Housing illusions

MillionDollarJourney had a post about Cash Back Mortgages.

Instead of the usual comment, I've devolved into one my blog replies, original comments included.

@Nolan: However it does not change the fact that if you buy a house to live in it, and the payments are reasonable for your income, then you are better off owning than renting in the long run.

This has been hashed and re-hashed on this forum and elsewhere. The data in no way supports your thesis and I would urge not to spread such dangerous information.

At best, owning a home is a lifestyle decision with a set of associated risks. We can argue this elsewhere, but there are a dozen guys who've run the spreadsheets. You've successfully listed a few of the risks:
... the ones who can’t afford their payments, speculators (like you said), and the ones who panic and sell when housing prices fall.
but there are more:

• Risk - People with jobs that are heavily dependent on some local resource (mill-towns, mining towns, etc). This is actually doubly risky, b/c if you're losing your job it's likely that nobody else is moving in which means that your housing "investment" won't be doing well at the very time you need to sell.
• Risk - People working in highly transient / mobile fields. If you're in IT and changing jobs every 3-5 years (quite common), being tied to a location can be quite costly. If you're an athlete, a long-haul trucker, etc. similar logic would apply.
• Risk - purchasing a high-maintenance house. Even if you can "reasonably afford the payments", you still need to afford the maintenance. A 20k basement repair on a 120k house is a realistic risk and would definitely wreck your financial plans.
• Risk - property tax increases. As independent homeowners you're still on the hook for these taxes, Yes there are processes, but it takes personal time (read "money") and you don't necessarily have a lobbyist group on your side.
• Risk - school district changes: This is primarily in the US where people pay premium home prices for "top-rated" school districts. A certain % of value is actually tied to the continued school district prosperity. Buying a house for your 5-year old could be a liability by the time they're 18 and it's time to "downsize".
• Risk - Energy Costs: once you buy a place you're locked in to paying the energy required to keep that place running. If your rental place sucks up too much energy (due to size or just poor maintenance), you can move at the end of the lease or request changes (you're income, you have a good bargaining chip). If your own home leaks heat (or cold), you're on the hook for this cost. I don't know if you've noticed, but energy costs are going up almost universally. Right now, 50% of the earth's population is using about 4% of the world's energy, and we still haven't figured out that whole "cold fusion" thing. That's a lot of pressure for energy costs to continue to rise.
• Risk - Politics: don't like that new factory that's being built just around the corner? Think it will influence your house price? Well, the ball's in your court now, b/c it won't be easy to move, especially with that factory weighing down on your home value. (also, see property taxes)

I want to echo one of Jordan's comments here: ...ignorant customers just desperate to get in before they’re “priced out forever” or other such non-sense.

If you are making above-average income you will not be "priced-out forever". The rules of supply & demand still apply. Either house prices will deflate drastically or the salary prices will rise to match the growing cost of living. House prices do tend to be stubborn, but since 1990 we've since house prices grow well beyond the rate of inflation, with people re-investing the money from their first place into the second (and third and so on). Barring government interference they're going to dip like every other investment.

Personal aside: I expect this dip to happen when the average baby boomer retires and "downsizes". But it may be happening sooner, check out this blog on Edmonton housing market (with lots of pretty charts). Notice the Supply vs. Demand and the Price and Inventory Comparisons?

If you want a home and can't afford one, just keep saving your ducats and investing elsewhere. Especially the 20-somethings and 30-somethings with "good jobs" (i.e. average or above-average income).

Did I miss any home-owner risks?
There are definitely some renters risks, but that's a different post.

Consumer confidence vs House Prices

I for one believe that most housing in the US is way over-priced. I'm currently living in KC and I'm seeing some "reasonable" prices. But I think it's worth noting that I'm making twice the median income and I can't see buying anything out here.

That's right, my wife doesn't work, so together, we make the median income for a two-person family and the cost of owning our own place is prohibitive. Of course, house prices are dropping, which makes me feel great, maybe I'll be able to afford one soon, but it looks like people aren't. I just found this graph on swivel (which is a pretty cool site BTW).



Of course, in the grand world of causation vs correlation, I'm going to chalk up the drop in confidence to more factors than just dropping house prices. If anything, it's likely the economy in general mixed with a healthy dose of "back-to-reality". For great helping of "back-to-reality", check out this post on MDJ:

California couple, family of 8, 100k / year:

• No medical insurance for the themselves OR the kids.
• $135,000 in credit card debt.
• Two mortgages totaling $658,000.
• Large mortgage with payments of $1800/month, but payments will increase to $3300/month in a few months.
• They have 3 cars, 2 of which are leased, the other one they own. The cost is $1700/month.
• Wife spends $300-$400/month at Starbucks (It was the wifes morning routine).
• $60/week on tanning and manicures
• $4k on hair extensions in the past 2 years.
• Constantly shopping.
• The wife would regularly buy brand new clothes for the kids, then have a garage sale a month later to sell the “used” items at pennies to the dollar. (This one blew me away)

Scary stuff.

Maybe it's time to practice "positive cash-flow techniques". Of course, YMMV.

Paying down the mortgage early?

OK, there have been a couple of posts on the blogs that I read discussing the benefits of an early mortgage paydown vs. an alternate investment.

And me, well I'm kind of a chump, so I ran the numbers quickly. For reference, this is a 200k fixed mortgage at 6% over 25 years. Here's what the monthly breakdown looks like for the standard mortgage. That Purple Stuff is the money the bank is taking for interest which, as you may know, is mostly taken first. And the Light Tan stuff is what you're actually paying down. For the last two, I've taken an equal size payment (~$4600), off the principal at different points in time. So that Blue Strip on the last two is the amount of interest that you save each month as time goes on.


When you pay down interest early on, things change like so:


Paying things down late gives you something like this:

Now, the original posters were talking about applying extra money against the principal and calculating the interest saved as a percentage of that principal. So if I paid down 10k on a 6% mortgage with 10 years left, I'd basically be saving $600/year or $6000 in interest.

However, the graphs would seem to imply that something terribly different is going on here, I mean, you can only save chunks of the purple stuff and if you're paying down the mortgage later rather than sooner, there's a lot less purple stuff to save on.

Imagine it this way: say you took out 100k @ 10% for 10 years and made your regular monthly payments ($1321) for a full year. Then, magically at the end of the year you win the lottery and pay down the house in one swoop, how much would you pay? A quick run to my information source, indicates that you still owe $93.8k, you were going to pay $58.5k in interest on that mortgage, but you paid $9.7k in interest in the first year alone, the bank took 16.6% of the money you owed them in the first year. In fact, in the next year, they would've taken $9.1k which was 15.5% of what you owed them, or 18.6% of what was left. By the end of two years, they have 32% of what we owed them, that's 32% in only 20% of the time.

So let's back off and go to our equation. Both posters are saying: if I drop 10k on a 10% mortgage I'll get a return of 10% times the number of years, and I'm saying that the calculations are flawed. So we'll use the 100k @ 10% for 10 years example to make life easy, if I put down 10k, it will "earn" 1k/year. Let's say that I get to my final year and decide to put down the 10k. With 12 months to go, we've paid 57.7k out of 58.5k in interest and we owe 15k on the place.

Wait, hold on right there! we're supposed to save 1k in interest, but we don't even have that much owing in interest. If I put down my 10k, I'll still owe 5k on the house, but I won't have saved 1k in interest, there's not even 1k in interest to save! What if I do it the previous year? At this point I owe 28.6k on the house and I have 3k left in interest to pay. So now the model is telling me that I can save 2k (or 2/3 or the remaining interest) by paying 10k of the 28.6k principal that I still owe (or more than 1/3)?

If the numbers seem weird, it's b/c they are, I mean, they're clearly wrong. You're not going to save 66% of the interest over 2 years by paying down 35% of the principal, that's pretty clear.

What's going on here is equally clear, if you're at the end of the 10% mortgage, you're not actually paying 10%. In the last 2 years of the 100/10/10 example, you will normally pay 31k into the mortgage and only 2.3k will go towards interest, i.e.: you only pay 2.3k/28.6k or about 7.5% interest. If you're in the last year, that number drops to like 5.5%. Here's the "effective interest" chart:


At the start of year 2, the 100/10/10 mortgage owes 93.8k, but will only pay 9.1k, which is actually just under 10%. So where did the original posters go wrong? Well, you can't "save" 10% interest if you're only paying 7.5%. The other problem is that the 6% is relatively small, so it's easy to gloss over the math. In the 200k @ 6% for 25 examples (the first graphs), you're actually paying between 5.15 & 5.95% "effective interest" for the first 22 years, so you can basically just gloss over the number (even if it's wrong) b/c you're still within a percentage point. If interest rates go to 10%, then suddenly you're losing whole percentage points and the bad math becomes evident.

So after a few hours of number crunching, what do I think? Well, the basic premise of both posts is actually still good: where am I going to get better returns? And the simple answer is that all things equal you'll get better returns from whatever is paying/charging the higher "effective interest rates". (where the "effective" part is key)

However, right now, things are pretty muddled b/c today's interest rates are yesterday's mortgage rates. This is complicated by tax law. You see, in Canada, we get tax breaks for RRSP investments and in the US you get tax breaks for mortgage interest. So in Canada if you have room to contribute to your RRSP (they do have caps), then you actually get an immediate 20-40% return on putting the money in the RRSP. In the States you'll only get a tax break for a certain period at the beginning of the mortgage, and then the interest will become too small. All in, the numbers could really "go either way" so there's no clear winner.

Personally, I'd rather have the money in something liquid and diversify. "Cash is King" and your home isn't bringing in any cash (unless you're renting rooms). Give the cash to someone who can make you more cash and if you're still itching to pay down the home then use the income from that cash to help with payments. At least this way you're making and spending money rather than just spending it. That way you can redirect the cash flow if you need to.

Housing Market Woes?

In response to a MyMoneyBlog article.

There is a lot of stuff going on here.

OK, US median household income: right around the $45k range with about 1.4 income earners. A quick search brings up some median house sales numbers of around 220 to 250k. Interest rates are going up, 6.84% may be causing less house competition and the WSJ is writing articles about people losing their (150k) places. We're all talking about housing being kind of a giant bubble right now and we now have the wonder of the 50-year mortgage.

I mean 45k = $3750/month or about 3k after taxes. On this salary you have an allowance of maybe 1700/month for housing if you want to stretch it, especially if you plan to operate a car and still feed the family. Now really, between utilities, repairs, insurance and taxes, you're talking like 5-700/month, which leaves you with about 1000 for a mortgage.

Clearly, 1000k/month doesn't buy the median 220k home. So the median income does not safely buy the median home. Let me put this differently: average people cannot afford average homes.

Jonathan, I'm with JW here these numbers just don't look good. Obviously, as you've pointed out, housing cost increases are also coinciding with larger houses. Some markets (like Vancouver) actually have people taking "interest-only" mortgages (let's not even talk about that level of crazy). As you've also discussed, the inflation adjusted median income hasn't changed very much in 30 years. So technology may have provided us the means for somewhat larger houses, but I don't think that we've magically doubled our ability to make larger houses, people are just taking out 50-year mortgages instead.

So with all of this talk, maybe we're finally pushing the edge of the big bubble. I mean, check out this board, look at Red's example, people are in really deep and digging deeper b/c they don't know what they can afford. We all know people in too deep, heck we probably all know a dozen people in too deep and the american economy is sliding downwards. The market will only bear this hysteria for so long.

People will miss their payments, interest rates will rise, banks will foreclose record numbers (already happening?) and the value of homes will go downhill b/c nobody will be able to afford them.

There will be resistance of course, people will avoid selling for less than they owe, but then the foreclosures will come, rates will go up and the cycle will continue until those people that really can't afford homes will be shoved out. Banks don't care, it's not their job and the US government can't stpe in. If the US government intervenes in foreclosures, then USD will plummet internationally.

Either way Jonathan, I'm with JW here when it comes to buying, patience will definitely be a virtue b/c we're peaking here.