What should you pay for a house?

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What should you pay for a house?

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2015 Jul 11, 2:06pm 36,885 views 71 comments

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.

Which one is better? In the first case, you're not getting any investment
income, but not paying any rent either. Owning outright means giving up
interest rather than paying interest, a different kind of loss, but a loss
nonetheless. In the second case, you're getting $12,500 in interest income from
your bonds, but paying out $12,000 in rent. $12,500 income - $12,000 rent =
$500

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.

Buying would cost $15,000 in interest, but you could pay only $12,000 in rent.
So you would be $3,000 better off per year as a renter.

"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.

So buying would cost you $12,000 per year, and renting would also cost $12,000
per year, but if you rent, you get the $2,500 in interest on your $50,000.
So you would be $2,500 better off as a renter.

"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.

Buying would cost you $17,140 per year, but renting would cost you $9,500.
So you would be $7,640 better off as a renter. (Not even considering the
standard income deduction.)

"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.

So you would be $20,140 better off as a renter.

If you look at the very long term, houses have been the worst investment
available to the general public:

From Yahoo finance

"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:

sell or hold from landlord's point of view
ny times housing calculator

#housing

« First « Previous Comments 32 - 71 of 71 Search these comments

tatupu70 2015 Jul 12, 5:35pm

in the long term, both the typical house price and typical rent must increase at the overall inflation rate. if you just think about it for a minute you realize that has to be true, or pretty quickly no one could buy or rent. here's a good explanation of that:

Yes, but you need to also remember that a mortgage payment is constant as rent rises with inflation. That is why buying wins over longer timelines. Not due to capital appreciation.

tatupu70 2015 Jul 12, 6:04pm

Call it Crazy says

Wrong... a mortgage payment is not constant, as property taxes keep rising in many areas as well as homeowners insurance.

There have also been people here who have said that their rent payments had stayed the same for many years and didn't increase.

You're trying to put a blanket statement on a variable condition on both sides of the argument.

A mortgage payment is principal and interest. Property tax and insurance are separate entities and may or may not increase(typically they do with inflation).

tatupu70 2015 Jul 12, 6:20pm

Call it Crazy says

Oh Tat, a typical mortgage payment for the majority of people is PITI,

I don't know if it's a majority, but yes, some people accrue their taxes and insurance. So, mortgage doesn't increase but property taxes and insurance might. Happy now?

35 CDon 2015 Jul 12, 6:39pm

true - in relatively poor areas, where basic economics works, meaning places landlords have to make a profit to stay in business.

as you move upscale, it gets to be a better and better deal to rent. the ratio skews because lots of people are grossly overpaying without regard to the rental value of the house. there are fewer rentals in those areas, but they are generally a good deal for the renter when they come on the market.

Wow - Its almost as if you have learned nothing in the decade plus that you have run this site. You and I had a discussion about this just over 3 years ago.

http://patrick.net/?p=1212971

Point being, highest best use is but one of the many factors which dictate price. Even landlords recognize this when they decide whether to bid on "blue chip" properties or not.

tatupu70 says

in the long term, both the typical house price and typical rent must increase at the overall inflation rate. if you just think about it for a minute you realize that has to be true, or pretty quickly no one could buy or rent. here's a good explanation of that:

Yes, but you need to also remember that a mortgage payment is constant as rent rises with inflation. That is why buying wins over longer timelines. Not due to capital appreciation.

Precisely. In 1999 the rent ($2,500) vs. buy ($2,900) calculator was screaming rent rent rent!!! Today the rent ($4,000) vs buy ($4,500) is also screaming rent rent rent!!! Yet I thank god every day that I ignored it back in 1999 such that my payment ($3,100 - it rises slightly as CIC noted) is $900 less than what my rent would be had I followed the calculator. Oh and this is a blue chip area just outside of DC.

Thus, the capital appreciation is simply gravy at this point. The $900 a month savings is the true reward here - and I only got this because I was willing to sacrifice (paying more to buy than rent years 1-7) to get the rewards (cheaper to buy than rent years 7-30... Massively cheaper to buy than rent year 31 til death). Even better than this, now that I am just over a decade away from being mortgage free, I salivate at the prospect of being in my early fifties with a payment of only a few hundred bucks a month. Had I not had the discipline to put myself in this position in 1999, I would be looking at a mid fifties payment of (probably) $5,000 a month with no end in sight.

Strategist 2015 Jul 12, 6:47pm

House prices track inflation, on average, in the long term.

Completely false. Maybe in certain parts of the country, but not Coastal California and regions with expanding populations where land is limited.
Here is my view:
Price increases in CoastalCal is 6%
Interest rates and property tax roughly 5%. Tax benefits on a 500K home will reduce that to 4%. Inflation is 2%, therefore the real interest is just 2%.
The annual cost of a home in Cal. is just $10,000 for a $500K home. The annual rent is an easy $30K for the same home. The difference is $20K, which easily pays for repairs.
Now add the 6% annual price gain, less inflation, which gives you 4%, i.e. another $20K
I intentionally excluded principal payments, as that is not a cost. I applied the mortgage rate to the down payment to compensate for opportunity cost.
Bottom line. Buying an average home in California, leveraged by a mortgage is very profitable over time.
Buying a home with all cash not as attractive, because the stocks do better over time.

tatupu70 2015 Jul 12, 6:48pm

Call it Crazy says

In all my years, I haven't seen a bank give anyone a mortgage but let the owner pay the taxes. The bank doesn't want to lose the house to a tax sale, which is why taxes are included in the payment. The same with insurance, as the bank wants to make sure the property is insured against loss.

I'm not accruing insurance so I guess this is the day!

Call it Crazy says

Which kills your assertion that mortgage payments "stay the same"...

Nope. mortgage payments stay the same. Taxes and insurance do not.

Strategist 2015 Jul 12, 6:53pm

Call it Crazy says

In all my years, I haven't seen a bank give anyone a mortgage but let the owner pay the taxes. The bank doesn't want to lose the house to a tax sale, which is why taxes are included in the payment. The same with insurance, as the bank wants to make sure the property is insured against loss.

The bank will not require property taxes and insurance be impounded with at least 20% down. With 5% down, yes, they will impound it.
Makes no difference over time.

Strategist 2015 Jul 12, 7:01pm

Call it Crazy says

Strategist says

The bank will not require property taxes and insurance be impounded with at least 20% down. With 5% down, yes, they will impound it.

Makes no difference over time.

The average down payment today for buyers is approx. 10%, so the majority will have taxes/insurance escrowed with the monthly payment.

Yes. Most people must have it impounded. Even those with high down payments might choose impounds, just for the convenience.

Strategist 2015 Jul 12, 7:09pm

Call it Crazy says

Strategist says

The average down payment today for buyers is approx. 10%, so the majority will have taxes/insurance escrowed with the monthly payment.

Yes. Most people must have it impounded. Even those with high down payments might choose impounds, just for the convenience.

Yep, but apparently Tat doesn't think so. According to him, mortgage payments NEVER change.

And I didn't even touch on the percentage of mortgages that are ARM's that readjust....

You guys are talking about apples and oranges. Assuming a fixed rate fully amortized mortgage.
Principal changes every single month.
Interest paid changes every single month.
Principal + interest remains constant for the life of the loan.
Property taxes and insurance changes every year.

Patrick 2015 Jul 12, 8:21pm

tatupu70 says

remember that a mortgage payment is constant as rent rises with inflation. That is why buying wins over longer timelines. Not due to capital appreciation.

OK, let me try again.

Even with a constant mortgage payment, the owner is tying up money in a house which is appreciating more slowly than the stock market.

This why you cannot say that "buying wins". Renting and investing is a viable alternative to owning.

Consider the first year of a $300K mortgage at 4%. The interest is something like $12,000. Say the rent on the house is also $12,000. Also say the principle payment is $833, and the renter puts $833 in the stock market every month. So both the buyer and renter are investing $10,000 per year, the buyer into the house, and the renter into the stock market. Say the downpayment was $60K, but the renter started also with $60K in cash to invest.

By the time the load is paid off, both have invested another $300K, but who has a greater total wealth?

Depends on appreciation, stock market gains, and rent increases! Say the house appreciates 3% per year. So now the owner has a house worth 360000 * 1.03^30 = 873814, but he paid 215608 in interest payments (see http://www.amortization-calc.com/ ) so he is left with total assets of 873814 - 215608 = 658206. (The interest deduction goes away as interest is paid off, and anyway is mostly wiped out by property taxes and maintenance costs.)

The renter has the compounded gains at 6% from investing the $60K plus $833 per month which is $1,182,626 (see http://www.moneychimp.com/calculator/compound_interest_calculator.htm ) but minus his rent of $12,000 per year plus, say, 3% annual increases in rent, for a total rent of $360,000 + $228,032 in rent increases. So the renter ends up with 1182626 - 588032 = 594594.

Oops, owner wins, though not by much!

But change that 6% to 7% gain in the stock market, then renter suddenly has 1467465 - 588032 = 879433. One freakin percentage point and the renter is way ahead.

But then you say hey, the rent on a $300K house is going to be more than $1K/mo (4%). Say it's $1500/mo. Then the renter paid 882,048 total in rent then, and his total assets are only 585417. So renter is behind.

But forever after, the renter is gaining 6% or so while the owner is getting 3% or so. So then the only question is whether the 6% that the renter is getting is being evened out by the rent he has to pay.

The point is that you cannot say that "buying wins over longer timelines" just because rents go up.

42 bob2356 2015 Jul 13, 4:46am

But forever after, the renter is gaining 6% or so while the owner is getting 3% or so. So then the only question is whether the 6% that the renter is getting is being evened out by the rent he has to pay.

That is incorrect. The owner will now have the amount that was going to mortgage to invest every month in addition to the 3% gain in value.

Again, where in the world are you finding 360k houses renting for 1000 a month to support your calculations? Rent has to cover the mortgage, taxes, and repairs. If it doesn't, like with rent control, landlords will walk away and you have Detroit or NYC in the 60's/70's. How many renters are out there that will pay 1000 a month in rent PLUS invest 883 a month? Damn few. I did it when I lived where rents were way below owning, which only happens with rapid price increases (aka a real estate bubble) and only exists until rents catch up. I haven't ever found anyone else doing it.

At any given time some places renting is better, some places buying is better.

FNWGMOBDVZXDNW 2015 Jul 13, 5:33am

Patrick's calculator is good as is any other online calculator without errors. What these all show is that the interest rate of the mortgage, the assumed inflation (rent increases), and presumed stock market performance make all the difference.

What would be useful to accompany these calculators is some data on how inflation, stock market performance, and rent increases are correlated. Although there are some spots where these diverge, in general, they are correlated. So, people should be careful when putting in these assumptions. It would be useful to have default parameters for say a strong growth model or a recessionary model. It would also be useful to have some error estimates on the parameters and do a little simulation or analytical calculation to show the likelyhood of one situation outperforming the other. I'm sure that these models are available. At least, if my business depended on the the results (banks, insurance, and investment companies), I would have these models developed.

Qualitatively, the calculators show that in general, long term holding of houses (when you include the place to live dividend) is better than short term holding of houses. Over the short term, renting usually wins, and over the long term, owning generally wins. When house price to rent ratios are high, the time required to pay-off increases. At some point, buying will never be better than renting if you assume a high enough stock market return and low enough rent inflation. It would be nice to see a graph of years to pay off versus stock market performance, rent appreciation, and housing price appreciation for various price to rent ratios. I think that price to rent ratio would be a good universal indicator (instead of using actual prices, which change from market to market). I'm not sure how to collapse the stock market performance, rent appreciation, and house price appreciation to one or two parameters. A good starting model would be to assume that rent and house prices appreciate at an inflation rate of 2% and that the stock market could beat this by X%. Then provide some curves if house prices and rent inflation are > 2% or

tatupu70 2015 Jul 13, 5:43am

Consider the first year of a $300K mortgage at 4%. The interest is something like $12,000. Say the rent on the house is also $12,000. Also say the principle payment is $833, and the renter puts $833 in the stock market every month. So both the buyer and renter are investing $10,000 per year, the buyer into the house, and the renter into the stock market. Say the downpayment was $60K, but the renter started also with $60K in cash to invest.

Bottom line is that there are calculators out there (and on here) that allow you to run the numbers very easily for individual situations. My experience is that if you put in real world numbers for price and rent and price and rent increases, over log time horizons, buying usually wins.

45 anonymous 2015 Jul 13, 7:34am

tatupu70 says

Yep--and I think it would have been better to buy anywhere in the 90s if you planned to stay there for the next 20 odd years until now. It would take a very unusual situation for a rent/buy calculator to favor renting with a 20 year horizon.

I agree with you, but the meteoric rise in housing from 1997 and beyond, along with the fact that interest rates are going up in the long term, skews what the future appreciation will likely be for housing. Plus, I don't think most people stay in a house for 20 years...isn't the average timeline like 7 years?

46 anonymous 2015 Jul 13, 7:44am

CDon says

Had I not had the discipline to put myself in this position in 1999, I would be looking at a mid fifties payment of (probably) $5,000 a month with no end in sight.

You are absolutely right...for the "once in a lifetime opportunity" of buying a house in the late 90s before housing rocketed to the moon. But, that was a statistical anomaly...I wish I had graduated college 5 years earlier and took advantage of the golden buying opportunity, but I was too young and missed it.

47 anonymous 2015 Jul 13, 7:52am

Here's my situation. My house is a rental in San Diego, and I pay $2900/month in rent (locked in a 3-year lease with no rent increases)...this house (San Diego) would sell today for about $720,000. Is it worth it for me to buy? If not, how much would my rent need to increase in order for me to make it worth buying?

Patrick 2015 Jul 13, 8:56am

try the ny times calculator:

http://www.nytimes.com/interactive/2014/upshot/buy-rent-calculator.html

i'm not sure they actually calculate the return on all the principle that the renter could invest, aside from the downpayment, but it's the best calculator i've seen.

the trick is that you have to correctly guess lots of things that are in the future, like appreciation and investment returns.

Patrick 2015 Jul 13, 9:02am

bob2356 says

But forever after, the renter is gaining 6% or so while the owner is getting 3% or so. So then the only question is whether the 6% that the renter is getting is being evened out by the rent he has to pay.

That is incorrect. The owner will now have the amount that was going to mortgage to invest every month in addition to the 3% gain in value.

no, it is correct, because the owner and renter both continue to invest the same amount every month, and they both invested $360K in an asset (house vs stock).

so the question at that point is just whether the renter's extra income from investing in stock is enough to cover his rent.

bob2356 says

Rent has to cover the mortgage, taxes, and repairs. If it doesn't, like with rent control, landlords will walk away and you have Detroit or NYC in the 60's/70's.

actually it does not have to cover anything in rich areas. there are literally people around palo alto who buy houses and let them sit vacant. sometimes they rent them out, sometimes they don't. but that's because this place is nutty and there is too much money sloshing about.