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Current time:0:00Total duration:15:17

Video transcript

welcome so I've done this series of presentations about housing and and at least my thesis on why housing prices might have gone up and and how you should maybe on simple terms think about the rent versus buy decision but one thing that's happened a lot of people said Oh Sal you're making over simplifying assumptions you're assuming interest only loans you're not taking you're not factoring in the tax deductions of mortgages etc of interest on your mortgage which I did but I did make some simplifying assumptions so that we could kind of do back of the envelope math and just think about what the main drivers are when you think about renting versus buying but it is fair you really you know that's just kind of a first cut you really should do a multi-line model trying to figure out what could happen to you and then tweak your assumptions and really figure out what's going to happen to you if housing appreciates depreciates if interest rates change if you put a 10% down or 20% down or whatever so with that in mind I've constructed this model what I call that this is the home purchase model and you can download it yourself and play with it I think this will prove to be useful for you you can download it at khanacademy.org downloads slash buy rent XLS it's an excel spreadsheet so if you have excel you should be able to access it and maybe you want to follow along while you watch this video so just kha an academy org I know if you can read this on YouTube downloads do W NL o ad s slash buy rent dot XLS so once you download it let me explain what what I assumed in the model so the yellow what I did in yellow both this bright yellow and this less bright yellow these are our assumptions these are the things that are going to drive the model and tell us whether over and I calculated over 10 years over 10 years whether we will do better of renting versus buying so here and and and so if you download this model and want to play with it yourself just unless you are fairly sophisticated with Excel all the only things you should change are the things in yellow everything else is calculated and and it's driven by these inputs so of course what matters in a home well the purchase price matters right so you just input it there the down payment matters you could if you want you can just write you know like I wrote 20% of whatever the purchase price is so you can you know you could write your the exact number or you could just leave it the way I did it in whatever the down payment percentage is it'll calculate it this is the interest rate you assume this is the principal amortization so principal amortization just means well if I just keep paying this mortgage after how long is the entire principle amount not just the interest how long is the entire principal amount going to be paid off in so essentially thirty-year a 30-year fixed-rate loan has a 30-year principal amortization if you have a 10-year loan you would put 10-year this is the property tax rate this is what I assumed because I live in California and in most areas of California this that's the property tax this is why I assumed about annual maintenance that's just an assumption at some houses might be less might be more that's up for you to decide this is housing association dues maybe if you live in a community that has a shared golf course or a shared pool or something put it at zero if you don't this is annual insurance for things like hazard insurance and flood insurance or earthquake insurance or whatever insurance you need where you live and then this bright yellow I say what is the assumed annual appreciation of the house itself and this is a huge assumption that's why I made it that's why I put it into this bold this bold yellow color because we'll see later in this video that to some degree to some degree that assumption is is one of the biggest drivers of assumption or you could say that the model is very very very sensitive to that assumption here this is your assumed marginal income tax rate and why does that matter well because you can deduct your the interest that you spend on your on your mortgage and also you can deduct actually the property tax so if if you can deduct a hundred dollars in interest and property tax if your marginal tax rate is thirty percent so that means you know at what rate are you being taxed on every incremental dollar if it's thirty percent that that means a hundred dollar deduction will save you 30 dollars if your marginal tax rate is twenty percent one hundred dollar deduction will save you $20 so that's where that comes into play the two percent that's general inflation and this what what this assumption drives is well there's going to be some inflation on things like Housing Association dues annual maintenance insurance and so this what you assume about what is just the general rate of inflation in our model that's actually going to drive how these grow over the life of your loan and then once you type in all of these things the monthly mortgage payment is calculated I assumed that the interest compounds once a month you can if you know your geometric series you can go in there and you can tweak it around so it compounds more frequently or less frequently but my understanding is that most mortgages compound monthly and then this right here so this is everything that's driving the buying a home decision now these assumptions are are so that we can make a comparison to well what if instead of you know using that down payment to buy a house what if we actually just save that downpayment put in the bank and rent a house instead so this is cost of renting a similar home this is the annual rental price inflation and I would argue to some degree that rental price inflation over the long term should not be that different than housing price inflation because to some degree rental is kind of the earnings on a home and if and if earnings increase and the overall asset doesn't increase in your return increases or the other way around your return would decrease but anyway don't get too complicated and then this is the 6% I just assumed at 6% but you could you can change it this is what you assume that you can get on your cash so if I don't if I don't put $150,000 down deposit on the home and I put it in you know I don't know maybe I'm a good investor I could put in the stock market maybe I can get 20% a year or maybe I'm really risk-averse and I you know I put it in in government bonds and I get 4% a year so this is the assumption that you get it on on that and it actually should be an after-tax return on that cash so if I if my tax rate is 30% and I think I can get 10% of the stock market I should actually put a 7% here so you know we want to make sure that we're come lately accurate for taxes so now let me explain the rest of the model to you and I want to make sure that I can fit it all within this this window actually let me just squeeze this a little bit this is doing this on YouTube is a excel on YouTube is a new thing for me that's not what I wanted to do so let me unfreeze window unfreeze ok so now I could show you the rest of my so all those assumptions that we did that drives this model let me freeze the window right here window freeze pane okay that should make things a little bit easier so this is the butt up buying scenario up to line 40 this says okay at period 0 what is the home value and and don't type in anything here it's all automatically calculated so it period is 0 what is your home value and then it and then it uses essentially the appreciation numbers and each period is essentially a month and I actually wrote that down here and then it figures out what is the value of your the market value of your home and it's completely driven by the depreciation number this right here is the debt or essentially the principle payment on your on your mortgage or how much do you owe to the bank and as you see as months go by when you pay the mortgage note and I show that right here this mortgage payment some amount of that which is line 33 the principal paid some of that goes to decrease the amount you owe and then a lot of it especially initially goes to be actually the interest on the amount you owe and then obviously when we if you've watched the the video on introduction to balance sheets your equity in the home is the value of the home minus the debt or minus what you owe the bank so this actually calculates your equity or essentially your some one way to view this actually say well what what am i worth or what is this investment worth to me at that point and all of this so these are kind of the important numbers in the home buying scenario is driven by you know this interest on debt it's calculated by what interest rate you assume times the debt you owe in the period before the mortgage payment we calculated that before using our medical knowledge of geometric series the paid principle that's going to be the mortgage payment - your interest insurance payment it's on a monthly basis right so we essentially took whatever our our annual insurance payment was and we divided by 12 but then we grow it by the rate of inflation on a monthly basis so we took the inflation rate divided by 12 and we multiplied by each of these months the housing Association dues that's once again this is on a monthly basis so we just took your assumption divided by 12 maintenance same thing property tax same thing although I assume that your house gets reassessed so you're in a state where every year the the Assessor or every several years the Assessor comes at Oh your house is worth more now so I'm going to raise your taxes that's not the case in a lot of parts of California but it's a lot it's the case in in many parts of the US so actually to some degree this product the dollar value of the property tax is driven by this home value assumption up here this income tax saving from interest deduction this is assuming that at that marginal tax rate you can deduct the property tax and the interest on the debt and then this is the total cash outflow after adding back the income tax saving so this is essentially how much cash goes out the door even after the tax saving every month in the buying scenario that's what that is so hopefully that makes a little bit of sense so what we want to do is we want to figure out okay you could do that you could buy the house put hundred fifty thousand dollars down and every month put this much out in and as you as you see that that number grows the mortgage is the same but a lot of these expenses grow with inflation but I want to compare that to what happens if I take that exact amount of cash after adjusting for how much money I get back from taxes and if I said well I am going to use that cash to pay my rent and any other expenses associated with renting which really aren't much to pay my rent and then put the rest in the bank so what we're saying is well that assumption was that you could rent a similar house for $2,500 maybe right maybe wrong it's up for you to play with and and of course it grows with inflation slowly obviously your rent doesn't increase every month but I assume it does fairly continuously it's it's a reasonable assumption I think although you could change it you can make it only step up every every year excuse me and then this line down here tells us the savings while renting or how much and I'm not saying the savings like from like you know something's on sale so I save money but your savings in terms of how much you have in the bank so if you rent it instead of putting one hundred fifty thousand dollars as a downpayment you could have put it in the bank so that would be your savings account at period zero and then your savings account at period one would be this amount of money and how about whatever return you got it plus the difference between your cash out from buying a home and your rent so this is your savings so what I do in the video in the indy in this model and I could show you I could scroll through multiple periods you know this this model goes it actually goes as far as Excel would let me but the average house if anyone who's traded mortgage bonds will tell you the average house has a the average mortgage loan has a ten-year expected life and because that's when on average people tend to move or refinance so I what I do is I figure out well given your assumptions and whatever you can make your own assumptions given your assumptions what is your home value so let me make sure I can get to that so given your assumptions what this calculates is what tells you what the home value is after ten years your debt after 10 years your home equity after 10 years and then it assumes you were to sell your house because that's what the average American does after 10 years and so what is the transaction cost you pay 6% to a broker hopefully that won't be the case in 10 years and the intermediate and then the and the internet will disintermediate real estate brokers but who knows I apologize too if you are a broker and and and and then this line line 54 that tells you what the net cash is if you sell your house at a market price you pay the broker this number right here is much simpler to some degree it just tells you well let's say you decided not to buy the house given all your assumptions how much would you have saved in the bank at that time and so this number right here this number is the difference between those two numbers in 10 years discounted back to today discounted back to today and actually I meant to present value it but did I present value these numbers oh no I didn't so actually this was meant to be the presently I'm going to correct that before you actually play with the model right now I just took the ten-year value so this is the value in year 10 this is the difference between the two the present value would be if you discount this by some discount rate whatever you think probably the inflation rate and it would tell you in today's money what is the benefit or the advantage of buying versus renting anyway I've spent 14 minutes of your time I encourage you to to download this model play with it and then work out the assumptions because I think that's that's the important thing you know some people they'll make some set of assumptions say aha I need I need I should rent or they'll say aha I should buy but they don't realize that they made some assumptions that although it looks really reasonable you know like let's say I make this 3% annual appreciation assumption right that doesn't seem crazy but it's amazing how much it'll change the model if you make that 3% into a 1% or if you make it you know into I don't know even a negative 1 or negative 2% it's completely possible it's happened before in the past that you have flat real estate prices for a significant period of time even ten years and actually most of the studies show that real estate over the last hundred years has actually roughly grown on real terms maybe one or two percent so actually a one or two percent here isn't that isn't that conservative and actually especially after a big real estate boom may be prudent so play with these assumptions and I think it'll give you an intuition of what are the what are the real drivers and another big thing you know sometimes you don't rent a similar home you'd rent a smaller home so that would be different type of savings and their trade-offs there but anyway hopefully you'll find this model useful I think I think you know it should be when people this is the biggest investment of their life they should do serious analysis when they think about how they want to approach it and I'd like to think that this is fairly serious analysis is about as serious as you can get so enjoy see in the next video