Before buying anything, you evaluate an item's worth to determine if its greater then its cost. For most purchases, the cost is obvious, you just look at the sticker and compare it to things of a similar price. For example, when comparing two apartments, one that is $800/month and another that's $900/month, its easy to make a decision. You just have to ask yourself if the more expensive apartment is nice enough to justify the extra $100 a month. Hmmm, you could get pretty good cable TV for $100 a month. Is the nearby pool and attached garage worth that much to you? Which do you like more?
Reducing an item's cost into a number is a great way for us to associate it with other things in the same ballpark. Once we've made the association, buying decisions really just become a matter of which do you like more. Knowing how much you like a house is the easiest part about house shopping. Take the tour, see the back garden, check out the neighborhood, etc. But how much will this house cost you? Ah, here we enter into a nightmare of sorts. Unlike all other purchases we are familiar with, the true cost of a house is obscured...greatly obscured. Is there an actual cost to be had, one we can understand? Not an uber large number over so many years, but something small that we can compare against other things of value?
Such is the goal of this web page, to reduce all the complications of purchasing a house into the simplest measurement, how much money goes out-the-window each month in order to live there.
For starters, it should be obvious that the cost of an apartment is a sure thing (agreed upon ahead of time & signed into a contract), while the cost of living in the house is not a sure thing. But this doesn't matter. We will be dealing with averages, in the middle of best and worst case scenarios. Things could cost less then what we predict, and they could cost more. We are calculating an average of what is most likely. For some people, uncertainty itself is a bad. While other people consider it a good thing (e.g. those who visit casinos). Now it doesn't hurt to punch in a few bad numbers into the calculator (e.g. 0% appreciation, move in 2 years) to see just how bad it could get. But unless you are completely incapable of taking calculated risks, you should not let bad scenarios discourage you from getting the house. In fact, the key point to remember is that uncertainty itself is neither a cost or a benefit, it is a wash.
Since housing loan interest rates (for the moment) are less then the historical average of stock growth, it simplifies our calculations. We need not consider the option where we wait so many years to save up our pennies to buy the house out-right. Even if we had $200k, we would not want to tie it up into our house to avoid a loan, we'd rather take out the house loan so that our $200k remained free to be invested in the stock market. I know, I doubted this logic myself for a long time. But since I've become familiar with online trading, its pretty easy to conclude that stock investment will net you more then 10% a year, even when you take into account transaction fees, capital gain tax, and rate variance (which lowers your actual growth rate). And while a loan price may be a little more then the advertised 6% from banks, after all their hidden fees are added it up, its still much less then 10%.
So let's take a very simple view of what it costs to live in a house: the interest rate of the loan. Ah, but if that was all that we took into account, we'd never move out of apartment into a house. 6% of a $200k house is $1,000/month. You can get a pretty nice apartment for that price, probably with a pool and several other amenities that a $200k house wouldn't provide. But this is not the complete picture of course, so let's try to find out what other things add or subtract from our total cost of home ownership:
| House Cost | $k | House Value | $k Deal Adjustment $k |
| Loan Term | $yrs | Loan Rate | % |
| Monthly Payment | Loan Points | $ | |
| Other Misc. Loan Costs | $ | Total Closing Cost | |
| Housing Appreciation | % | Expected Stock Growth | % |
| Inflation | % | Property Tax | % |
| Length of Stay | yrs | Realtor Fee | % |
| Standard Deduction | $ | Tax Bracket | % |
| Itemized Deduction | Tax Credit | first yr | |
| Principal Paid at End | House Value at End | ||
| Real Cost | /month |
While the historical basis of housing appreciation gives us some idea of what to expect in the future, obviously this is a number that no one really knows. If you have some special information that you feel gives you better insight on what to expect, then adjust the number above. It is my understanding that the long-term trend of housing appreciation is not much higher then inflation itself. While recent trends in the US market might look closer to 5%, I believe that is not the true average and it would be misleading to expect that.
Let's begin with the most obvious pieces every one considers:
Though it lacks several pieces, this is still an important number to consider. The real magic behind it is appreciation. It is the best part about getting a house. You are using the banks money to invest. Though the return rate of a house is not as good as stocks, its alot of money being appreciated. No matter how much or little of the loan you've paid down, you always reap the appreciation rate on the full asset. And right there, that takes away much of the pain of the interest cost. From this perspective alone, the house looks real affordable compared to an apartment.
I should point out that the Interest rate is higher then the Appreciation, so unfortunately you cannot use the logic that a more expensive house is better (darn!). Yes a more expensive house would have more to appreciate, but your loan rate is higher, so it cancels out the appreciation and then some. Simple economics dictate that housing appreciation is lower then bank interest rates. While momentary exceptions to this rule get a lot of press coverage (e.g. Florida's and California's recent +100% appreciation), the market simple says this cannot last and always corrects (like a rubber band that snaps back with a vengence, don't want to get caught holding the assest when this happens).
Also, be careful about putting too much down in the Deal Adjustment/Bargaining Bonus. Though you might think you got the house for $25k less then market value because the seller was desperate, did you really just create $25k out of thin air, through stern negotiation tactics? Both you and the seller may like to think that house is worth an extra $25k, but then why didn't the seller find someone willing to pay that higher price? Though realtors (and other purported market "experts") may claim the house is worth X, these guys are often cheerleaders for the market (i.e. they're full of crap). The definition of "market price" is what someone is actually willing to pay. So you can only claim a bargaining bonus if you know that the house could be turned right around and sold to someone else for the higher price. In most cases, the price other people are willing to pay is very close to the price you just paid...or possibly less. That is to say, you just made the deal, and not them. In fact, when it comes to "other people" you can only assume one of two things:
In case I'm sounding overlay negative here, do keep in mind that the average person's opinion of the house doesn't matter. When you sell, you are going to sell to the highest bidder. So you only need to find one person with a high opinion of the place. But right now, you are the highest bidder. Which means you should put down $0 for Deal Adjustment, unless you've truly believe you somehow hoodwinked the market.
Now let's take into account a huge fee that is often over looked: the cost to move.
Most people can stick it out 5 years. This adds an acceptable, but by no means insignificant, amount to your total monthly cost. Try 2 years and see how bad this number becomes.
While I've now covered the main points to consider, it is still not the complete picture. For starters, there is no such thing as an infinite loan, where you pay nothing towards principal. The amount you do pay towards principal is important, because its money that has left your hands and cannot be used by you, either for misc. purchases, or to invest in the stock market. You of course get the money back when you sell (years from now), but until then its tied up. While tied up, it does serve one useful purpose: it reduces the amount of money you pay towards interest.
So we can take two extremes: 0% paid and 100% paid. At 100%, we are no longer paying any loan interest, but a large portion of our money is now tied up, unable to be invested. Our cost of living in the house has actual gone up, since our money is only fetching us 6% return now (in cost avoiding the loan) instead of 10% in stocks. Most people assume a 15-year loan makes more financial sense, because you are paying down your loan more quickly. In the current situation where stock prices fetch higher returns then loans, you do not want to pay down the loan quickly. A 15-year loan may be better a 30-year loan, but only because it has a lower interest rate. We'll have to calculate the break even point between them, as there is a definite advantage to a 30-year loan which let's us keep more of our cash free to invest.
PMI is another potential cost. But here I made the assumption 20% down has been paid to avoid it. You should have that much money saved up before purchasing a house. It is age-old wisdom that I don't believe people should ever disregard. The calculation above clearly shows how financial trouble can arise if you have to move more quickly then you planned. Without some excess cash available, you could be hurting big time if the worse case situation should hit. Not only do you eat the actual cost of the worst case, but you'd have to add other costs related to foreclosure or a rushed sale of the property. You may even be in debt after all is said and done. Not pretty.
So I repeat, you should have 20% available, and to avoid the PMI, I suggest using it on the loan itself. I know there are other ways to avoid PMI (e.g. 2nd loan) but those solutions are going to be more expensive then 6%. They are in fact, right about 10%. Which means they're equal to the money we expect to lose not investing in the stock market. So I've ignored those other options.
Though the utopia scenario of starting with 0% cannot be done, let's pretend for a moment that we could. Does it make much of a difference compared to 20%? Interestingly enough, it does...
So we are starting with 20%, and in 15 or 30 years we'll be at 100%. How much difference does a totally paid off loan make?
First of all, we must recognize that 30 yrs is a long time. If $200k is left to compound at 10% a year, it turns into over $1 million. Now a house's appreciation compounds too, just not as fast. The difference between them after 30 years is quite large, stocks yield more then double what the house would (at 3.5% appreciation). So that's half-million in lost oppurtunity, a cost. The cost is divided amound 360 months, and still winds up being a princely sum. Living in a $200k house for 30 yrs never looked so expensive.
Even if you lower your stock expectations to...let's say 8%, and bump you house expectations to 4%, you'll notice that this tied up principal is still a huge cost, something you wouldn't have living in an apartment (or if you can continually re-finance back to 0% loans).
And these two numbers, the housing appreciation and stock appreciation are historical numbers that have not deviated much over the past 150 years. Stocks have always fetched better returns. What this leads me to believe is that tying some of your money up in a house is not bad if its done latter in life. But at a young age, when all of your dollars have the greatest chance to compound, it would not be wise to put any of them into the slower returning asset.
Out of curosity, what happens if we have lots of excess cash, we're sick of apartments and want to live in a house, and there are no cheap loans to be had? Well, we can bypass the loan and buy the house outright. It has the nice advantage of avoiding all bank fees. If the house is completely ours, how much does it cost to live there? Again, we must consider the lost opp cost of tying a lot of our excess cash up.
One last argument in favor in houses: diversification. Its a fancy term for not keeping all of your eggs in one basket. One could argue that its great to have a lot of your money in stocks, but if you already have plenty (for those lucky few who sneeze at small sums like $200k), one investment strategy is to hedge your risk by moving a small part of your wealth into a house. I don't believe this to be a very convincing argument, because diversifying is easy enough to do with stocks alone, by keeping your portiflio filled with shares from different industries. Which is why I think a house should always be viewed as a cost. As long as you are honest with yourself about a house's true cost, you'll only get a house when you truly feel the need for more space then what apartments can offer.
Upon completing my lengthy analysis, it was quite humorous to run into this article: Palo Alto - Rent vs. Buy. It has to be some of the worse advice ever. Specifically...
Well, I'm sorry but sales people never were an objective bunch.
People in general (and I should include myself in this category) are largely ignorant of how to build wealth. More precisely, it just sounds like a lot of work to all of us, so we don't bother. But I have my reasons for wanting to figure it out. For starters, having $300k saved up would allow me to walk away from jobs that suck. The appreciation of that would net me $30k a year, and I can live on that! Can you imagine not having to work for a whole year? To just work only on those things you feel are important?
Well like everyone else, I want a house and will eventually get one. But if you're prudent, and have dreams of taking it easier latter in life, then delay getting a house and stay with an apartment in you're youth. Its just cheaper, and any wealth you can start to accumlate earlier reaps larger dividends.
But I do need to bring up one last point, that some might feel doesn't belong in a paper like this. I want to remind everyone of a fairly obvious truth: that financial independence is not the only thing that will make you happy. You shouldn't sacrifice love, marriage, and kids to the goal of financial independence. I'm talking from limited experience here, but I have watched many adults who made various choices along these lines, and I noticed that people who chose to raise families, despite the financial challenges, are undoubtedly more happy then those that avoided this challenge. So, I know it may sound cliche and totally obvious, but don't sacrifice your dreams of a happy family just because you wanted to maximize your retirement fund's growth rate.