October 29, 2018 by Ivan V. Sichkar
There are many reasons for owning a home, but making money on your real estate purchase should not be your main reason to buy. In some cases, owning a home can be more expensive than renting one. Owning a home for 7 years or less can be described as renting from a bank. The monthly payments that you will make to own a home will be like renting one, and you will likely have a negative return on the investment. With the increase in interest rates, the new 2018 tax reforms, and increase in home prices, owning a home became less profitable than before. You may pay more money to own a house than you would to rent one.
Owning a house may not provide you with a significant tax benefit as it used to. The new 2018 tax reform increased the standard deduction from $6,350 to $12,000 for individual or from $12,700 to $24,000 for married couple (IRS.com). For example, the interest payment on $240,000 30-year mortgage with 5% interest will be $11,920 for the first year (see table 1). That is below the standard deduction for individual. Let’s look at another more speculative home purchase with zero down payment and 6% total interest rate. If you take $309,000 30-year mortgage with 6% interest, your interest rate will be $18,437 for the first year (see table 1). Standard deduction for a married couple filing jointly is still greater than the interest paid to the bank during the first year. Depending on your personal tax situation, you may not be able to deduct any of the interest paid for the mortgage any more.
The four hypothetical examples bellow are based on the following information:
- $300,000 purchase price of a house
- $9,000 closing costs
- 30 Year fixed mortgage
- Interest Rate of 5% with 20% down payment
- Interest Rate of 6% with PMI insurance and zero down payment
- Time horizon 7 or 30 years after which a house is sold
- 6% real estate sale commission
- No tax benefit from owning a home due to increase in standard deduction in 2018
- $50 monthly HOA fee adjusted annually to reflect house price changes or inflation
- $2,100 annual property tax adjusted annually to reflect house price changes or inflation
- $1,750 annual home insurance adjusted annually to reflect house price changes or inflation
- Since I do not know where home prices will be in the future. I will analyze six potential outcomes for home price appreciation or depreciation over the holding period: 4%, 3%, 2%, 1%, 0%, and -1% per year
Let’s look at the hypothetical scenario number one. You are purchasing a house for $300,000 with zero down payment. After adding $9,000 in closing costs, your total mortgage will be $309,000. The interest rate at the time of purchase is 5%. After adding the PMI insurance, your interest rate will be 6%. You intend to live at this house for 7 years.
The investment return on your home purchase will depend on what your house will be worth in 7 years. I will analyze six different outcomes based on how much your house prices may change in the next 7 years: 4%, 3%, 2%, 1%, 0%, and -1% per year. The best outcome is when your house appreciates by 4% per year for the next 7 years. In this case, you will lose $92,315.62 total or $1099 per month (see table 2). The worst hypothetical case scenario is when the house price declines by 1% per year for the next 7 years. In this worst case, home owner will lose $196,257.12 total or $2,336.39 per month. If you intend to own a house for 7 years only with no money down, your monthly cost of home ownership will be between $1099 and $2,336 (see table 2). You may pay more for owning a house than for renting one. Owning a house for the first 7 years or less can be interpreted as renting a house from the bank.
The second hypothetical scenario has the same purchase price of $300,000 with the time horizon of 7 years and 20% down payment (see Table 3). If you put 20% down payment and finance the remaining $240,000 with 5% mortgage, you will expect to lose between $48,001 and $151,943.36 over 7-year time period. These losses translate to the monthly cost of home ownership between $571.45 and $1,808.85. Having a down payment helps to lower potential losses significantly and to have lower cost of living. However, you are still going to lose money in this example.
The third hypothetical scenario extends time horizon from 7 years to 30 years. In this example, you purchase $300,000 home with zero down payment and $9,000 closing costs. Your mortgage is $309,000 at 5% 30-year fixed with PMI Insurance of 1%. Your potential total net gain over 30 years is between positive $56,405 and negative $532,422 (see table 4). This translates to the monthly cost of home ownership between positive $156.68 and negative $1,478.95 per month. So, in the best case scenario with 4% annual home price appreciation, it is like you are being paid $156.68 to live in the house. However, the distribution of potential outcomes is negatively skewed. There is a greater chance to have a negative return on the purchase of the house over 30-year time horizon.
The forth hypothetical scenario is the most favorable to home buyers. In this example, you purchase the same $300,000 home but you are also making 20% down payment. Your mortgage is $240,000 financed at 5% over 30 years. Your potential total net gain over 30 years is between positive $163,092.96 and negative $425,735 (see table 5). Having enough money to put 20% down payment helps lower the cost of home ownership significantly. However, the distribution of potential outcomes is still negatively skewed. Home owner remains exposed to the risk of home price decline and potential losses of $425,735 over 30 years (see table 5).
Home ownership today is a new home renting from the bank. Instead of paying rent to a leasing company, you pay: mortgage, taxes, HOA fee, and sale commissions. Recent increase in home prices, increase in the interest rate and changes in the tax code made home ownership less attractive from the financial stand point. In addition, home owners take on real estate price risk. By borrowing money to buy an expensive house, home owners have a highly leveraged investment subject to real estate price decline. You should have other reasons besides financial to purchase a house. These reasons are starting a family and having children, preference for a more comfortable and bigger space, be able to customize the place for your specific needs. If you still decide to purchase a house after reading this article, you should follow these recommendations: stay in the same home for longer than 7 years, pay off your mortgage early, save for 20% down payment, buy the place you truly love, and be ready to take on potential decline in real estate prices.
The analysis of a housing market is based on hypothetical scenarios and future expectations that may not be correct. This paper was written as an opinion only. The data is not guaranteed to be accurate or complete. Please consult with your financial advisor and accountant before making an investment decision.