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Studying for a test? Prepare with these 4 lessons on Housing.
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Video transcript
Welcome back. I'm now going to take a slight tangent and cover a topic that, I think, this is probably the single most important video that really anyone can watch. I go to all of these parties where I go see family. And my wife and I right now, we live in Northern California. And we're renting. And I like to point out, by choice. And I have family members, why don't you buy? You're at that stage in life, that's a major milestone, all of this. There's a lot of pressure to buy. And when I tell friends, I tell them I'm not going to buy. Because I think I'm pretty convinced, almost 100% convinced, that housing prices are going to revert back. And I'm going to do a bunch of presentations to justify why they will. But then my friends, they'll just throw out the statement that I hear from them, that you hear from real estate agents, because obviously they want you to buy. Well, isn't buying always better than renting? And I think that kind of common wisdom comes out of the notion of, when you have a mortgage or when you borrow money to live in a house, every month that money that you give to the bank is kind of going into savings. That's the perception. While when you rent, that money's just disappearing into a vacuum. In this video I'm going to work through that assumption, and see if that actually is the case. So let's say I have a choice. Let's say there are two houses. This is house number one. And this is house number two. And let's say that they're identical houses. These are three bedroom, two bath, townhouses some place in Silicon Valley, which is where I live. And I want to live in one of these houses. I'm indifferent as to which house I live in, because they are identical. So living in them is the identical experience. I can rent this house for $3,000 a month. Or I could buy this house for $1 million. And let's say that in my bank account right now, let's say I have $250,000 cash. So let's see what happens in either scenario. Let's see how much money is being burned. So in this scenario what happens? I'm renting. So in a given year, let's just see how much money comes out of my pocket. So in a given year I pay $3,000. $3,000 times 12 months, so I lose $36,000. So I'll put a negative there, because that's what I spend in rent. $36,000 per year in rent. And then of course I have that $250,000. I'm going to put that into the bank, because I have nothing else to do with it. I didn't buy a house with it. And let's say that I can, in the bank, let's say I put it in a CD. And I get 4% on that. So let's see, 250, that's what? $10,000, I think. That's 0.04. Right, I get $10,000 in interest a year on that. So I get $10,000. So plus $10,000 a year in interest. So out of my pocket, for the privilege of living in this house, in Silicon Valley, with beautiful weather, out of my pocket every year goes $26,000. So that's scenario one. So what happens if I give in to the peer pressure of family, and realtors, and the mortgage industry, and I buy this house for $1 million? Well I only have $250,000, which is more, frankly, than most people who buy $1 million houses have. But I have $250,000 cash. So I need to borrow $750,000. So I take out a mortgage for $750,000. And I'm going to do a slight simplification. And maybe in a future presentation, I'll do kind of a more complicated one. In a lot of mortgages, when you pay your monthly payment, most of your monthly payment, at least initially, is the interest on the amount that you're borrowing. And you pay a little bit extra on that, to bring this value down. That's called paying off the principal. You can also take an interest-only loan, but the component of the interest is the same. Essentially, when you take a traditional mortgage, kind of a 30-year fixed, every month you're paying a little bit more than the interest, just to take down the balance. But for the simplicity of this argument, I'm just going to say that we're doing an interest-only mortgage. And then maybe with any extra savings, I can pay down the principal. And that's the same notion. And right now, if I do 25% down, and I'm buying a $1 million house, I'll have to take a $750,000 mortgage. I don't know what a good rate is, 6%? So let's say at 6% interest. So to live in this house, how much am I paying just in interest? Well I'm paying $750,000 times 6% a year. So $750,000 times 0.06 is equal to $45,000 in interest. That's coming out of my pocket. And of course, on a monthly basis, that means in interest per month, I'm paying, just to get an idea. I'm paying about $3,700, $3,800 in interest a month. My mortgage actually might be something like $4,000 a month. So I pay the interest. And then I pay a little bit to chip away at the whole value of the loan. It takes 30 years to chip away at the whole thing. And over time, the interest component becomes less, and the principal becomes more. But for simplicity, this is the interest that I'm paying. $45,000 a year. And then of course at a party, when I start to explain this, it's like, ah-ha. But interest on a mortgage is tax deductible. And what tax deductible means, is that this amount of money that I spend on interest on my mortgage, I can deduct from my taxes. I can tell the IRS that I make $45,000 less than I actually did. So if I'm getting taxed at, let's say 30%, what is the actual cash savings? Well I'll save 30% of this. I'll have to pay $15,000 less in taxes. How does that work? Well, think about it. Let's say I earned $100,000 in a year. And I normally have to pay 30%. So I normally pay $30,000 in taxes. Right? This is, if I didn't have this great tax shelter with this house. Now I have this interest deduction. So now I tell the IRS that I'm actually making $55,000 a year. And let's say my tax rate is still 30%. it actually will probably go down since I'm -- but let's, just for simplicity, assume my tax rate is still $30,000. So now I'm going to pay $16,500 in taxes to the IRS. So how much did I save in taxes? So I saved $13,500 from taxes, from being able to deduct this $45,000 from my income. So let's say tax savings, plus $13,500. Now what else goes into this equation? Do I get any interest on my $250,000? Well, no. I had to use that as part of the down payment on my house. So I'm not getting interest there. But what I do have to do is, I have to pay taxes on my property. In California, out here we have to pay 1.25% in taxes, of the value of the house. So what's 1.25%? So, taxes, this is property tax. And that's actually tax deductible too, so it actually becomes more like 0.75% or 1%. So let's just say 1% just for simplicity. Property taxes. So 1% times $1 million. That equals what? 1% of $1 million is another $10,000 a year in property taxes. And notice, I'm not talking about what percent of my mortgage goes to pay principal. I'm just talking about money that's being burned by owning this house. So what is the net effect? I have a $13,500 tax savings. I have to pay $10,000 -- actually I have to pay a little bit more than that, but we're getting a little bit of income tax savings on the deduction on the property taxes. And then I actually have to pay the $45,000 of interest that just goes out the door. So I'm paying $41,500. Notice, none of this $41,500 is building equity. None of it is getting saved. This is money that is just being burned. So this is a completely comparable value to this $26,000. So in this example -- this example is not that far off from real values. Out here in the Bay area, I can rent a $1 million house for about $3,000. But in this situation I am burning, every year $41,500, where I could just rent the same house for $26,000 out of my pocket, when I adjust for everything. And then people a couple of years ago said, oh, but houses appreciate. And that's what would make it up. But now you know, very recently -- we know that that's not the case. And in the next video, I'll delve into this, and a little bit more. I'll see you soon.