House Economics

07/23/2008

Housing. Housing. Housing. It’s all over the news as foreclosures rise, sales decline, and value drops. And now the most inefficient organization in America, Congress, is going to attempt to bail out homeowners.

But the problem starts with what we’ve been told our whole lives. For a long time now, it’s been expressed that a house is an investment and renting is throwing money away. It’s the American Dream. But in reality, it’s more of a half-truth. Let me explain.

Home Ownership doesn’t equal riches. In fact, it drains your pocketbook, fueled by maintenance, interest on the mortgage, and taxes. There is no guarantee that your house will rise in value, as many in America are finding out right now. And lastly, home ownership doesn’t bring in any capital or cashflow.

Let’s look at an example…

When my wife and I started out, we rented an apartment for $650 a month. It was a nice little place with about 800 square feet of living space. We lived in it for one year, wishing every month that we could own a house. Finally, we saved up what we could, about $3500 and bought a house for the price of $115k. Now, after 6 years of marriage, we are building our semi-dream house.

My question is, after 5 years of home ownership, did I really not “throw money away” during this time, or would I have actually accumulated more wealth by renting? Now, in reality, we sold our first house after two years. But let’s pretend we are selling that house right now after five years, compared to renting for an additional five years.

If I had rented our first apartment apartment during that entire time at $650, my costs would be $7800 a year. But we all know that rent rises as time goes on. So, for the next five years, let’s include a 4% increase each year. Our total comes to $44,295! That’s a lot of money down the drain, or is it?

When we bought our home in 2003, our interest rate was about 6.4%. At a purchase price of $115k, with the seller paying all closing costs and a down payment of $3500, that left us with a $111,500 loan and a $697.44 monthly payment…about the same as our apartment. After five years of making those payments, our total comes to $34,601 paid to interest and $104,255 left on the loan.

Considering that I saved $7245 through my mortage, I only paid $27,356 to live in my house, compared to paying $44,295 to live in an apartment. Not a bad deal at all! But wait…we didn’t include taxes, PMI and insurance. Added up, those added an additional $350 a month to my mortgage. I also need to add about $500 a year in maintenance costs. That brings my five year costs to $50,856. My costs are now higher than living in an apartment over a five year period.

But now your screaming, “what about all that equity you’ve built up through home ownership once you finally sell your house”!

That’s right…equity. Let’s check it out.

During that five year period, my house value has risen to $140k, about the average appreciation rate of 4% a year. So I decide to sell my house. I get a $138k offer from a lovely young couple who is going to follow our life example, because they don’t want to throw money away as well. After we sell the house, pay off the loan, pay closing costs of about 2% and pay the real estate lady her 6% commission, we walk away with a check for about $22,900! Now that certainly beats paying $44k a year to live in an apartment!

But not really. Like many young couples and others who struggled to get into that first house, we did not have enough to put 20% down. We were also forced to max out what we could afford to live in a decent and safe area.

Remember taxes, PMI and insurance at $350 a month? This is where that comes into play. We were basically paying an extra $350 more to live in a home. If my goal was to be financially wise, I would’ve stayed in that apartment and used that $350 I saved by not living in a home, to invest in the stock market. At 10% a year in compound interest, I would have saved $28,000.

That means I was throwing about $5k away buying the house without 20% down and maxing out what I could afford in the first place. And really, that’s a conservative estimate. I probably would have walked away with even more by going the stock market route than buying that house. And if the real estate market had turned for the worse in our area, I could’ve ended up in trouble because of the lack of equity I started out with.

When we talk about home ownership in this country, we need to use the correct terms. Too many people bought over-inflated properties with zero money down, thinking they weren’t throwing money away anymore by taking on a mortgage they could barely afford.

Yes, buying a home can be very profitable. Yes, it can even be a good investment. But it has to be under the right terms. It’s not automatic that your house will appreciate or that you will make lots of money when you go to sell it.

Owning a home is a wonderful freedom…a luxury. And it’s worth the price to me. But we need to teach people to sit down and do the math before they rush into such a responsibility.