Mortgage Myths

“Renting is throwing money down the drain.”

“Real estate is a good investment.”

These major myths circulate about home-buying, though maybe the housing market slump exposed the truth. Housing, transportation, and food costs represent the three largest areas of expense in our country. We covered some basics of food costs in Cut Your Grocery Bill in Half and Cut Your Grocery Bill in Half, Part 2. Now here’s a primer post on buying a home.

When we began our house hunt, I thought buying a house at a decent price was automatically a good investment because real estate values rise. What I didn’t analyze was how much a homeowner pays in interest, taxes, insurance, maintenance, utilities, and other incidentals, plus the impact of inflation. Over 30 years you’ll pay something like 115% of the loan value in interest alone.

Let’s break down the promise of easy earnings by crunching some numbers. For example, say you buy a $150,000 home with a 20% down payment ($30,000), to be paid over 30 years. For round numbers make the interest rate 5%.

A mortgage payment is made up of four parts which are represented by the acronym PITI: Principle, Interest, Taxes, and Insurance. A realistic cost for the monthly taxes and insurance on a $150,000 home would be $250. So your total PITI or total mortgage payment each month will be $894. If you don’t make a 20% down payment you also have to pay PMI, or Private Mortgage Insurance, of about .5% of the loan value, until you have gained 20% equity. Gaining this equity takes some time because so little of your PITI actually goes toward principle, and therefore equity, the first 5-10 years.

If you pay $894 each month for 30 years and never borrow against your equity, you will pay $321,908 before you own your home. $111,908 of that amount is interest. Taxes and insurance account for $90,000. These figures assume the cost of your taxes and insurance never increase, but they most certainly will.

Will a $150,000 home be worth $321,908 in thirty years? Probably. On the other hand, you spent tens of thousands paying for utilities, taxes, repairs and maintenance, home improvements, yard care, and the like. Spendthrift blogger Ken Rockwell calculated the total cost of his mortgage, interest, taxes, utilities, repairs, association fees, and other related expenses over the seventeen years he owned a condo. When he sold it at four times what he paid in a favorable market, he found his investment averaged to 1% a year.[1]

Counting utility value, owning a condo wasn’t a waste of money for him, but it wasn’t a stellar investment either. Even a basic savings account can offer a better interest rate.

One problem the mortgage myth overlooks is that most people only stay in their homes for five to seven years. Is that a good investment? Let’s crunch the numbers. For the above scenario, you’d pay $53,600 in PITI over 5 years, but you’d only gain $11,000 of equity. And you’d be out $42,600 in interest, taxes, and insurance. Plus you paid about $5,000 in closing costs, and any remodeling, improvements, or incidentals (appliances, lawnmower, broken AC unit) you encountered those five years.

Will the value of your home increase by $42,600 in five years? It certainly isn’t guaranteed, and you’ve spent $60,000 to get there. And people say paying rent is flushing money down the drain?! In my Midwestern town you can rent for less than that. We chose to purchase a home because we wanted one, but with several principles in place:

1. Make a 20% down payment. This is the minimum percent to avoid PMI.
2. Get a 15-year mortgage and pay it off quicker if possible. This dramatically reduces the amount paid in interest, plus debt sucks.
3. Don’t view your house as an investment or asset. Too many people are upside down in their mortgages. If you want to invest, do so in a 401k or IRA.
4. Be hospitable. Whether hosting neighbors, events, overnight guests, or even providing a place for someone in need to live, our home is not just for us.

If you’re considering buying a home, go in with eyes wide open to the hidden costs of home ownership. If you’ve purchased a home, why not work toward paying down your mortgage in order to lower your expenses and increase flexibility? Stay tuned for more ways to free up cash for this purpose.

Has anyone else decided to pay off their mortgage quickly? What are your reasons?

[1] Ken Rockwell. “How to Afford Anything.” http://www.kenrockwell.com/tech/how-to-afford-anything.htm