Welcome back. I’m now going to take a slight tangent and cover a topic that I think this is probably the single most important video that anyone can watch. My family and I live in northern California. We’re renting. And I like to point out, by choice. I have family members say, why don’t you buy? You’re at that stage in life. And I tell them I’m not going to buy because I’m pretty convinced, almost 100% convinced that housing prices are going to revert back.
Isn’t buying always better than renting?
I think that common wisdom comes out of, when you have a mortgage, or when you borrow money to live in a house, every month that money you give to the bank is going into savings. That’s the perception. While when you rent, that money is disappearing into a vacuum.
Let’s say I have a choice, there are two houses. House #1, and House #2. And let’s say that they are identical house. Three bedroom, 2 bath townhouses in Silicone Valley, which is where I live. I want to live in one of these houses. I’m indifferent to which one I live in, because they are identical. So living in them is the identical experience. I can rent this house, for $3K a month. Or I could buy this house for $1M. And let’s say that in my bank account right now I have $250K in cash.
So we will see what happens in either scenario and how much money is being burned. I’m renting, so in a given year, I pay $3K times 12 months, so I spend $36K. I’ll put a negative there, because that’s what I spend in rent. And then of course, I have that $250K. I’m going to put that into the bank, because I have nothing else to do with it since I didn’t buy a house with it. If I put it in a CD I can get 4% interest on that. On $250K, I get $10K in interest a year. Out of my pocket, for the privilege of living in this house in Silicone Valley with beautiful weather, out of my pocket every year goes $26K. That’s scenario one.
What happens if I give in to the peer pressure of family, and realtors, and the mortgage industry, and I buy this house for $1M?
Well, I only have $250K, which is more than most people who buy $1M houses have. But I have $250K cash, so I need to borrow $750K. I take out a mortgage for $750K. I’m going to do a slight simplification, and maybe in a future presentation, I’ll do a more complicated one. On a lot of mortgages, when you pay your monthly payment, most of your monthly payment is the interest on the amount that you’re borrowing. And you pay a little bit extra on that to bring this value down. That’s called paying off the principal.
You can also take an interest only loan, but the component of the interest is the same. When you take a traditional 30-year fixed mortgage, every month, you’re paying a little bit more than the interest, just to take down the balance. For the simplicity of this argument, I’m going to say that we’re doing an interest only mortgage, and that maybe with any extra savings I can pay down the principal.
On the $750k mortgage, let’s estimate that I’m paying about 6% interest. That makes $750K x 6% a year equaling $45K in interest coming out of my pocket. Of course on a monthly basis, I’m paying about $3700 a month. My mortgage might be $4K a month, so I pay the interest, and then I pay a little bit to chip away at the whole value of the loan. It takes 30 years to chip away at the whole thing. Over time, the interest becomes less and the principal becomes more.
For simplicity however, this is the interest that I’m paying. $45K a year. The interest on a mortgage is tax deductible though. Tax deductible means is that this amount of money that I spend on interest, I can deduct from my taxes. I can tell the IRS that I make $45K less than I actually did. So if I’m getting taxed at 30%, what is the actual cash savings? I’ll pay 30% of this which is $15K less in taxes. How does that work?
Think about it.
Let’s say I earned $100K in a year, and I normally have to pay 30%. So I normally pay $30K in taxes. This is if I didn’t have this great tax shelter in the house. Now I tell the IRS that I’m actually making $55K a year. I’m going to end up paying $16,500 in taxes to the IRS. This means I saved $13,500 from taxes, from being able to deduct this $45K. So tax savings, plus $13.5K.
What else goes into this equation? Do I get any interest on my $250K? Well, no. I had to use that as part of the down payment on my house, so I’m not getting any interest there. What I do have to do is I have to pay taxes on my property. In California, we have to pay 1.25% in taxes of the value of the house. So let’s round it to about 1% since taxes are tax deductible as well. 1% times $1M equals another $10K in property taxes. And notice, I’m not talking about what part of my mortgage goes to pay principal. I’m just talking about money that’s being burned by owning this house. So what is the net effect?
I have $13.5K tax savings and I have to pay $10K. I actually have to pay a little bit more than that, but we’re giving some income tax savings on the property taxes. Then I have to pay the $45K interest that just goes out the door. It ends up that I’m paying $41.5K. Notice, none of this $41.5 is building equity. None of it is getting saved. This is money that is just being burned.
This is completely comparable to the $26K, and this example is not that far off from real values. Out here in the Bay area, I can rent a $1M house for about $3K, but in the mortgage situation, I am burning every year $41.5K, where I could just rent the same house for $26K out of pocket.
Then people a couple years ago said, houses appreciate, and that’s what would make it up. But now, very recently, we know that that’s not the case. In the next video, I’ll delve into this a little bit more. I’ll see you soon.
