Welcome back. I now want to play a little ‘devil’s advocate’ with myself. I made this argument where I show that for the $1million house, you’re burning $41.5K a year.

This is not going to build equity. It’s not going to be your house. This is money that is going out of your pocket and you’ll never see again. In reality, you can view this $41.5K as rent on the money you borrowed. Interest is nothing but rent. So when you have an asset, if the asset is cash, the rent is interest. If the asset is a house, your rent is the monthly rent on it.

So when you think about it this way, when people say home ownership, they really aren’t home owners yet. You aren’t an owner until you don’t have debt. You are a money renter. So your choice is either to be a money renter here, or a house renter here. And I show that you are burning almost double the money.

But then there’s the argument that there are still advantages to buying this house. What are they? Well, in one situation, if I did get a fixed rate mortgage, and when we look at all those adjustable rate mortgages, we know that a lot of people didn’t. But if I have a fixed rate mortgage, I know what my payment is for the foreseeable future. For the next 30 years.

While in the renting situation, my landlord could keep raising my rent. So this might look good right now, but what if my landlord raised the rent to $3500 a month. Well then, out of your pocket, you’d be spending $42K a year, and then you get the interest from the money you put in the bank, so in that case if the rent goes up then out of your pocket is $32K every year.

Or what if the interest that you get on your cash in the bank goes down. Then this $10K will become lower. But as we can see, the rent would have to go up a lot to make this a break even situation. Let’s figure out how much this would have to go up in order for your net outflow to be $41.5K. You’re assuming you’re getting $10K from the money in the bank. Your rent would have to be $51.5K. Your rent would have to be $4300.

And this is another way to view it. If I were to buy the house and if I were to move, how much would I have to rent this house out for in order to not be losing money every month? I would have to rent it out for $4300 a month, even though the market rents are only $3K. And there’s another devil’s advocate argument, and that’s housing. This was something you heard a lot 3 years ago. People aren’t talking as much now. They would say, housing has done nothing but gone up, and I will build equity from nothing but housing appreciation. How much does my house have to appreciate every year?

Well, to make up this difference, $41.5K, minus $26K, so to make up that $15.5K difference, every year, this is $15.5K my house would have to appreciate by a comparable amount. How much appreciation is that on my house? That’s $1M house. So $15.5K on a $1M house, that’s only 1.5% appreciation. So if my house appreciates by 1.5%. That’s it! If my house appreciates by 1.5%, I’m going to make up this $41.5K. So it is worth it for me to blow this money by renting the money for renting the money for more than I would have to pay to rent the house.

And that might sound like a very reasonable proposition, that the house will appreciate by 1.5%, from 2001 to 2006, houses were appreciating 10, 15% per year. And a real estate agent would often do this very math with you and say, you’re definitely going to get 1.5%. And in fact, you’re probably going to get 10% appreciation. But think about what, in the presentation of the balance sheet and leverage, what happens if housing prices go down by 1.5%?

Well, then you’re going to spend this much to rent the money, and you’re not going to gain this much. You’re going to lose this much every year. And so the proposition becomes even worse. So this is a big deal, now that on a nationwide basis a lot of the housing indices show that a lot of the housing prices have gone down, I think by 6%. That’s what the Case-Schiller index says.

6%’s a lot, especially on a $1M. That’s $60k a year that’s just evaporating. That’s wealth someone thought they had that’s just disappearing out of their equity. So this rationale of paying more to rent the money for a house than to rent the house is justified if housing prices go up. It becomes 10 times worse if housing prices are flat, or God forbid if housing prices actually go down.

And now we see that housing prices actually go down, in the last couple of years especially in the areas, like the Bay area, or Florida, southern California, where this is happening. Even 2, 3 years ago, when people used to make this argument, my house just has to go up 1 or 2% and I make up the difference, I say, why is your house going to go up 1 or 2%? Is it because, there has to be some reason why next year someone’s willing to pay 2% more for that house. Is it because rents are going up 2% per year, so the income stream is going to be 2% higher?

And actually in the Bay area, from 2001 to 2003, rents were going down. There were people moving out. All the tech workers are getting laid off. You had a lot of programming jobs being outsourced to India and whenever else. So you had these situations where the population was increasing, demand for housing was going down, but for some reason, housing prices were going up. So people said, they’ve been going up for the last 5 years, so they’ll continue. And they’ve never gone down, etc., etc., But they didn’t make an economic argument.

And I’ll show in a future video that the only reason why housing prices did go up is it just became easier and easier and easier to buy a house. Financing got, the standards that bank used for giving out a loan became lower and lower. There are examples in Southern California and in San Jose, and some of the suburbs where people who had incomes of $30K or $40K a year, the bank actually gave them a $1M loan to buy a $1M house based on stated income.

There are things called stated income loans, where you just tell the bank what you earn. You don’t have to prove it to them. So every year that went by it just became easier and easier. More people just though that housing always appreciated, so that’s why they wanted to pay more and more to essentially rent the money for a house. And it just became a self-fulfilling prophecy. But as we see, on the way down, it works completely against you. So in a situation we are now, where nationwide, housing prices are declining. And they will decline until this rent versus buy equation starts to make a little bit more sense; it really hurts the homebuyers.

And what’s even worse, and this is kind of adding insult to injury is that this guy, once, if I bought this house, and I lose my job, and I can’t pay the house back, I might lose my entire $250K down payment. Maybe I can’t sell the house, or the house is selling for less. Or maybe I want to move and there’s no one out there who can buy a house. Because the banks all of a sudden got smart again and realized they should get more serious in terms of whom they give money to. And so I’m stuck holding this house, and my flexibility in terms of where I can move is limited.

A friend of mine was telling me that they had done studies and there’s a correlation between unemployment and home ownership. Because when you own a home, you have less flexibility in looking for a job. If I have a house in San Jose, but there’s a job in LA, I might not be able to take that job because I can’t sell my house. Or I might not want to look for a job in LA.

While the renter, of course, my lease ends and I leave. This is just a rough sense of the rent versus buy. And I know I get very impassioned about this, but that’s just because I explain this a lot, and when I’m at parties, and I start talking about the calculations, people’s eyes glaze over. But I made this video now, and I’ll just tell people to watch it.

See you in the next video.