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Friday, January 05, 2007
The Folly Of A Home Mortgage For A Young Couple
Ever since your Curmudgeon penned the first Sturdy Wisdom essay, various persons, most of them fairly bright, have written to upbraid him about condemning the home mortgage. Why, everybody knows a mortgage is the only way to buy a house, and a house is the only remaining significant middle-class tax shelter! EVERYBODY KNOWS THAT!
What "everybody knows" is usually wrong -- and this is no exception.
Consider all the following:
- A typical modest middle-class house, outside the coastal population centers, costs in the neighborhood of $250,000.
- A typical 30-year mortgage sells for about 7% annual interest, compounded monthly, apart from any application fees or "points."
- Such a house eats money in many ways, but let's limit ourselves to the truly inevitable: mortgage principal, mortgage interest, and property taxes.
- Property taxes outside the coastal population centers average about 1.5% of market value.
- Money spent on real estate is unavailable for other duties.
- The average first-time homebuying couple averages only 7 years in residence in that house.
- Except for anomalous periods such as the early 1980s and the early 2000s, real estate prices track inflation. In other words, real estate doesn't actually appreciate in real terms.
To avoid morgage insurance, the buyers will have to put down 20% of the purchase price at closing. This leaves them with $200,000 to mortgage. On a 30-year, 7% mortgage, their monthly payment, apart from property taxes, would be $1330.60. Property taxes would add another $312.50 to that payment, for a monthly "nut," all other considerations excluded, of $1643.10.
Here's what happens over 7 years of those mortgage payments:
| Payment | Amount Owed | Payment Equity | Payment Interest | Accumulated Interest |
| 12 | 197968.38 | 174.77 | 1155.84 | 13935.64 |
| 24 | 195789.89 | 187.40 | 1143.20 | 27724.41 |
| 36 | 193453.93 | 200.95 | 1129.65 | 41355.71 |
| 48 | 190949.09 | 215.48 | 1115.13 | 54818.13 |
| 60 | 188263.18 | 231.06 | 1099.55 | 68099.48 |
| 72 | 185383.10 | 247.76 | 1082.85 | 81186.66 |
| 84 | 182294.83 | 265.67 | 1064.94 | 94065.65 |
The debt has been defrayed by less than $18,000.00, at a cost of $94,000 in interest and $26,250 in property taxes. If we assume that the purchasers are in the 33% tax bracket, they'll recoup approximately $40,000 of their interest and property tax payments in income tax refunds. That leaves them with a net loss on their "investment" of about $62,000, assuming they can sell the house for the price they paid for it. But still, there is that $18,000 in equity...
Since we're discussing first-timers here, the comparison should be to a one- or two-bedroom apartment in a middling area. A glance at last week's Poughkeepsie Journal, the main daily newspaper of Dutchess County, NY, indicates that two-bedroom apartments in nice areas are available for approximately $1000 per month. So residence in such an apartment would cost the young couple $643 less per month than the house they considered buying.
Today, one can easily get 5% interest from a money-market account -- and without tying up the monies put there. So if our protagonists were to save the difference at 5%:
| At Year | Amount Saved |
| 1 | 7895.30 |
| 2 | 16194.55 |
| 3 | 24918.39 |
| 4 | 34088.57 |
| 5 | 43727.91 |
| 6 | 53860.42 |
| 7 | 64511.32 |
That's $64,000 cash in hand, compared to the $18,000 "equity" they'd have accumulated in the house they didn't buy. Nor have we considered the "operating expenses" on a single-family home: building and yard maintenance, homeowners' insurance, the price of oil and gas, and other incidentals that raise the actual cost of home ownership to a surprising degree.
But what if our heroes are utter exceptions to all the rules? What if they stay the full, 30-year course all the way to unencumbered title? Why, then they'll have spent a grand total of $529,000 buying their house, plus another $112,500 to the property tax authorities -- and it will still be worth only $250,000 in real terms.
In short, a house must be regarded as a consumption expense, not an investment. For young persons overwhelmingly likely to need (or want) to move within a decade of the purchase, it's a particularly bad deal.
In other words: Do the BLEEP!ing math before arguing money with your Curmudgeon.
Comments
OK, even discounting those of us with way more than 20% equity at closing (55% in our case, and it’ll be 80% within the year, once she closes the sale of her old house) and a probability of relocation below 10%, you’re still comparing apples to oranges when you compute the total paid for the house in nominal dollars while assessing the value of the house in constant dollars.
And maybe renting is meaningfully cheaper than buying where you are, but it definitely isn’t around here...especially when you consider the difference in housing costs between the locations where property is rented and the locations where it’s generally only sold. (Even before rolling the extra cash into equity and refinancing, and paying a relatively high interest rate due to spotty credit history, our mortgage payment is only $300/mo more than our old rent was, for more than 6 times as much space. Once the refi is complete, we’ll be paying _less_.)
And since you’re making a numerical argument, I won’t get into the enhanced liberty interests we’re enjoying, but they’re nevertheless quite significant.
What you say may be true for some people. They may be true for every particular couple you know, in every particular trade-off they face. I’m not saying you’re wrong in all those cases, because you know the facts in those cases better than I do. But they’re not univesally applicable, and those of us for whom the applicable facts on the ground are relevantly different don’t appreciate the implication that we must necessarily be imprudent, innumerate, and/or stupid.
Posted by Matt on 01/05/2007 at 04:55 PMMatt, read what I wrote a bit more closely. Real estate tracks inflation; a valid simplified computation can be done that omits inflation.
As for renting being cheap around my area, you don’t know Long Island, do you? But that’s why I picked Dutchess County for my examples: it’s an extreme-commuting-distance region where realty prices are approximately aligned with the national averages.
When you speak of increased space or enhanced liberty interests, you’re talking about consumption goods. The argument that’s been hurled at me is that a mortgaged house is an investment. That’s the position I refuted.
As for being imprudent, innumerate, and/or stupid, I would never presume to say such a thing about someone who enjoys Eternity Road. But most of you, if I can judge from the commentary, have never bothered to do the arithmetic on the subject. Inasmuch as it’s somewhat complicated arithmetic—accumulation and decay of compound interest—it’s not that surprising. But to go by what “everybody knows,” when “everybody” hasn’t done the arithmetic, doesn’t make it correct from a financial standpoint.
I repeat: Do the BLEEP!ing math!
Posted by Francis W. Porretto on 01/05/2007 at 05:26 PMYou’re right that a valid simplified calculation can be done omitting inflation. But you’re still comparing one sum in constant dollars (the value of the house) to another in nominal dollars (the total sum paid out for the house over the life of the mortgage), and treating them as economically equivalent statistics, even though we both know they’re not. But frankly, that’s not the core of my argument.
My point is that, while you’re probably (in the main) correct that, under your assumptions, buying a house in what’s come to be perceived as the default way and then paying for it in the default way is not the ideal investment that some people think it is, your assumptions are nevertheless not the complete set of applicable facts, and the default method of initial financing and subsequent repayment is not the only one, nor is any serious commentator on personal finance arguing that it’s the best one.
Even if one doesn’t have 55% of the sale price of the house to put down, and another 25% available to add to equity within a year, one can still shave a great deal off the total lifetime cost of the mortgage by making periodic extra payments toward the principal balance, whereas there’s no comparable way to cut the total-over-time cost of renting a residence by paying more frequently or making larger payments up front (or indeed any other method). By borrowing money today, at interest rates likely to be lower than they are for many years to come, one can lock in a fixed monthly housing cost that is unavailable to renters, who must leave a significant fudge factor in their long-term plans for the inevitability of periodic rent increases of unpredictable magnitude.
Is assuming that appreciation per se will make one rich a rather innumerate practice? Of course it is. But that doesn’t mean that buying a house is the wrong decision, even as a purely financial matter, as long as one does it in the correct way and repays the loan in a better-than-default manner.
I _have_ run the numbers. My objection is not to doing the math, but rather to your apparent assumption that anyone who had done the math applicable to their circumstances and their decision must necessarily either agree with your conclusions or have an error in their arithmetic.
Posted by Matt on 01/05/2007 at 06:03 PMI still wish the hell I knew anyone who could “own” their home and not, as you put it, “live beyond their means”.
My aunt Kate bought her home in Gary Indiana in the 50’s.(approx $7500) They remodeled, did some work here or there, and by the time they’d sold their home, it was worth about twice the value of the whole mortgage(14,500) and the cost of the upgrades(2200).(the house sold for about 30k) Plus, they had a mortgage deduction for at least part of that time. Had the home been five miles further south, it would have sold for more than ten times the entire value of the mortgage (similar homes in crown point sold, at that time, for $140,000). I remember sitting with her while she did the math, while I was in my teens.
So I don’t understand why this is a bad thing. I guess I’ll probably never understand your point.Posted by og on 01/05/2007 at 06:25 PMMatt, I’m going to say this very slowly:
1. A house is a consumption expense on the strength of the numbers—even if one buys it in cash.
2. A mortgage makes a house cost more, even when one factors in tax deductions. A typical mortgage makes a house cost much more.
3. In the average case, an adequate rental is considerably less expensive than the house it supplants, which allows him who chooses it to save the difference to great advantage.
4. Non-pecuniary considerations cannot affect the argument from the numbers.
5. To omit inflation is approximately valid both from the perspective of the sum borrowed and the debt service paid, because of the short time intervals most persons keep any particular house. (At 3% inflation, it takes 17 years for the dollar to lose half its value.)
6. Your relentless repetitiveness is leading me to believe that this is a personal, emotional matter to you—that what matters to you is to have your own judgment proved right. Perhaps, in your particular case, it was right—but this is not about you. If that hasn’t been clear before this, it should be clear now. At least, I hope I’ve made it clear.Now, if that isn’t enough for you—if you absolutely have to have the last word—go ahead and have it. But if it does not strictly address my argument as I made it, on the strength of the arithmetic, it will be the last comment you ever post at Eternity Road. I refuse to be consumed by your apparent determination to argue that alternate, non-mortgage funding, increased down payment, accelerated repayment, and unspecified “other factors” invalidate my argument about the typical, overwhelmingly most common cases.
Given what you’ve had to say so far, I advise you to drop the subject.
Posted by Francis W. Porretto on 01/05/2007 at 06:28 PMI’m with Fran. In most urban areas it is far cheaper to rent than to own an equivalent space. Liabilities are minimal and that leads to phenomenal savings opportunities. Having owned a house for 5 years, I wish I knew a bit more then than I do now. We’re currently in great financial shape but we would be on top of a financial mountaintop if we would have leased for an additional five years instead of buying.
Am I making this up? No. We rented an equivalent house to the one we bought. $1000/month. Owning, we have $1400 month mortgage, $500 month tax and insurance, $100 month basic maintenance (old house) as well as the major maintenance that needs to take place. $1000 month difference over five years is $60k without interest gains. That’s a hell of a lot of cash on hand.
We’ve since learned and our paying everything off as fast as we can while saving as much as we can. Debt free is a damn powerful place to be in this society.
MC
Posted by on 01/06/2007 at 03:08 AMThere are two fairly unassailable principles at the base of the argument here:
1) Debt is something to be avoided;
2) Inflation is not your friend.
And while I live in a place where decent rentals actually cost more (in terms of monthly outlay, anyway) than ownership - tenants on my block pay at least 15 percent more in rent than I pay in my monthly check to the bank, including taxes and insurance, and before tax considerations are applied - I’m not quite insane enough to think of my house as an investment-grade investment. The intangibles made the sale here, and I make no apologies for that; on the other hand, intangibles play no role in the cold equations of mathematics.
Posted by CGHill on 01/06/2007 at 12:21 PMAnd you were even nice enough to presume that we can actually “own” real estate any more, Fran, even though Kelo made it quite clear that we’re merely squatters on government property who are
permittedrequired to pay for its upkeep.Add to that “adjustable rate” mortgages, property tax increases far in excess of inflation, etc. and only a fool can believe that a home is a good investment. What you are actually paying for, Matt, is marginally more control over the space you live in, and a higher degree of privacy (that being key with us out-in-the-woods folks).
Raw undeveloped land or income producing properties can be good investments, but the home you live in? As Fran shows, not bloody likely.
Posted by JoeCF on 01/06/2007 at 12:30 PMIf you believe in eternity, you can’t really “own” anything anyway.
At any rate, I’ve pretty much resigned myself to the fact of not owning a house or even a mortgage for a looooong time, since our work has put us in California, ground zero of the housing bubble. In 2006, a stunningly high percentage of California “homeowners” obtained payment-option mortgages, where you can make payments all the way down to negative-amortization levels, where the payment doesn’t even cover the level of interest.
That in turn has driven the median California home price to around $350K, and the lot size involved is usually .15 acre or smaller for that median house price. I kid you not. It’s insane.
Now the nasty fallout from this problem is going to affect me, a renter, because as these unsustainable loans fall apart (median INCOME is around $50K) they affect the rental market. Overall, there should be lower prices (as many borrowers try desperately to make back some money and flood the market), but that can have extremely local fluctuations. Furthermore, as people start getting desperate, fraud increases.
All I want is to be able to have a place where I can have kids and not be worried about my landlord running off with my deposit and finding out that I have to move in half a day because the house is being repossessed. Sure, I’ll rent the sucker— and it’s taken much reading on sites such as The Housing Bubble Blog to come to terms with the fact that I cannot hope to afford a house. Which hurts. But I really resent the fact that the loose money spending spree has appreciably hurt MY chances for stability in the next few years.
CGHill, if renting and owning are comparable in your area, you probably won’t be feeling the fallout. But it really sucks for those of us who had hoped that a promotion would lead to better things.
Posted by B. Durbin on 01/06/2007 at 06:14 PMThanks for the tips, we are learning how to do this <A href= “http://austingirl78704.blogspot.com/2007/01/as-you-may-know-from-talking-to-us-or.html">along the way.</A>
Posted by Austin Girl on 01/07/2007 at 11:17 PMNot all debt is bad debt per se. If used correctly, the bank can be your way of leveraging greater returns on your money.. but one must be exceedingly careful.
If one were to simply purchase a house, pay the whole 30 years (or a shorter span, but move into another mortgage afterwards) then you would be correct, that is not financially sound.
However it is my intention to purchase a house that is somewhat distressed, renovate the home, and then sell it off… Thus I pay a year or so in interest, and the costs of renovation, while reaping still greater profit. My long term goal in such things is to eventually accumulate enough money to buy a home in cash while keeping my present job. It’s still a risk, but the rewards (no rent or mortgage in the future) outweigh the risk. I must also point out that I have already run the numbers on this, and they are quite favorable. It may take 3 or 4 such homes to accomplish my goal, but it is quite reasonable.
My father made a living doing this and did quite well for himself. And he didn’t start out with enough money to buy the houses upfront either (really, who does?). He does now though. Leveraging the bank as a means to increase one’s income through intelligent home-buying and renovation can work quite well.
However this is not quite in line with what you are saying, and this is more of a business idea than a living arrangement. Nonetheless it demostrates that real estate debt has positive uses when taken from a purely business standpoint. It also demonstrates the real estate is not necessarily a bad investment, though certainly it is not universally good either.
However I do agree with your conclusion that real estate is often over-hyped and people get ridiculous mortgages without thinking it through.
Posted by Xealot on 01/09/2007 at 11:02 AMBut isn’t the money saved and placed in a money market subject to tax, and that 5% “earned” must also be reduced to real dollars, taking into account inflation. If we figure 3% inflation the real return would leave us with roughly 2% earned on the money saved, that is, if we are going to truly compare apples to apples.
Posted by on 02/15/2007 at 11:58 PM
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