Friday, October 19, 2007

Homeownership Cost Cliches: Housing Myths Part 10

Previous: House Depreciation-Maintenance: Housing Myths Part 9

Housing Clichés Can Cost You Dearly

The last article mentioned that counting just 2 factors (inflation and maintenance/repairs) can cancel any supposed real-estate “investment” appreciation but there are many more costs that can turn home ownership into a loss: mortgage interest, taxes/insurance/fees, and opportunity costs of missed investments.

Your mortgage costs DO increase every year and these increases disprove the "payments never go up," "payback with cheaper money," and "good debt" cliches.

“Your rent goes up but my mortgage payment does not” is just another way of saying that the "fixed" mortgage payment starts too high, in real (inflation-adjusted) terms (plus, rents DO NOT always go up). The mortgage-holder tends to assume that the first mortgage payment is the “just right” size and everything later is discounted (by inflation) but rarely considers that the last payment might be the “just right” size and everything earlier is at a penalty rate.

“I get to pay back my mortgage later in cheaper money” is another common cliché that undermines the first cliche: If postponing repayment is so lucrative, then you would want to pay little at first and more later, so mortgage payments that do not increase over time would be bad. The “cheaper money” slogan argues for the ultimate balloon-payment plan of paying $0 for 29 years and paying everything (several times the purchase price) in the last year.

Both of these common quotes misread the mortgage situation:

All mortgages have annual cost increases built-in but people overlook the increases by looking at the nominal payment rather than the accrued cost. If your mortgage rate is 5%, each year your new, extra cost is an additional 5% of the year’s debt. The mistaken belief of no payment increases is an illusion simply because the bank has pre-calculated your 30 years of cost increases and front-loaded your money-up-in-smoke interest costs.

You are repaying your mortgage with more expensive money (not cheaper money) because the interest rate is almost certain to increase the debt cost at a rate faster than the official inflation rate. The repayment would be "cheaper" only if the mortgage had no interest rate (or one less than inflation), but I have not seen any mortgages like that, so I think the banks have figured out that loophole. Unless you find a bank that is so stupid that it lends for less than its costs decade after decade, you are losing more money each year that you keep a mortgage.

A $225k 5% fixed-rate mortgage is about the same as taking 30 years to pay off a $225k 5% credit card debt. Debt is debt. Compound interest compounds.

Pre-paying principal is so powerful at lowering your costs because it reduces the compound-interest increases.

The only escape from annual mortgage-cost increases is to end the mortgage.

Non-debt home-ownership costs increase too and these costs disprove the "but eventually I'll have free housing" cliche.

Owning has many costs such as taxes and insurance that can increase faster than the inflation rate and faster than rent increases. Experiences vary from person to person but consider these real-life examples: One person rented for 7 years without a penny increase in rent while another person during the same period bought a house and saw property taxes skyrocket 50% in 5 years. Even with no mortgage, a homeowner’s costs can increase faster than a renter’s costs.

Opportunity costs of missed investments disprove the "renters end up with nothing," "at least I have home equity," and "mortgages are forced savings" cliches.

Neither borrowing 100% nor paying 100% cash to buy a house necessarily beats renting:

Borrowing $225k at 5% costs $11,250 in interest in the first year ($937.50/mo), not counting loan origination “points,” closing costs, taxes, repairs, and other fees/costs--none of which creates a penny of equity.

Anyone who likes to pay principal on top of the consumption costs can just as well save/invest on top of paying rent, so "owning" and renting offer similar equity opportunities.

Building equity depends primarily on the individual. Spendthrifts can find a way to stay in debt whether they rent or "own."

0% downpayments, interest-only loans, HELOCs, reverse mortgages, and other house-as-ATM "equity harvesting" all prove that home-"owning" is no guarantee of "forced" savings. An automatic payroll deduction into a money-market account might be a cheaper "forced" savings plan. A renter's security deposit has more equity than some no-money-down homebuyers do.

Renters might beat homeowners in the equity-building race because renters are more likely to have lower early payments and therefore benefit from the renown compounding magic of saving early (contrary to "mortgage payments do not increase" and its backward logic of high costs/low equity-building now and low costs/high equity-building late in the game).

Paying $225k cash for a house will avoid paying interest but then you have nearly a quarter-million dollars tied up in an illiquid asset that might appreciate nominally at 5% but can have zero or negative real “appreciation” after all input/carrying costs are considered.

You instead could invest the $225k cash in stock or other investments to earn net 5% ($937.50/mo) and keep your $225k stock equity while the interest/dividends/appreciation income pays your rent, maybe in perpetuity (depending upon exact rent, inflation, etc.).

The Good Cliche: There Is No Such Thing as a Free Lunch in Housing

Housing is consumption when you own as well as when you rent so do not be surprised by the possibility that homeowner’s net costs might be similar to renter’s net costs.

More Misleading Housing Cliches (Parts 1-9, in reverse order):
"Renting doesn't build equity like my house payments do!"
"I'm debt-free! . . . with a $500,000 mortgage."
"My mortgage rate is really 1/3 less and I want to get as big a tax deduction as possible!"
"Buy as much house as you can afford!"
"My mortgage is free because I'm renting to myself!"
"My mortgage doesn't count as an expense because you have to live somewhere!"
"I really increased my ROI by leveraging as much as possible with no-money-down!"
"Never prepay your mortgage!"
"I borrow against my house to invest in the stock market!"

Next: Home Decorating Costs: Housing Myths Part 11

2 comments:

allen said...

I found many parts of this article to be inflamatory and highly suspect, to say the least. You suggest that rent almost never increases: I have yet to see it not; & even if it stayed at the SAME LEVEL, that would still be worse then ownership.

Example: House A costs $600 a month in mortage + taxes. Rent B costs the same. over ten years, the renter in Rent B will have paid the owner $72,000 dollars. This meanns that the owner in House A could "loose" that much and still be equal. As long as the owner didn't go into a stupid ballon payment, or adjustable rate, when was the last time you heard of the average home loosing that much in ten years?

I've said it before: Renting is a suckers game [99% of the time].

J at IHB and HFF said...

Allen,

Hello. Most of House A’s $72k is gone like rent (interest, taxes) and House A has additional costs (extra insurance, maintenance, etc.) that can wipe out the rest while Rent B often starts the day after moving in with much more cash in the bank (the security deposit being a small fraction of a traditional downpayment) and can add investments equal to the small amount of House A’s mortgage principal (starting about $25 per week).

I suggested that rents usually increase but so do homeowner costs, so I ended with the modest point that neither choice is an automatic slam-dunk over the other. Thank you.