This is a topic of great personal interest to me. It’s something I’ve discussed with family and friends on numerous occasions, and it’s something that I’ve looked into quite a bit. I’ve even touched upon it briefly on this blog in the past.
It truly amazes me how many people choose to buy a house simply because that’s what the world, or their real estate agent tells them to do. Traditional wisdom says that buying a house is the smart thing to do. The thinking has always been that you buy a house with a mortgage and eventually, once the mortgage is paid off, the house is all yours. It’s called building equity.
This is presumably better than renting because at the end of the mortgage, you own the house and can simply sell it to recover most of your money. In the case of renting, you are not working towards owning the house. You are simply paying on a monthly basis for the privilege of being able to live in that house.
On the face of it, it all seems to make perfect sense. Why waste money renting, when you can use that same money to build equity and eventually own a valuable house? But things are not always as they seem. There are a number of factors underneath the surface that need to be considered.
Let’s run through an example. Assume you buy a house for US$ 250,000. You make a standard down payment of 20% (=US$ 50,000). In addition, there are closing costs that need to be paid. Conservatively, let’s say these costs are around 3% (=US$ 7,500) of the home value. So, the total value of your mortgage is US$ 200,000 + US$ 7,500 = US$ 207,500. Like most people, you get a 30 year mortgage with a moderate annual interest rate of 5%.
The bank gives you the money, using which you buy the house and start to live in it. Every month, you pay the bank US$ 1,142 towards your mortgage. Annually, that adds up to US$ 13,704.
Now it starts to get interesting …
You realize you have spent so much on buying a house, you should probably protect it. So, you buy homeowner’s insurance. This typically costs 0.3% of the home value and is paid annually.
A few months in you realize that the community you live in has its own dues. Typically, homeowners’ association dues go towards the upkeep of the community. Let’s assume 0.2% of the home value annually.
A year in, you get a bill from the government telling you your property taxes are due. That’s right. You have to pay taxes annually on the value of your house. Conservatively, let’s say 1% of your home value annually.
Life starts happening: your washing machine breaks down, the drain gets clogged and parts of your home suffer small amounts of water damage. You might also have a number of small repairs that need to be carried out. In addition, routine maintenance is also required like mowing the lawn, changing the lights, cleaning the air conditioning filters, etc. These costs are typically in the range of 1.5% the annual home value annually.
So, let’s review how much we spend annually on the house:
- Mortgage payments: US$ 13,500
- Homeowner’s Insurance: US$ 750
- Homeowners’ Association Dues: US$ 500
- Property Taxes: US$ 2,500
- Maintenance, Repairs, etc.: US$ 3,750
That’s a grand total of US$ 21,000. Now, you might say to yourself, that this is turning out slightly more expensive that you had thought, but it’s okay because you’re building equity. But have you thought about the alternative? Over a 30 year period, the total cost of buying and owning that US$ 250,000 house add up to US$ 680,000. That’s almost 2.7x the cost of the house. Renting for 30 years @ US$ 900/month would have cost you US$ 324,000 and you wouldn’t pay anything else. The landlord would take care all of the maintenance, repairs, property taxes, etc. That’s a saving of US$ 306,000. If you invested these savings at 5% annually, that’s another cool US$ 15,300 in your pocket every year.
Now, you might be wondering how you ended up paying so much for the house. Well, let me give you a breakdown.
You paid a total of US$ 404,879 on your mortgage. That’s right. Over the 30 year period, you paid US$ 404,879 on your US$ 207,500* mortgage. Even though 5% interest might seem low, it adds up to almost US$ 197,000 over the 30 year period. And it doesn’t end there. Even after having paid off your mortgage in full, the ongoing expenses continue. Between insurance, property taxes, maintenance, etc., you will continue to spend a minimum of US$ 7,500 every year.
As for the equity you’ve built, let’s take a look. You want to sell the house, but before you do, remember that there are costs associated with selling your home. These so-called closing costs are about 5% on the value you sell your home for. All things considered, the only way you can make a profit on your home is if its value has increased 266%. That means your home has to be worth at least US$ 662,500 30 years after you bought it. That’s an increase of about 3% annually. I’m not saying that’s not possible. It’s possible that it might even increase more than that. But, there also exists the possibility that the value might decrease, and if market conditions are bad, you might even end up selling it for less than you paid for it. While a lot of people have made a lot of money off their homes, there are also many who have lost everything because of it. In an ideal world we would all have enough money to simply buy a house outright without a mortgage, and the economics would then make a lot more sense.
I don’t mean to discourage anyone from buying a house. Everyone’s situation is different and everyone needs to evaluate for themselves whether they are taking the right decision. The point of this blog post is simply to help increase awareness of all the moving parts and intricacies involved in buying a house and not get swayed by popular myths.
*For the sake of simplicity, I have:
-rolled the initial closing costs into the total mortgage
-ignored the cost of furnishing the house
-ignored the potential tax implications of selling your house at a profit
-ignored the effect of inflation
-ignored tax deductions you might receive for interest on your mortgage because more often than not, people don’t qualify for the deduction, and if they do, the deduction is relatively minimal