this does not discuss the rental business) can be summarized with
these three points:
1. If you buy a home at the right time for the right price, because
your home purchase will be a leveraged investment (explained
below), then over a long period of time - over most of the span of your life - the home will rise in value and will turn out to be a very good investment, possibly the best investment in terms of return that you will ever make in your life.
2. Under current tax laws, owning a home offers a tremendous tax advantage that is not enjoyed by renters - in fact a tax advantage that is so huge that it discriminates against renters.
3. If you plan ahead properly, owning your own home can and should be a significant part of retirement planning. Generally speaking, if you live in a home that you have paid for, your cost of living during retirement
years will be a fraction of the cost absorbed by those paying rent.
1. Real estate as an investment
The real estate investment is a leveraged investment because at least 80% of the purchase price (typically) and sometimes more is financed with debt. For example, if the purchase of a home requires a 20% cash downpayment, then a full 80% of the purchased price is financed with borrowed money. The degree of leverage is equal to the inverse of the percentage of the down-payment, or in this example, 1/0.20, which is equal to 5. Here is why. Once the property has been purchased, then all capital gains that arise from an increase in the value of the property accrue to the owner.
Consider an example. Suppose you make a 20% down-payment of $50,000 to purchase a $250,000 home, which implies that you borrowed the remaining $200,000. Suppose five years later the house has risen in value 10% to $275,000. Because you are the owner of the house, all of this capital gain accrues to you - it represents a rise in your net worth. This is called the equity in your home. But even though the rate of price appreciation was only 10% over the five years, the rate of return to your equity investment, which was $50,000, is a full 50%, five times as much. In this example, the degree of leverage is 5, as described above.
Obviously, this leverage works both ways, as was discovered by hapless real estate investors in the terrible
markets of 2004-2006 (and earlier in some cases). Clearly if you buy a house that is overpriced in a heated
market, and you put so little down that your leverage is, say, 10 to 1 or higher rather than 5 to 1 (because the down payment was 10% or less), then a decline in home prices is an open invitation to foreclosure (the formal
loss of the home) and possibly bankruptcy. Remember, the stated condition for treating real estate as a winning investment was to buy a home at the right time at the right price. Given the torrid real estate speculation thatbegan before 2004 and continued to the inevitable bust, millions of new homeowners, many of them chasing the elusive huge gains on leverage, forgot that and paid the price. As such, they have created the market that will enable you to benefit from the long-term historical tendency of real estate prices to rise in the United States.
2. The tax considerations of investing in real estate.
Because homeowners are faithful voters, they have been extended a tax boondoggle for decades that almost by itself makes home ownership worthwhile.
When you buy a home your monthly payment will consist of four components: (1) interest on the mortgage loan, (2) principal reduction on the mortgage loan, (3) property taxes, and (4) property insurance. Of these four
components, two of them, interest on the mortgage loan and property taxes, are deductable from your taxable income for both national and state income taxes.
If you finance your real estate with a conventional 30-year fixed rate mortgage, in the early years of the loan about seven eighths of the payment goes to interest (this is shown later). In other words, for every $800 of your monthly payment, in the early years of the loan, about $700 of it is for interest and only $100 is used for principal reduction.
This implies that about seven eights of your entire mortgage payment is tax deductible! And so is the property tax that you pay to the state if you live in a state, like California, that collects property taxes (not all states do). For example, if you were to buy a home in California and finance it with a 30-year fixed rate mortgage with a balance of $300,000 at an interest rate of 4.5%, your monthly payment for the mortgage alone would equal about $1,520. Of this amount, in your first payment, $1.125 would be paid for interest, leaving only $395 for principal reduction (obviously each month the interest portion goes down slightly such that on the 360th payment it goes to zero and the loan is paid off). On that same house in California you might pay annual property taxes of around $3,000. That will mean at the end of the year you will be able to deduct more than $16,000 from your taxable income for both federal and state income taxes. The final tax savings will depend upon your marginal tax bracket. If for example if your marginal tax bracket is 25%, then your direct tax savings will amount to around $4,000 just because you own a house and don't rent.
From an investment point of view, this subsidy is paying for about 25% of your house. Although your gross
mortgage payment equals $1,520, your net cash payment is only about $1,180! This is why in states like California where property taxes and high income taxes are levied, once you take these tax deductions into account, for any equivalent house (given square footage or comparing one 3-bedroom, 2-bath house with another of similar quality) it is often less expensive to buy a house than to rent a house! To drive this point home, in the Inland Empire of California, where the author lives, at the time this was written there were many, many nice homes that could be purchased for less than $300,000 - much less in some cases.
At the same time there were almost no homes for rent in the same area for less than $1,200 per month.
Even if home values don't rise much in value this advantage alone justifies home purchasing.
Under laws current when this was written it was also possible to deduct interest payments on a second home,
like a vacation cabin, although there is always some discussion about eliminating this additional tax break in the future.
Now and then, especially when flat tax proposals get floated, political pundits suggest that the Congress may finally do away with this favored and frankly unfair tax loophole. Such talk is utter nonsense. No politician
would ever consider alienating such a large and powerful group of voters. The home interest tax deduction will
never be touched.
3. Planning for retirement
Fifteen or thirty years may seem like a long time to have to pay for a home before it is yours. But the last point
made in the section above is that if you don't buy the home, you are going to have to rent one from a landlord, and for possibly for much more money. Because this is true, it is financially healthy to think of your monthly payment as a rent-equivalent. In fact, once you move into your new home, if you financed with a fixed rate mortgage and you stayed in the home, your rent (equivalent) will never rise. I absolutely guarantee that would
not be true of actual rent. You can count on rent rising by at least the inflation rate, and probably more.
Far more important, if you plan right, the rent equivalent will stop around the time you retire. You can live in your home with no mortgage as long as your health will allow and then possibly leave the home to heirs, to give them a grateful head start.
If planning for retirement, there is one golden rule that must be followed and was forgotten by legions of
homeowners caught up in the speculative excess of 2004 to 2006: do not borrow against any equity that
is building up in your home because of price appreciation!
All of the investment advice in this chapter is thrown out the window if you make the huge mistake of succumbing to the temptation to take out a home equity loan just because your house has risen in value.
Of the homeowners who lost their homes through foreclosure after 2007, most bought their homes at the wrong time and at the wrong prices. But there was a second category of victims. Some homeowners bought their homes long before the bubble began to inflate, perhaps even in years before 2000. The initial purchase prices of their homes were still far below the depressed prices of 2007. But many of them borrowed against their rising home equity by using home equity loans (borrowing with a second mortgage or even a third mortgage secured by the house) or refinancing the home entirely with a new loan at a higher principal value. Sometimes these loans were used to finance improvements to the homes (which is actually justified from an investment point of view if done prudently) but also may have provided financing for new cars
or vacations or college educations (possibly justifiable, although this can involve a frankly unfair intergenerational wealth
transfer) or even, worst of all outcomes, to finance speculation in real estate. Regardless of the reason, this had the effect of eliminating the investment value built up in the home.
More important, for millions of Americans, it eliminated the dream of fully owning a home upon retirement, possibly the most important objective discussed to this point.
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