Hidden Burden of Overbuying: Housing Myths Part 6

Previous: Do Not Confuse Houses with Housing: Housing Myths Part 5

Would You Pay $250,000 for a Room?

The Housing Bubble: Historical Growth in Houses Square Feet per Person

4 Reasons People Overbuy Housing--and How To Avoid It

1. Expected Duration of Use: People who borrow, say, a lawnmower are not inclined to scour the city to borrow from the person who has a mower with all the exact, ideal features of the borrower's tastes. However, a decision to purchase often launches people on the slippery slope of pursued perfection to find a mower with the highest horspower and best cup-holder.
2. Timing of Use (Now V. Future): People who make small, instant-total-consumption purchases, such as buying lunch, are likely to buy just enough to do the job. That sizing job gets harder with longer time horizons and increasing risk or uncertainty of how much you will need years in the future. Imagine if you had to buy all your food for the next 30 years today.
3. Uncertainty and Insurance Premium: People tend to pay extra to overbuy as insurance against future unknowns, which is why long-term, fixed interest rates usually are higher than short-term adjustable interest rates over time (overpaying as insurance against future unknowns).
4. Infrequency and Information/Experience Deficit: People also tend to overpay when they do not buy an item frequently and therefore lack cost-benefit knowledge, so they overestimate both their needs and the value of the product, such as the case with choosing a college and buying a college degree.

House purchases are both infrequent and long-term (or at least many buyers treat them as such) and so people are prone to overbuy to compensate against future unknowns. Mission creep adds dens, offices, exercise rooms, decks, and saunas. House size doubles from 1,500 to 3,000 square feet—“just in case.”

Upsizing the house is like buying the $50k camper or boat that you use once every few years. People tend to imagine the temporary time of maximum needed space and then go into decades of debt for infrastructure that is rarely used.

Know Your Life-Cycle Needs

A newlywed couple might go 5 years with no children and even a baby does not require a new bedroom. It is not historically unusual for several children to share 1 bedroom (even boys and girls together). Teenagers tend to need more room but that is why they get drivers licenses and go away to work or college. Long life spans indicate decades of life as “empty nesters.” So, people tend to overbuy the largest purchase of their lifetime based on a brief 5-10 years of peak usage.

The Marginal Cost of an Extra Bedroom

The price difference between 1 house and another house with an extra bedroom might be $50-100k, which costs $100-250k for that 1 room after today's typical finance charges of a 30-year mortgage to pay for it (ballpark figures). If you only truly need the room for 10 years, you are paying maybe $10-25k per needed year for that 1 room (not counting the luxury use of the spare room before and after the peak).

Basic finance rules say that it might make sense to buy what you need daily for 50 years but to rent what you need briefly and occasionally. Another option is the pay-as-you-go method to add-on to a house as needed. Buying and selling houses is problematic both because of the high transaction costs and because of government regulations about public-school districts which can prevent families' smart housing choices.

Do Not Buy Too Early

Why borrow and pay interest for extra space over a decade before you need it? Why not save for over a decade and then pay cash for extra space exactly when the need arises? Do you borrow to finance an extra car when your baby is born because the baby will be driving age 16 years later?

The best financial choice is the opposite of what most people do.

The best financial choice for a lifetime house purchase would be a smaller house geared to the minimum points in the lifecycle (because you will have smaller needs many more years than you will have larger needs), with temporary conversions within the original house dimensions (no additions) to accommodate temporary needs for “increased” space. The Brady Bunch’s Greg Brady made an attic room for himself and today’s smaller families average only about 3 persons each (either 1 child or 1 parent) so that fleeting teenage bubble of demand for space will not require much change.

If you want to live in the “perfect”-size home at each stage in your lifecycle, renting might be the best choice for many of the years.

Your Choice Makes a Big Difference:

How much health insurance could you buy by not spending an extra quarter-million dollars for 1 extra room?

Next: Home Mortgage Tax Deduction Snake Oil: Housing Myths Part 7

Personal Finance Carnival 118 Features Home Finance Freedom's "Do Not Confuse Houses with Housing: Housing Myths Part 5"

Home Finance Freedom's "Do Not Confuse Houses with Housing: Housing Myths Part 5" was featured by the 118th Carnival of Personal Finance at Money, Matter, and More Musings in a "Fun Money Facts" edition, along with a number of good articles from fellow PF bloggers. Thank you.

Personal Finance Carnival 117 Features Home Finance Freedom's "Ignore Average Annual Return Rates: Geometric Mean V. Arithmetic Mean"

Home Finance Freedom's "Ignore Average Annual Return Rates: Geometric Mean V. Arithmetic Mean" was featured by the 117th Carnival of Personal Finance at Kmull, along with a number of good articles from fellow PF bloggers. Thank you.

Bernanke's Zimbabwe Plan for the US Economy

Fed Raids Your Paycheck and Bank Account To Bailout Banks, Wall Steet, and Mortgage Delinquents

Ben Bernanke Music Video

Here is a Columbia Business School (CBS) spoof of Ben Bernanke's appointment as Chairman of the United States Federal Reserve, based on "Every Breath You Take" from The Police Synchronicity Album:

See more Fed spoofs:
Canada Forces US Federal Reserve To Raise Interest Rates?
Alan Greenspan: Fun with Financial Armageddon and Famous Movies

Canada Forces US Federal Reserve To Raise Interest Rates?

Here is a Saturday Night Live (SNL) Golords spoof of foreign frustration with "Easy Al" Greenspan's loose US monetary policy in 1998:

(Warning: violence and sexual content)

Except for a 25 basis points (bps) hike on March 25, 1997, the Fed only held or lowered the Fed-funds benchmark interest rate for over 4 years after Februart 1, 1995 and until June 30, 1999 while the stock market bubbled. The Fed dropped 75bps in September-October-November 1998 to 4.75% (deja vu now?).

See more Fed spoofs:
Ben Bernanke Music Video
Alan Greenspan: Fun with Financial Armageddon and Famous Movies

Alan Greenspan: Fun with Financial Armageddon and Famous Movies

Which movie best explains Alan Greenspan's tenure as Chairman of the United States Federal Reserve?

Comment on these and post your own choices.

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Dr. Greenspan: Or How I Learned To Stop Worrying and Love the Bubble

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Greenspan: The Man with the Golden ARM

(ARM=Adjustable Rate Mortgage)

See more Fed spoofs:
Canada Forces US Federal Reserve To Raise Interest Rates?
Ben Bernanke Music Video
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Do Not Confuse Houses with Housing: Housing Myths Part 5

Why Housing Is NOT an Investment
Why Home Mortgages are BAD Debts

Previous: Homeowner Profits Ignore Huge Costs: Housing Myths Part 4

“You Have To Live Somewhere” and Getting Rich by Eating Twinkies

Some people try to close their eyes to the bad investment of a home mortgage by asserting that the bulk of the borrowing costs “don’t really count.”

The common “You have to live somewhere” argument confuses opportunity costs/benefits and confuses houses (durable goods) with housing (the use of the durable goods).

(UPDATE: Economists recognize the distinction between house (asset) and housing (consumption) by referring to housing as a "shelter" "service"--although government's misuse of this valid distinction in its statistics and policies is another matter; see the Bureau of Labor Statistics (BLS) Consumer Price Index's (CPI) Owner's Equivalent Rent (OER) controversy.)

Rental Opportunity Costs/Benefits Negate Each Other

If the house was an income-generating investment, you could offset your borrowing cost with rental income. Living there yourself instead of renting to others (“renting to yourself”) means that you save writing a rent check to a landlord only by foregoing the receipt of a rent from a potential tenant of your own.

Imagine if you rented a house from someone but you bought an identical house next door and collected rent from your new house next door; the rents would cancel each other and net zero (paying rent to a landlord, collecting rent from a tenant). Owning and occupying a single house has the same result, net zero (not paying rent, not collecting rent). Therefore, the entire cost of the house including purchase/interest/maintenace/etc. is still an extra cost and not defrayed by anything. In other words, your savings are “not paying rent” but your costs are “not collecting rent” so you have not avoided one cent of the additional cost of house price and mortgage interest and insurance and maintenance and taxes.

Housing Is Consumption, Not Investment

You do have to live somewhere. That is exactly why housing is consumption, not investment. Do not confuse the house with housing; housing is the use of the house (shelter service). Housing is the consumption of time in a place (the house). When you "rent to yourself," instead of selling the consumption to a renter, you are consuming your own inventory.

No Such Thing as a Free Lunch: You Cannot Have Your Cake and Eat It Too

“Renting to yourself” means that housing is consumption (not investment) because time is money and the value of living in your house yesterday is gone with yesterday, not saved for tomorrow. Further, only one person can use a particular space at any one time and even renting one of your house's rooms to someone or other "shared space" is a reduction in your own consumption of housing, a reduction in your use of your own house (zero-sum game). Do not double-count.

Get Rich by Eating Twinkies?

You constantly consume housing like you constantly consume food.

Buy and eat a Hostess cake without trying to claim that paying to eat the cake is making you wealthy. Likewise, pay to consume housing (time in space) without trying to claim that paying to sleep in a room is making you wealthy.

Borrowing for Consumption Is Bad Debt

A typical rule of thumb is that so-called “good debt” (actually, less bad) increases productivity or generates income more than it costs (e.g. a tractor increases crop yield). “Bad debt” is everything else. Most people would see danger in taking loans to pay rent yet borrowing for instantly-consumed housing via a mortgage is essentially the same type of debt.

A 30-year mortgage is (in principle) no better than taking a 30-year loan to borrow 3 decades of rent in advance.

Think about that. In the first year of a 30-year rent loan, you could invest 29 years of rent in the stock market (a stock asset instead of a real estate asset).

(In practice, the securitzed mortgage and tax subsidies make a mortgage loan cheaper than a rent loan, but the principle is the same.)

The marginal asset value of a house, over and above the consumption cost of housing, is a separate factor that you can treat as a distinct investment.

You can try to use the historically minimal real appreciation of real estate as an investment but the appreciation is often small potatoes compared to the consumption cost/value of the house-for-housing--and the appreciation often is largely cancelled by costs (taxes, insurance, inflation, and especially borrowing costs if leveraged).

Satisfy your housing consumption and then choose the best investment for your surplus money (real estate? stocks?).

Before you borrow a quarter-million or half-million dollars, know if you are borrowing for investment or consumption.

Next: Hidden Burden of Overbuying: Housing Myths Part 6

Greenspan Needs YOU to Bail HIM Out?

Brother, Can You Spare a Trillion?

Greenspan Needs YOU to Bail HIM Out?

Personal Finance Carnival 116 Features Home Finance Freedom's "Simplify Your Bills and Life: Streamline Paperwork"

Home Finance Freedom's "Simplify Your Bills and Life: Streamline Paperwork" was featured by the 116th Carnival of Personal Finance at Advanced Personal Finance in an NSA edition, along with a number of good articles from fellow PF bloggers. Thank you.

Ignore Average Annual Return Rates: Geometric Mean V. Arithmetic Mean

Previous: Vanguard 500 VFINX Loses 20% of Your Money from 8 Years Ago

Protect yourself from slick marketing: This article explains the importance of the geometric mean and how to calculate it to read and report returns on investment (ROI) accurately.

Misleading "Average Annual Returns"

The average annual rate of return tends to overestimate your gains because it is an arithmetic mean (an average based on additive units) which is inappropriate for multiplicative products such as compounded interest.

Using the arithmetic "average annual rate of return" for stock performance is like trying to describe how tall you have grown in ounces or asking, "How many inches do you weigh?"

Simple hypothetical of a $100 lump-sum buy-and-hold:

Year - Investment - Return
0 ............ $100 ......... -
1 .............. $50 ...... (50%)
2 ............ $100 ...... 100%

• Average annual rate of return: (100 + (-50))/2 = 25%

You started with $100 and you ended with $100 but your $0 gain shows +25% average annual return.

Of course, you actually have 0% gain on your initial value after 2 years.

Use the Geometric Mean Instead

Ignore the arithmetic mean (average annual rate of return) and instead calculate the more helpful geometric mean (annualized rate) to find the factor that, if repeated, would result in your current/desired balance; for n years, the nth-root of the products of the rates-expressed-as-positive-growth-factors. For our example above that halved (*0.50) and then doubled (*2.00) in 2 years:

• The square-root of (0.50 * 2.00) = a factor of 1.00

So $100 * 1.00 = $100. The factor of 1.00 is equivalent to 0% interest, since you can multiply by 1 forever and still have the same number with which you started (in our example, 0% per year for 2 years). A factor of 1.12 would equal 12% growth (per time period). Note that 3 years would require the cubed-root, etc.

A shortcut is the nth-root of the last-year's-balance-divided-by-the-first-year's-balance. For our example:

• The square-root of (100/100) = a factor of 1.00

The shortcut shows that you can ignore all the "paper profits" ups and downs (unrealized gains and losses) of your stocks or home equity and concentrate on the end points of initial investment v. final cash-out (assuming no intervening hard cash inputs/withdrawals). The geometric mean simulates a consistent year-after-year interest rate so you can compare a volatile stock to something with steady progress such as a 5-year Certificate of Deposit (CD).

Use Geometric Standard Deviation

Ignore arithmetic standard deviation and use geometric standard deviation. That calculation is a bit more complicated (involving logs) but at least know how to read it. Unlike the arithmetic version which is reported as a quantity (e.g. 5% mean with standard deviation of 3% indicates a range of 2-8%), geometric standard deviation is reported as a factor (e.g. 1.05 mean with standard deviation of 1.03 indicates a range of 1.02-1.08, and the nth standard deviation is the nth power of the geometric standard deviation).

Always use the right tool for the job and do not let Wall Street or Madison Avenue tell you otherwise.

Geometric Mean Calculator for Annualized Returns on Investment (ROI)