“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.
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:
- Make a 20% down payment. This is the minimum percent to avoid PMI.
- Get a 15-year mortgage and pay it off quicker if possible. This dramatically reduces the amount paid in interest, plus debt sucks.
- 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.
- 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?
 Ken Rockwell. “How to Afford Anything.” http://www.kenrockwell.com/tech/how-to-afford-anything.htm
19 Responses to “Mortgage Myths”
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Thank you for making me understand the facts about mortgage. I think a real state is a good investment. But, it depends on how you can manage the mortgage.
Totally agree with your four principles. Real estate should only be looked at as an investment for a very select group of people! Keep the posts coming!
Good point, there are times when real estate can be a good investment, such as rental properties. Unfortunately this is not automatically true for the typical home owner.
I was given a gem of a statement by my mortgage lender. She said “There is no free lunch. Any changes are paid for somewhere else in the loan.” A good approach to buying a home is to save up as much cash as you can.
Love this! I’m a little annoyed when people talk about how much their house has gone up in value, because they aren’t considering the costs you describe. I actually bought a house for cash after living below my means for more than 15 years to save up. Everything I’ve read says don’t do that, get a mortgage (a “death pledge”, you call it elsewhere — perfect!), but that didn’t make sense to me. I’m not looking at the house as an investment, just a place to live for hopefully a very long time.
That’s awesome that you saved up to purchase a house in cash! We didn’t wait long enough to do that, but are counting down the days till our death pledge is gone.
(replacing the previous comment which somehow got posted before I finished)
I got lucky and for my first place I got in just before prices doubled in my area, which left me a nice nest egg to put down as my 20% (though PMI isn’t a concern since I am VA Loan eligible), basically I put down 10k, lived there for 2 years and left with 90k.
One advantage of mortgages over renting is that the A) the principal payment is increasing your overall share of the asset (so while it is a poor return on investment, it is still giving you something tangible) and B) interest (and taxes) deductibility on your taxes (for me that is 30.7% of that amount, state and local. Obviously it varies based on your marginal tax bracket). So I multiply the sum of the interest plus taxes by the marginal tax rate to get net savings (this is complicated later since this assumes that you are not taking the standard deduction and itemizing), add that to your principal amount and subtract that from your total payment (I call that my net cost).
That doesn’t take into account maintenance (or HOA fees….) but overall I know that in my situation I wouldn’t be able to find anyplace for my family near the net cost. Of course everyones calculations are different.
I’m glad you experienced such a return on your first home’s sale. That is great! I think the problem is when people are count on that type of situation, which isn’t really typical in many markets. But it’s awesome when it happens!