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 outright, you're still in the rental game -- you are renting to yourself. Even though all the rent goes to yourself, owning is still a lousy investment if you overpay for a house.
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. Ignoring taxes for now, say you can get 5% by investing in bonds 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.
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 the simplest case: an interest-only mortgage. To borrow $250,000, say you'll have to pay 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.
"What if I put down 20%? Would that help?"
Not much. That's just a combination of the two cases above, both of which show it 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. If you could get 5% by putting that $50,000 in bonds rather than in a house, 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 bond interest.
"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 you can reduce your taxable income by the amount of mortgage interest you pay, but the other costs of owning eliminate that advantage. Furthermore, every married couple gets a $11,400 standard deduction, just for breathing.
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% marginal 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 bond interest. Property tax, maintenance, and insurance are paid by your landlord, so you have a net cost of $9,500 as a renter.
"But haven't houses always appreciated in the long term?"
House prices track inflation, on average, in the long term. Prices did rise a lot from 2001 to 2005, but that was very unusual, caused by exceptionally 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
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% |
"But the bond interest is taxable, so you don't really get 5%"
Buying a bond is just the simplest possible investment example and not necessarily the 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 bonds in your 401K account. 401K's are tax-deferred until retirement.
- Buy your bonds in your Roth IRA. 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 in a taxable account. Though the rates are a bit lower than CD's, maybe 4% instead of 5%, there is no state tax on US Treasury bond 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 solid dividend-paying 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 historically risen much faster than housing. 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.
"What about leverage?"
When you hear someone telling you why you should use maximum leverage in real estate, run, do not walk, RUN to the nearest exit!
Leverage is a bet that the appreciation will be greater than the cost of borrowing. 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? Maybe. You spent $6,000 in interest, plus all the others costs of owning, but you got the use of the house plus the $5000. For many years this bet worked, so people assumed it would continue that way forever.
The problem is that 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 personal wealth are "liquor and leverage."
"What about inflation?"
Most of the apparent gain in housing value has actually been inflation. What you really 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.
Banks 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 the banks will be wrong and inflation skyrockets, greatly reducing the value of the debt that borrowers owe. In that case, owners do win, and banks lose. This happened in the S&L crisis of the 1980's.
"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 down by the large glut of available housing because there has been way too much building going on due to artificially low interest rates. My own rent is still less than it was 10 years ago, during the dot-com bubble.
Rising rents (but not rising house prices) 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 agents 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 agents, lenders, mortgage brokers, or anyone else 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:
- Patrick's rent-vs-buy calculator
- sell or hold from landlord's point of view