark (#51): Millionaire Mommy Next Door (http://millionairemommynextdoor.blogspot.com/2007/11/how-do-i-select-my-investments-why-are.html — she commented here as well) has a system of finding mutual funds where she consistently earns 13-14% a year. As soon as I have $30K liquid (the minimum needed), I will use her system. Remember, just investing in an index fund over the past two years has averaged 9.2%. This can be done with a little legwork.
@RandyMan: Agreed that 10% isn’t automatic… but it can be done with a few hours’ work a month (see above.)
@Ravi: Yep, agreed in the math error… not sure if I’m going to fix it since then I’d have to factor in the 6% for selling a home, etc.
@Jezel: To each his own. I recognize that I present a contrarian viewpoint. To me, complete financial freedom is significantly more important than owning a home. (It helps that I have a good relationship with my landlord.) Keep in mind that your mortgage payment won’t increase over time, but property taxes will, so you’re still not completely “fixed-rate” even if you own the house.
Thank you all for the excellent comments!
-Erica
25. February 2008 at 1:09 pm
considering you live in California you ARE much better off renting. I live in the South where the average home is $178K and the property taxes are usually 1% of that.
Much better to own in the south. Location is everything!
25. February 2008 at 5:03 pm
Erica, welcome to the rent vs buy debate! I have already staked out my position at my blog but I am always eager to enter a local fray…
First, let me start with what is missing from your analysis: A mortgage payment is not the equivalent of rent. A mortgage payment is made to purchase the asset a house represents. The bank is nice enough to let you live in the house for free and that nicety has genuine and real value.
The value of that free rent is what is known as imputed income and it’s value to you is exactly what it would cost to rent a similar property. So, using the numbers from your example, it is equal to $1,650 a month or $19,800 a year NET. In order to pay your rent in that same amount, you need to gross $24,750 (combined assuming a 25% Marginal Tax Rate; your mileage may vary).
Just that one additional consideration pretty much makes rent vs buy a wash, even in super markets. Away from those markets, there are a number of reasons to not only own a home but to invest in rental properties vice the stock market.
For one thing, every time I buy a house and fix it up, the neighbors love me! Not much love coming from a stock portfolio. And in doing what I do, I am adding value to the community. Yes there are some hassles in being in a landlord; those hassles we call “life.”
A goal of “doing what I want when I want” is valid, I guess. My goal is making communities better and giving good people a nice, safe place to live until the time is right for them to become owners of a home of their own.
Outside of the hyper-markets, buying makes much more sense IF the time is right. All politics are local and all personal finances are personal.
Kepp plugging away, I enjoyed the read!
25. February 2008 at 5:43 pm
@Moneymonk: Agreed — but don’t base it on price; base it on cost. If your mortgage, property taxes, and maintenance are cheaper or the same price as renting, I’d recommend buying (assuming you will stay in the same area for at least 3-5 years.) In a lot of areas of the country, that is the case. It’s “danger zones” like here, NYC, Chicago metro, LA, San Diego, Miami, etc. where I don’t recommend buying.
@The Debt Whisperer: I have no idea what you are talking about. No bank “lets you live in the house for free.” They charge interest. Also, I had never heard of the term “imputed income”, so I searched for it, and its definition doesn’t seem to match what you are saying.
Your numbers are pretty confusing. I stick with what I wrote above. My out-of-pocket costs would be significantly higher to own, and like previous posters wrote, painting the walls a different color is not worth $1M+ to me.
25. February 2008 at 7:07 pm
To Debt Whisperer:
Your style of thinking reminds of the traditional owner of the triple decker who rents out the largest units while keeping the smallest one for himself. And I agree, traditionally speaking, that that was the way of being a landlord and beautifying the neighborhood. I’d spent some time, as a kid, living in one of those multi-family homes and the landlord was one the sweetest old fellows around. The problem is that that’s not the reality of the housing market today. Outside of an apartment building with a decent management crew, many landlords are negligent and are intent on simply flipping the property.
26. February 2008 at 7:24 am
Erica, did you see the following site while you were surfing the term:
http://www.encyclopedia.com/doc/1G1-141482419.html)
The valuse of imputed income might not tip the scales entirely in favor of buying in every situation, but to exclude that value when running the numbers in not, then, comparing apples to apples.
The interest paid on a mortgage is for the use of the money; the house (property) is what secures the loan. The mortgage payments are paid as purchase money for the asset (the house).
Once you pay off the mortgage, you own the asset. The bank charges you nothing to live in the house and you can leave it vacant if you want and live somewhere else if you choose to do so: makes no difference to the bank (mortgage holder).
Let’s say, for example, that you want to buy some gold coins and you borrow the money to do so using the coins as collateral. That is an investment; you are betting that the gold will appreciate more than the cost of the loan.
You are borrowing the money to purchase the asset; in this case, gold. But you cannot live in gold, so there is no imputed income to be had in that arrangement.
The difference with borrowing the money to buy a house (the asset) is that you can live in it, and so you derive the benefit of imputed income equal to the cost of a like rental.
In fact, in Australia they are up in arms because the government is proposing to tax the value of the imputed income of mortgagees. Even on some US blogs in discussions on this debate, some posters argue that the benefit of free rent to mortgagees should be taxed!
To further illustrate the point, if I buy a house and rent it out (vice living in it myself), the government DOES tax that income! But, if I live in it and shift the benefit from rental income to imputed income, I avoid that tax entirely. It is, really, a very sweet deal that has real cash value.
RandyMan: Thank you for the response. And, yes, there are obviously people in real estate with their own agendas.
I have had days where I wonder why I am in the business, myself; like the day I saw a tenant loading all the interior doors (including kitchen cabinet doors) from the apartment he rented from me into his truck to use as firewood at the beach party.
So, there are some less than stellar landlords but, also, some tenants are wanting, as well. But I used to be a construction electrician and I still enjoy the physical nature of the work of maintaining a house and using my hands; even after twenty years behind desk.
But owning rental properties (IMO) is not best approached as a get rich quick scheme and not everyone is suited for the business. And if you invest in real estate you CAN lose money, just like you can lose money in the stock market or gold or collectibles.
And I am only diversified into investment real estate and, to that end, I usually only have one rental property at a time but I have had as many as three. There are some details on my latest project at my website. Then, I hold onto that single property until my equity approaches 60% or so then I sell, rinse, and repeat.
But I am not an advocate for the business; it is just that in discussing the rent vs buy issue, I think the numbers need to include imputed income to be accurate.
R/
26. February 2008 at 9:31 am
While it may be accurate that in some parts of the country it is advisable to rent rather than buy, I’d like to address the American Dream portion.
In many parts of the universe, owning a home is totally out of the question. Many homes are passed down from generation to generation, because there is only so much land to go around. Owning a home (or land) was only available to the very wealthy. In America, it was possible for a regular person to one day own their very own home.
Wall Street has managed to destroy this dream by their greed. Wall Street, also in 2000-2001 also managed to destroy the dot com explosion with their misguided venture (vulture) capitalists. Dot com start ups didn’t follow proven business practices. Dot coms thought they could buck the ’system’ and if they sold products below wholesale prices they would be rewarded with loyal customers. Obviously, it didn’t work out.
Same true today with Wall Street and their bundled mortgage offerings. Common sense and past housing practices proved that homeowners should be putting down 10 to 20% downpayments, getting 15 or 30 year conventional fixed rate mortgages and remain in the home for at least 5-10 years to see a return. A home was a place to simply live in. NOT a means to flip and make yourself a million bucks. No money down loans, interest only loans and giving bad financial advice to homeowners that they could either flip or refinance a home in 2-3 years was not a very smart or decent thing to do. Wall Street made their money (as they did in the dot com era) and mere mortals (such as ourselves) lost our money, our dreams and our hope.
Buying a home is just a place to live in. It is not supposed to be a revolving door of credit (tapping out equity). Greed both on the part of Wall Street and homeowners has destroyed what was once part of the so-called American dream. I find this to be very sad indeed.
Forgoing home ownership and renting in the guise of taking the money saved and investing it in Wall Street, with the very scum that has caused the stock market to collapse in 2001 and now 2007-8 is, in my opinion, insane. Every five years or so, Wall Street corrupts (think Savings & Loan, junk bonds, Enron to name a few). Sending your money to Wall Street is just fueling them with cash to fund the next disaster. I’d think twice before doing this.
When the housing dust settles and all the prices return back to normal (because the prices really did get out of control during the frenzy) it may be advisable to get back into the housing market BUT do it the conventional way ie: 10-20% down, 15-30 yr fixed rate mortgage, stay 6+ years and never, ever borrow out your equity. It’s still something to think about and decide if it is right for you.
Redefining the American dream as:
“My American dream is to have the freedom to do what I want, when I want to do it, with no worries about my finances.” As long as you still have to worry about paying rent, doesn’t make you very much free. Putting your trust in Wall Street is a fool’s game.
26. February 2008 at 2:07 pm
:As long as you still have to worry about paying rent, doesn’t make you very much free
Well, it’s either rent or property taxes and where I live, in the northeast corridor, the typical rent for an apartment is about 30-40% of the condo fees plus property taxes for an equivalent unit and this doesn’t even include the base mortgage payment which is already 1.5 to 2.x times the rent.
All and all, for me, freedom is being able to take a job anywhere in the country (or world, since places like S’pore, Toronto, and Hong Kong have a lot of US ex-pats working there) and being able to pack up and move and only having to give up a month’s worth rent plus the security deposit to keep my “reference” standing with the property management company.
utting your trust in Wall Street is a fool’s game
Can’t agree more, which is why the non-sophisticated investor should stick with utilities/tobacco dividend yielding equities and AAA intl govt bonds like Norway/Oz.
Other so-called intermediate swing traders can game (time) the system using options, futures, and ETFs.
29. February 2008 at 6:45 am
It’s old news now but worth reiterating:
::http://www.realtor.org/press_room/news_releases/2007/president_bush_signing_mortgage_forgiveness.html
Is this the moral hazard of the new century act?
Because when I read this, what it tells me is that quietly speaking, a house is an asset class (and not a place to live in). A place *to live in* wouldn’t have a bail out clause attached to it but a broad asset class would, for the safety of the investing population. Unfortunately, if pulling the exit hatch is as easy as turning in the keys without a subsequent IRS visit then I don’t see how this would protect an asset from major devaluation.
8. March 2008 at 7:53 am
Mark,
Your comment that “stocks CAN be worth 0$” seems to imply that the value of the stock market as a whole can be nothing. If this is what you’re implying then I’m going to have to disagree with you.
Individual companies can go bankrupt, which would drive the value of their stock to $0. But, if the value of the entire market were to actually be $0 then every company in the country would need to be be bankrupt. If this were the case you would not have a job to pay a mortgage with and you would lose your home. Or even if you had your home paid off it would be worthless because nobody would have a job and could therefore not secure a mortgage. The point is that if the stock market were actually worth $0 then your home would certainly not save you and would likely be the last thing on your mind.
Now if the stock market were selling for $0, but the companies were actually still in business then it would be free money. The current yield of the Wilshire 5000 is $292 billion. I would certainly risk $0 + trading fees to get $292 billion per year in return.
The overall stock market will never actually be worth $0. Its intrinsic value will increase in the long term in proportion to (1) real GDP growth and (2) inflation, as it always has.
12. March 2008 at 10:05 am
It’s so refreshing to read this! It doesn’t help that the artificially inflated housing market depended on more and more people buying, which consciously or not made people pressure those like us to buy buy buy. I’ve been talking about the housing bubble since I started blogging in 2003, so I just wasn’t going for that, even had I been able to buy.
18. March 2008 at 9:18 am
What’s striking here is how sensitive this calculation is to income and down payment in even the current environment. For example, the typical single dotcommer making 100K+ putting 20% down reduces the difference to about $500 or ~$2151/month (assuming a 28% plus 9% tax deduction on mortgage and property taxes for Federal and state respectively).
More strikingly, I had to rent for 6 months last year at $2000/month for 1200 square feet with a lousy kitchen. I’d have paid $150 more a month for a decent one, believe me.
Anyway, what it comes down to IMO is when a bottom is perceived, people are going to buy. When interest rates shift down due to FNMA, people will buy, and if any other factor shifts this balance, I think we will see mini-rallies in the market. Santa Cruz just had one in February apparently due to the transient drop in interest rates a few weeks back.
The downside of owning at that point becomes fear of loss of principle, which is a very valid fear. Like you said in a later entry, it’s a great time to wait another 2 months, and maybe morre afterwards and then suddenly someone else lost the principle for you. Strange times ahead…
27. March 2008 at 4:42 am
I will argue that the American Dream has never changed but American has lost its way.
Historically, a person’s home WAS THIER FINANCIAL FREEDOM. Worst case scenario, you have no income but you have your home – a roof, safety and perhaps some land to farm perhaps = you where FREE to do as you please.
Hence, a person’s home = the American Dream.
Property taxes in states such as California are so high today that you can never “own” your home “FREE and CLEAR” – you need significant income just to pay the state government for the legal right to live in your own home. Combine this with local governments, community watch dogs, … and it is not longer possible achieve the American Dream simply by owning a home.
Hence, a person’s home is no longer equal to the American Dream.
I argue that you are simply chasing the same age-old American Dream but are smart enough to realize that it no longer lives within the life of a wageslave + homeslave.
The only way to achieve the American Dream today is to generate enough wage free income (dividends) to cover basic living expenses – a roof, safety, and perhaps some land to farm.
I’m optimistic that young people such as youself will help America find it’s way again through less government and a return to property rights.
Then working, saving, and buying a home will once again give all Americans (not just entreprenuers) … “to have the freedom to do what I want, when I want to do it, with no worries about my finances.”
2. September 2008 at 5:57 pm
You cannot be serious!!
“However, an omission in your analysis of the costs of home ownership (which will reduce the spread between rent vs own some) is the tax benefits from the current deductibility of mortgage interest and property taxes. A very rough estimate would be tax savings of 35% (fed & ca), so if your mortgage & property taxes came to $10k a year, you’d save about $3,500/year in taxes.”
Is this “tax deduction” passed on to every person with a bond?
What would the income tax be on the average income mentioned, + – 74000 us pa? =(my zip code), and scrolling to the bottom of the page, we find that the estimated median household income in 2005 is $73,840. )
23. November 2008 at 5:27 pm
Ok, first this: Real estate only goes up because they are not making anymore land!
Ok, see this isn’t really true. While no more Earth space is being created, there are huge areas that aren’t built up. But also, in the space of one house, condos can be put up… more vertical housing space. So where 1 house stood, there might be 20 condos.
Wow, it really amazed me at first that so many people were still ardently defending the “house is the only way, you idiot” position, which is pretty much how it was always given to me over the last 10 years or so… I lived in Silicon Valley during the dot-com times, and I think the housing boom there at the time merely pushed out to the rest of the country, so even though I moved to LA in 2002, the bubble never seemed to stop growing… until it did.
I didn’t realize the emotional part was on both sides… I’m miffed at being called an idiot for several years(I’m a software engineer and make $125K a year right now), and they are miffed at being stuck in a house that’s under water and that they might lose, and are desperately trying to defend that position. Well, good luck, and maybe that attitude will keep me from having to bail out too many other home “owners”.
The real answer is, of course, that buying versus renting DEPENDS ON YOUR OWN CIRCUMSTANCES, including where you live, etc. But I agree with the blogger that people have bought into this bill of goods to such a degree, that that’s all ignored by so many, nope, you’re a fool if you are a renter. (Add in the fact that I’m a single person.)
Whenever your hear *nearly everyone* say that “it only goes up! you better buy now!”, run very fast. Or better yet sell them what they want to buy if you have any.
Stocks can become worth zero, but there are ways of mitigating this. I use target funds for retirement planning, which also contain bonds and such for diversification. Plus, the wider the net, the better, for most investors.
A house can effectively become worth zero too. 15 to 30 years is a very long time in the world, and even Beverly Hills can become an abandoned slum in this amount of time. Doesn’t seem likely, but less than 20 years ago the Soviet Union was an ongoing concern, and that’s one heck of a change. True, it’s hard to prepare for revolutions, but it is still quite easy for a localized economy to have a sharp decline, like Detroit.
diane sutton: “One advantage of owning that has been overlooked, is stability. YOU decide how long you want to live there.”
That’s both true and untrue in some possible scenarios. If you can’t sell because of the market, you do not have a choice about how long you will live there. You are stuck until you can sell or rent it. Also, unless you actually *own* the house, which means no mortgage, you can lose it if you lose your job, again for instance if that local economy disappears especially since there will be a lot of sellers.
Phil: “I want to buy, but I cannot justify a million dollar loss so that I can paint the walls a different color.”
Exactly. While it’s true you can’t do much remodeling as a renter, what’s even more incorrect about this is that usually you can repaint if you want to. It’s often prohibited by the lease, but they generally aren’t that surprised when people paint. Worst case is, you repaint it yourself when you leave, or let the landlord have people do it. The last place I lived amazing had one section in the lease saying “you can’t paint!” and then another section saying “well, at least try to choose nice colors” and an attachment showing the costs of repainting. Worst case, full apartment repaint was I believe only $600.
Another biggie in my book is opportunity costs and time… I can see some appeal of messing around the house, installing things, improving things, etc, but unless that’s considered entertainment, I have to consider that work… Would I make more money fixing my own house, or doing my trade as a software engineer? Everyone’s situation is different, but in my case, I clearly would be vastly better off doing more software engineering.
Related to that, and the 15 to 30 year mortgage thing…. you really can’t count on being able to move at all if you buy a house. That’s a 15 or 30 year contract! Every time I’ve changed jobs, I’ve moved to a nearby apartment, and never had a commute more than 3 or 4 miles tops. What’s the opportunity time in having an hour or more commute versus a 15 minute one?
Now that I am contracting, I moved to Brentwood, in LA, and have a nice 2 bedroom in Brentwood Village for $1650 a month. Now I can walk to many restaurants, etc. A comparable condo right now is at least $500K (well, for now) and have been much higher, so in this market, buying was literally insane.
23. November 2008 at 5:29 pm
Also, rents seem to be coming down too. I was amazed when I found this for $1650, but there are about a zillion condos on the market, and that are even still coming on line the Westside areas of LA.
20. December 2008 at 5:33 pm
Good logic, but your maintenance number doesn’t make sense, I respectfully submit.
If you’re saying house prices are too high and should come down to the point where it would make sense for landlords (which I agree with) then you’re house should be valued at say $300,000.
So instead of 1% of the bogus $500,000 figure, you should take 1% of the $300,000.
I realize it’s all about finger in the air, but the $2000 difference compounded for 20 years at 10% will add up to something.
But in general I agree – and rent.
7. January 2009 at 7:27 pm
Your figures are right on the money regarding the housing anomaly. By dumb luck I bought a house in 2000. It doubled in value and as my incentive options became worthless. I sold the house for double (dumb luck) in fall of 2004 and have rented every since.
18. January 2009 at 11:40 pm
Hey Erica, don’t know if you’ve seen this yet, but this NYT calculator was what talked me out of trying to buy a house in 2008.
http://www.nytimes.com/2007/04/10/business/2007_BUYRENT_GRAPHIC.html
It basically told me that at the current market, if I were looking to buy a house as an investment, it would never turn a profit.
And I totally agree with your view of having complete freedom that you mentioned in this post.
11. February 2009 at 10:48 am
Hello Erica
A great article………
That is why owning a house in the Netherlands is NOT part of the Dutch dream. Being in debt as a society is NOT financial freedom
Home ownership is an expense not an investment…..Renting is much more in line with financial freedom. I also have rented and owned property in Canada and USA
14. April 2009 at 8:55 am
Hi Erica,
It seems that you have hit on a hot topic. This whole discussion reminds me a bit of the saying, “Statistics don’t lie, but statisticians do.” You can make an argument either way – financially or on the basis of lifestyle. From an investment standpoint, the reality is – like any asset – there are times when real estate is overpriced according to its value and makes a poor investment and other times it is underpriced. With that said, I think there are a couple things to point out in your argument:
- The house price appreciatiation is actually applied to the whole house. So at the end of 20 years you have an asset that you own (part of) worth about $750,000 based on 2% appreciation.
- You say that you need to be able to cover the “whole house payment” even though $900 is actually the amount that you can deduct for taxes each month. Therefore you reason that you should actually be socking away $2000/mo if you rent. The reality is that you can adjust your withholding and take less taxes from your paycheck. Or you will simply get a tax refund at the end of the year. Either way, the actual difference is the $1136/mo you calculated initially. Which won’t add up to nearly the $1 million you calculated
- An assumption of 10% annual growth is very aggresive for your investments
- Finally, if you withdraw 10% from your investments you will find that you will exhaust your funds far quicker than you planned. If the market returns say 2% in a specific year and you withdraw 10% you have decreased your principal and you will need a higer return in the future to earn it back. As we know, the markets do not always co-operate with nice even 10% returns (ask anyone invested for the last 10 years). The generally accepted “safe” withdraw rate is 4%. This would give you a $40,000 income on $1 million dollars. Not chump change to be sure, but not what most Bay area people would consider financial freedom either.
I think one good thing to come out of this real estate bubble is the challenge the myth the home ownership is the “right” way to go. As you are pointing out and so many of the commentors are highlighting, the rent v. own decision is not so clear cut and both have significant pro’s and con’s that need to be fit with each individual’s situation.
Thanks,
Brian
21. December 2009 at 12:25 pm
10% interst rate for 20 years. haah. do that for me and i shall buy you your dream house.